How Canada Post is Reducing Risk through Innovation

At the end of 2022, the Canada Post pension plan joined the growing list of pension funds across the country whose highly funded status has caused the regulator to instruct a mandatory ‘contribution holiday’. The transition has significant implications for the investment approach, bringing advantages as well as challenges.

Michael Butera
Vice President and Chief Investment Officer, Canada Post Pension Plan

Thanks to a combination of strong investment returns and the liability-dampening effect of higher interest rates, this pension scheme–with assets currently in excess of 30 billion Canadian dollars–now has a substantial wind-up surplus. As such, the team’s attention has shifted towards delivering moderate-and-steady returns with an eye on volatility reduction.

“In the past, we were always about getting high returns on a risk-adjusted basis,” explains Chief Investment Officer Michael Butera in a detailed interview below. “Now, we can take a step back and focus on managing our risks within an asset/liability framework.” This adjustment has involved several significant investment shifts during Butera’s first year as CIO – shifts that have, no doubt, been facilitated by Butera’s own long-standing tenure; he has worked at the plan since its inception 22 years ago, including a stint as interim CIO during the Covid-19 period.

One key challenge in this new phase is the reduction in the plan’s liquidity caused by the required pause in contributions. The plan needs CAD 100 million of cash each month to pay pensions – which are 100% indexed to inflation (a notable issue in itself, Butera notes, particularly in light of the government’s decision to stop issuing real return bonds). Further liquidity is also required to fund increasingly large capital calls in private markets and to run the bond overlay and currency management programs.

Investor Spotlight recently sat down with Butera to find out more.

Q: How has your investment strategy evolved recently?

Right now, we have a large wind-up surplus in the plan thanks to recent interest rate rises as well as good returns over the last five-to-ten years. The surplus means that, as instructed by our regulator (OSFI), we have to stop making employer contributions. This is creating some immediate liquidity challenges: we need to make sure that we have enough cash to make pension payments and enough of a cash buffer in our collateral management account to meet collateral demands. We saw what happened to UK pension funds last year in that area and certainly don’t want to experience similar difficulties.

We don’t need huge returns now: we want decent singles, not home runs. That’s a change of focus: in the past we were always about getting high returns on a risk-adjusted basis. Now, we can take a step back and focus on managing our risks within an asset/liability framework.

This has implications for several areas. In our alternative investments, for example, we don’t have to do the co-investments and direct investments that we’ve done in the past: we can scale that back and just invest in funds. We’re implementing an equity hedge to manage our tail risks and dampen significant drawdowns in stock markets. We’ve also implemented a bond overlay to increase our interest rate hedge ratio. On the equity side, we’re moving towards a less concentrated portfolio with fewer managers with concentrated portfolios and a more global emphasis; we don’t mind if we don’t get a lot of upside capture. In fixed income, we’ve scaled back investing in high yield bonds. Looking ahead, we may make further changes: for example, we might look at trend-following strategies or other hedge fund types that would dampen our equity risk exposure.

Q: The surplus means you’ve had to stop making employer contributions. Tell us more – how does that work, and what are the implications of that change in your liquidity profile?

There are two metrics involved when deciding whether contributions should stop. The first is that the plan has to be a ‘going concern’ – more than 125% solvent (we’re at 130%). The second is whether the plan has enough money to pay pensioners, with future Indexation, if Canada Post ceased to be – a funding ratio of over 105% (we’re at 110%). As such, the suspension of contributions kicked in at year end.

More and more plans in Canada are encountering this question: when contributions are reduced, what should we do about liquidity?

More and more plans in Canada are encountering this question: when contributions are reduced, what should we do about liquidity? There are various demands. Our pension payments are about $100 million per month, which is quite high. On the investment side, we need liquidity to fund capital calls in private markets (which are getting larger) and we need to run our bond overlay and currency management effectively. We do have a cash buffer in place: if we had a UK-style event, we should be able to cope.

Our operations team and risk team are looking at the liquidity issue more closely. We’ve developed a liquidity coverage ratio (LCR) and look very closely at it on a monthly basis: this takes into account the securities that we could sell and makes conservative assumptions – for example, we assume we could only sell half of our long bond portfolio. Going forward, it might be helpful for us to find managers or strategies that can support these liquidity issues.

We try to approach the cash position in a strategic way. For example, if we know we’ll need liquidity for a specific investment in a number of weeks then we aim to opportunistically sell securities during rising markets before we actually need the cash: we look for rising markets over a ten-day period, for example, and as they occur, we sell securities.

