Ontario Teacher’s Pension Plan Essay

Ontario Teacher’s Pension Plan Board: Hedging Foreign Currency Exposure Ontario Teacher’s Pension Plan Board: Hedging Foreign Currency Exposure Issue Identification The Ontario Teacher’s Pension Plan (OTPP) is a defined contribution plan that was created in 1917 to provide and administer a pension plan for Ontario school teachers. Sponsored by the Ontario Government and the Ontario Teacher’s Federation, the plan currently supports 343,000 teachers, former teachers and pensioners. The recent government decision to eliminate the 30% constraint on foreign investments and the increased volatility in the currency market has prompted the OTPP Investment Committee to address the following: 1. Whether to continue the International Equity Swap Program 2. Whether to administer changes to the Foreign Exchange Hedging Policy Goals and Objectives In order to come to a decision, it is necessary that any solution put forth must align with the goals and objectives of the fund. OTPP is a long-term fund determined to minimize risk, costs and the additional contributions required to fund the plan while maximizing its returns. OTPP Investment Strategy In the early 1990’s the OTPP board realized that it was essential to begin investing abroad to diversify risk and to capitalize on international opportunities to achieve greater returns, given the size of the fund. However, it was not until 1996 that the Foreign Exchange Hedge Program (FX Hedge Program) was implemented in response to a significant rise in currency exposure. As the fund faced increased foreign currency risk, risk management became essential and thus, a hedging policy of 50% of its foreign currency exposure was introduced. Due to the fact that OTPP has a continual commitment in supporting its pensioners, it must expose itself to limited risk and effectively hedge against any unexpected changes in its investments. Hence, a conservative policy of hedging 50% of foreign exchange exposure was enforced. Additionally, the International Equity Swap Program (IE Swap Program) was implemented as a solution to the government restriction of 30% ownership of foreign investments. Since most assets were tied up in non-marketable Ontario Debentures, a swap program enabled OTPP to reallocate its assets. OTPP Performance Evaluation The strategic decision to diversify beyond Canada and into global markets has proved to be beneficial to the OTPP investment portfolio. It has contributed substantial value to the fund over the 10 year period (1995-2005) by reducing potential losses, since five of the six foreign currencies appreciated against the Canadian dollar. For the past 15 years, OTPP investments have also consistently outperformed the benchmark rate of returns, generating a 10-year average rate of return of 11. 4% and a gross return of $15. billion over benchmark returns. Despite the portfolio’s negative rate of returns in 2001-2002, it has still produced considerable investment growth in relation to the benchmark, demonstrating the strength of OTPP’s investment policies in risk management. However, since interest rates have declined by approximately 3% (1990-2004), the value of the pension fund has increased. This has resulted in larger amount of payments made to pen sioners. Additionally, the demographics of the OTPP plan membership have changed significantly over the past 30 years. The ratio of active members per retiree has decreased from 10:1 in the 1970s to the present ratio of 1. 6:1. Moreover, the expected years retirees rely on the pension have also increased to 29 years. All these factors have exerted a great deal of pressure on the pension plan to sustain its funding with contributions from fewer working teachers. With the foreign currency market being increasingly volatile, OTPP is concerned regarding its future ability to support pension payments. Decision Criteria The Investment Committee must consider the following criteria when deciding whether to implement changes to the International Equity Swap Program and Foreign Exchange Hedging Policy: the fund’s exposure to foreign exchange risk, transaction costs, and an alignment of goals and objectives of the fund. Alternative: Although OTPP has performed well in the past, the future outlook of the pension plan remains uncertain. Therefore, OTPP has four alternatives to the future direction of the fund. OTPP can continue or discontinue the IE Swap Program and maintain or revise the current 50% FX Hedge Policy. Continue/Discontinue the Swap Program Previously, the swap program was used as a means to bypass the government restriction on foreign investment. With the regulation being lifted, OTPP has to now evaluate whether the swap program remains necessary. The program has allowed OTPP to reallocate their assets cost-effectively as it eliminates OTPP’s cost of transacting directly in foreign exchange market. Moreover, since OTPP does not gain ownership of the securities, it has reduced the amount of cash required and limited its risk by transferring the risk to counter-parties (UBS, Credit Suisse, JP Morgan, etc. ).