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Microsoft Word - 9b01N008 S w 9B01N008 “TIMBER!”: ONTARIO TEACHERS’ PENSION PLAN BOARD CONSIDERS AN ALTERNATIVE INVESTMENT CLASS Farzin Afshar prepared this case under the supervision of Professor Stephen R. Foerster solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail
[email protected]. Copyright © 2001, Ivey Management Services Version: (A) 2010-01-05 In September 2000, Barbara Zvan, director, research and economics department of the Ontario Teachers’ Pension Plan Board (OTPPB) was preparing an analysis for presentation to the board of directors concerning the possible investment in a new “alternative” asset class: timberland. Timberland investments were like investing in a “tree factory” and represented a unique opportunity to diversify the fund. However, current North American institutional investment in timberland was only $12 billion, a tiny fraction of institutional investment in other “traditional” asset classes such as equities and fixed income securities. There were also numerous problems in attempting to measure the potential returns and risks associated with such an investment. Zvan needed to present a complete picture of both the pros and cons associated with timberland investments and ultimately recommend whether such an investment was worth considering, if so, how it would be implemented, and, if not, what OTTPB should consider in order to achieve the objectives set out in the fund’s investment policy statement. PENSION PLANS IN NORTH AMERICA In 1875, the American Express Company established the first private pension plan in the United States, and shortly thereafter, utilities, banking and manufacturing companies also began to provide pension plans. By 2000, there were more than 44,000 private defined benefit pension plans in the United States, where the top 100 (1,000) funds held around $3.1 trillion ($5 trillion). In Canada, by 1998, there were more than five million employees that belonged to an employer-sponsored or union-sponsored pension plan. The total assets of these plans exceeded $670 billion, much greater that those of the public Canada and Quebec Pension Plans and individual registered savings plans combined (see Exhibit 1 for a list of the top 10 pension funds in the United States and Exhibit 2 for a list of the top 10 pension funds in Canada). Pension funds were classified into two major groups: defined benefit plans and defined contribution (or money purchase) plans. Under a defined benefit plan, the employee’s after-retirement benefit entitlements were defined by a formula. The benefits were calculated as a percentage of the employee’s average compensation over his or her entire service or a particular number of years, or both. The amount of Au th or iz ed fo r u se o nl y in th e co ur se B U SI 44 05 P or tfo lio a nd In ve st m en t a nd B U SI 47 01 S tra te gi c M an ag m en et a t U ni ve rs ity o f O nt ar io In st itu te o f T ec hn ol og y ta ug ht b y Be lin da B am br ic k fr om J an 1 1, 2 02 1 to A pr 1 2, 2 02 1. U se o ut si de th es e pa ra m et er s is a c op yr ig ht v io la tio n. Page 2 9B01N008 benefits was either specified or could be calculated in accordance with a set formula based on various factors such as age, earnings and service. The amount of annual contributions needed to provide the specified benefits could be estimated actuarially. Since this type of pension was managed and maintained as a group, no individual accounts were maintained. Fund managers were legally obliged to ensure benefits for future retirees, thus, the asset mix and investment strategies were adopted in such a way that this obligation would be met. Defined benefit plans were subject to government regulation and laws. In a defined contribution plan, the benefit was based on the fund amount built up by plan members’ and employers’ contributions and by the investment earnings of the assets in the fund. The plan specified the contributions paid by and on behalf of each member, rather than a formula for the amount of pension. The contributions were attributed to each individual and accumulated with interest or earnings. The pension was based on the amount these contributions would provide at retirement, typically through an annuity. Most of the early pension plans were defined benefit plans that paid workers specific monthly benefits at retirement, funded entirely by employers. By 2000, in the United States 81 per cent of pension fund asset were in defined benefit plans and 19 per cent were in defined contribution plans. Over the years, the North American pension investment strategies had become more sophisticated and had diversified into more return-enhancing asset classes. In 1999, on average, pension funds in North America held about 60 per cent to 65 per cent in equity investments. Investments in emerging markets, venture capital, private equity and derivatives were becoming mainstream in the pension industry. Exhibit 3 indicates the asset mix of the top 100 Canadian pension funds. ONTARIO TEACHERS’ PENSION PLAN A pension plan was first established for Ontario teachers in 1917. By 2000, the Ontario Teachers’ Pension Plan Board was responsible for the retirement income of approximately 153,000 elementary and secondary school teachers, 77,000 retired teachers and their survivors, and 92,000 former teachers with money in the plan. The plan was sponsored by a partnership between the Ontario government and the plan members, who were represented by the Ontario Teachers’ Federation. Until 1990, the plan was restricted to investing in non-marketable Government of Ontario debentures. In 1989, however, an actuarial assessment of the fund determined that the funding of the plan was in jeopardy. The report indicated that the value of the liabilities exceeded the value of assets (about $20 billion) by about $8 billion. In 1990, the Ontario government created the Ontario Teachers’ Pension Plan Board with full authority to invest all assets, administer the pension plan, and pay members and their survivors the benefits promised. The pension board had the fiduciary duty to administer the plan and to manage the investment fund in the best interests of present and future plan members and their survivors. A nine-member board of directors had been appointed equally by the partners to govern the plan; further, the board delegated the day-to-day management to a chief executive officer and his staff.1 By the end of 1999, the OTPPB merchant banking group had generated a 25.6 per cent annual compounded rate of return since its inception in 1992. The merchant banking activities consisted of equity and mezzanine capital investments in businesses of all sizes in a wide range of industries. More than $3.1 1See “Ontario Teachers’ Pension Plan Board: The Asset Allocation Decision,” Richard Ivey School of Business Case 9A97N003, for an examination of the initial asset allocation decisions. Au th or iz ed fo r u se o nl y in th e co ur se B U SI 44 05 P or tfo lio a nd In ve st m en t a nd B U SI 47 01 S tra te gi c M an ag m en et a t U ni ve rs ity o f O nt ar io In st itu te o f T ec hn ol og y ta ug ht b y Be lin da B am br ic k fr om J an 1 1, 2 02 1 to A pr 1 2, 2 02 1. U se o ut si de th es e pa ra m et er s is a c op yr ig ht v io la tio n. Page 3 9B01N008 billion was invested in 83 corporations. The plan also launched a venture capital fund in 1997 to invest equity in early-stage enterprises primarily in the technology and biotechnology sectors. More than $300 million was allocated to 24 North American early-stage companies directly or in partnership with other venture capital firms. As a result of a progressive investment strategy, the plan had a surplus of $8.9 billion as of December 31, 1999. However, the risk of surplus loss was the plan’s biggest fund concern. A steady surplus was needed to avoid any future needs for an increase in contribution rates (currently eight per cent for employees with a matching amount contributed on behalf of Ontario district school boards). One major concern was that pushing higher long-term surplus growth through active management could lead to short-term surplus losses and a rise in contribution rates. The surplus risk was managed using a value at risk (VaR) methodology.2 Value at risk was basically a measure of the potential change in value of a portfolio of financial assets with a given probability over some predetermined time. For example,