Q: In view of the changed liquidity circumstances, will you be pulling back a bit on your exposure to private market investments?

No. In infrastructure and private equity, we still have a 3% buffer before we reach our target of a 10% allocation and we do still want to get to that level, and with real estate we are almost at our target allocation of 15%. And I find that whenever you have a challenging period, such as the year 2022, the following year tends to be very good for private markets. We also see that other investors are selling out of private markets to get back to their policy allocation levels, which gives us an opportunity to see some interesting deals from motivated sellers on the secondaries side.

We see that other investors are selling out of private markets to get back to their policy allocation levels, which gives us an opportunity to see some interesting deals from motivated sellers on the secondaries side.

That being said, building up our allocation to private equity and infrastructure has slowed down. Right now, the funds we’ve allocated to aren’t deploying as fast as we’d have expected: the market has quieted down somewhat; it seems to be in ‘price discovery’ mode, with sellers wanting a price and buyers wanting to pay a different price, so there are fewer deals happening.

Q: Equity risk overlays can be challenging to understand and implement. How did you get everyone on board?

We’re fortunate to have a very experienced investment advisory committee of investment professionals with a lot of experience, but they’re not necessarily fully knowledgeable of the details of this topic. We arranged an educational session for them with bfinance and a follow-up session on this subject which was well received. The strategy we’ve put in place means that we won’t get much protection if equity markets go down gradually – i.e. if there isn’t a big change between spot and forward markets. It needs a big change in volatility—up or down—to have a pay-out. Education helped them to get comfortable with that.

It can be challenging to hold onto overlays. You need to be disciplined and committed to the approach. While you’re waiting for falling markets and rising volatility, you’re paying a ‘cost’ that is very visible – and this “bleed” can run for several years of benign markets. But the worst strategy would be to take that protection down after a couple of years.

Now that we’ve worked out the overlay side of things, we’re thinking about other strategies that can give that ‘convex’ pay-off when equities do poorly. We may look at trend-following strategies (e.g. CTAs) or other hedge fund type approaches; we might look at some commodity exposure. Hedge funds could be viewed alongside the bond overlay and the equity hedge – essentially, we’d like to look at anything that dampens our volatility and could offer some valuable convex payouts at the total fund level, not just at on asset-only side but in the asset-liability space.

Our biggest fear as a plan is any kind of decline in interest rates. You could see a scenario where we have a financial or economic calamity and equities get hit hard, and then central banks lower rates.

Q: Can you talk us through the bond overlay program?

Our biggest fear as a plan is any kind of decline in interest rates. You could see a scenario where we have a financial or economic calamity and equities get hit hard, and then central banks lower rates, which means that our liabilities would go up. That’s the biggest concern for us.

When we were about 90% and 85% funded, we held off on implementing a bond overlay, though we faced some pressure on this subject. We put it on in early 2022, as soon as rates started going up. Today we have a 50% interest hedge ratio. (It’s worth mentioning that if we hadn’t put it on at all we’d have an even higher surplus than we do now!) We manage it dynamically, adjusting it depending on where rates and yields are at the time.

Q: Can you talk us through the bond overlay program?

This is absolutely crucial for us. Our benefits are 100% indexed to inflation: unlike some other plans there’s no conditionality; it’s required. Right now, 15% of our fund is in Canadian real return bonds — inflation-indexed bonds. But the government of Canada is stopping the issuance of those bonds. This is a problem for us: we like them, we’d like to buy more. We may have to look at the US TIPS market, which is linked to US inflation: this is not the same as Canada, and there’s currency risk, but it’s something to explore. We’ve got a couple of people on our fixed income team and others looking at the TIPS market.

Right now, 15% of our fund is in Canadian real return bonds — inflation-indexed bonds. But the government of Canada is stopping the issuance of those bonds.

We do also get inflation sensitivity from infrastructure and, to some extent, from real estate. But it’s not necessarily straightforward. In infrastructure, inflation linkages are written into contracts and holding up well, though it’s possible that the government entity could potentially alter the rules. In real estate, however, we’ll have to see: will they actually be able to collect more in rents, especially in office (the most uncertain, I think) and retail? We’re likely to increase our allocation to infrastructure—more so than to private equity—and inflation sensitivity is definitely a factor in this. We’re interested in seeing whether managers can develop strategies with payouts that rise along with inflation.

bfinance would like to thank Michael Butera and the team at Canada Post pension plan for sharing insights with the investment community.