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Pensions face repercussions from government bond program cancellation

End of real return bonds will weaken the ability of pension plans to accurately assess whether they can meet their long-term obligations

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The federal government’s decision to stop issuing real return bonds last month was “poorly thought out” and will weaken the ability of pension plans to accurately assess whether they can meet their long-term obligations, said Wayne Kozun, former senior vice-president of fixed income and alternative investments at the Ontario Teachers Pension Plan Board.

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Kozun, who was at Teachers for 11 years, and is now chief investment officer at Forthlane Partners, said the long-term inflation-linked bond rate was used by actuaries at Teachers “as one of the key inputs” for the plan’s discount rate, a key measure used to calculate the present value, or current cost, of future pension obligations.

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With real return bonds now poised to run off, pension plan actuaries will need to turn to less precise alternative metrics such as applying the difference between Canadian and U.S. interest rates on nominal bonds to U.S. inflation-linked bonds, he said.

“Having that inflation-linked bond, or real return bond, gave them sort of the pillar on which to begin building their discount calculation, and the reason you calculate that is because you want to know how much money you have today to pay pensions” in the future, said Kozun.

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This present value of the pension liabilities is compared to assets to determine whether the plan is solvent or not. Without the key metric of real return bonds, he said, “there would be a loss in the quality of the estimate that you would get or what the proper discount rate is.”

Kozun, who was senior vice-president of fixed income and alternative investments at Teachers’ from 2013 to 2016, said Canada was a leader in issuing the inflation-linked real return bonds beginning in 1991, the same year the Bank of Canada committed to aiming for a rate of inflation between one and three per cent. For pension plans with long-term liabilities — future payouts to pensioners — linked to the consumer price index, the bonds proved popular because they provide protection against future inflation. Canada now stands alone among G7 countries in abandoning them.

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Last month, the government said the Department of Finance and Bank of Canada had conducted 25 bilateral meetings with market participants in September and October, and received written comments from them about the design and operation of the domestic debt program, before it decided to stop issuing the real return bonds (RRBs).

But a growing list of institutional investors including senior executives and directors at large Canadian pension funds have said they were caught off guard by the decision and are calling on the government to reconsider.

Jim Keohane, a veteran pension executive and director at Alberta Investment Management Corp. (AIMCo), said earlier this week that government’s rationale — that there is low demand or lack of liquidity in the bonds — doesn’t make sense because longterm investors like pension funds and insurers tend to buy and hold the bonds rather than trade them.

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And Bert Clark, chief executive of the Investment Management Corporation of Ontario (IMCO), which manages more than $70 billion of assets for public-sector clients in Canada’s largest province, said in an interview Monday that his organization owns real-return bonds and that he was surprised by the government’s declaration that it would no longer issue them. Clark said he hopes the decision will be reconsidered.

Senator Clément Gignac, an economist and former Quebec cabinet minister, has called on Finance Minister Chrystia Freeland and the Department of Finance to conduct “a ‘real’ and broad consultation,” and said Monday that he intends to keep the pressure on and hopes the government will reconsider the bond decision in the new year.

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Malcolm Hamilton, a senior fellow with the C.D. Howe Institute and retired pension actuary who advised large plans in the public and private sectors for more than 30 years, said a consequence of discontinuing the issuance of new real return bonds is that it will leave the market for previously issued RRBs intact and largely in the hands of public sector pensions and the central bank — the latter of which he said is a “reasonably active buyer and seller” of  real return bonds.

“The market will gradually shrink, become less liquid and be more easily manipulated by the Bank of Canada and a few large public sector pension funds,” Hamilton said. “Is this a good thing? Probably not.”

He said he is not surprised the government is looking at ways to lower its financing costs, and real return bonds carry additional debt-servicing costs when inflation rises.

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“Canadian governments are heavily indebted. They cannot afford high real interest rates,” Hamilton said, adding that “the story is not much different (than) for homeowners.”

A National Bank of Canada economics report last month said there had been “particularly hefty inflation adjustments this year” for real return bonds. The report gave an “ultra simple” example where inflation running even one percentage point above the target or expected rate “now adds almost $700 million to Canada’s inflation-adjusted debt stock.”

Hamilton said assumptions about inflation rates made by pension funds such as Ontario Teachers are influenced by the difference between the yield on long-term nominal bonds and the yield on long-term real return bonds — known as the break-even rate.

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“It is a bit of a stretch to view the real yield as a market interest rate as opposed to an interest rate actively managed by the central rate,” given the participation of the Bank of Canada, he said. “But it was all we had and better than nothing.”

A spokesperson for Teachers declined to comment on the government’s cancellation of the real return bond program.

Keith Ambachtscheer, a pension expert and founder of KPA Advisory Services, said there will be no immediate impact for pension funds that rely on real return bonds because the bonds they buy tend to have very long terms of up to 30 years. As a result, there is time for the funds to consider alternative inflation hedges, such as investments in real estate, infrastructure, or commodities.

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The government has been issuing about $1.5 billion in real return bonds annually for the past couple of years, representing about one per cent of total bond issuance, according to the Nov. 10 economic report from National Bank. Though that’s a bit lower than prior years, the report said the government’s decision to abandon real return bonds “at this point in the economic cycle raises unnecessary questions about Canada’s commitment to fighting surging inflation.”

The government’s decision came under fire last month from a group of institutional fixed-income investors who are members of Canadian Fixed-Income Forum, which is overseen by the Bank of Canada.  But their views, which included disagreeing with the government’s reasons for ending the program, only became public Dec. 16 when minutes of a Nov. 29 meeting were published on the Bank of Canada website.

The 15-member group includes representatives from Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Bank of America, the Health care of Ontario Pension Plan (HOOPP) and Canadian National Railway Co.’s investing division.

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