Managing Balance Sheet Risk: Do Pension Funds Know What They Are Doing?
“No pension fund can achieve a 4% average real return in the long run without assuming a certain amount of properly calibrated and well-diversified risk.”
BANK OF CANADA STUDYIJUNE 2016
Balance Sheet Leverage: Good, Bad, or the Wrong Question?
The just-released 2016 Annual Report of the Healthcare of Ontario Pension Plan (HOOPP) states that its year-end gross plan assets were $164 billion versus gross plan liabilities of $148 billion. However, its net plan assets were only $70 billion versus pension liabilities of $54 billion. The implication is that HOOPP carried an additional $94 billion in asset positions on its books funded by $94 billion of payment obligations owed to third parties. Using standard finance terminology, the leverage ratio of HOOPP’s balance sheet on December 31 was 2.3x (i.e., $164B/$70B).
How should we think about a leverage ratio of 2.3x? Is it good, bad, or the wrong question? The short answer is: ‘if the focus of the question is understanding, assessing, and managing HOOPP’s (or any other pension plan’s) balance sheet risk exposure, it is the wrong question’. If leverage ratio questions are beside the point, what kind of questions are on point? And what do we know about the answers? Further, what do the answers tell us about how well pension funds are managing balance sheet risk? The goal of this Letter is to address these questions.