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Ontario Teachers Pension Plan Board: The asset allocation decision

We have been requested to help William Booth, a member of the management team of the Ontario Teachers' Pension Plan Board (OTPPB), re-examine the diversification strategy that the fund had been pursuing since its inception to the present date (early 1994) and to determine an optimal longterm asset allocation policy for the fund. Of primary concern is to determine whether the shift in asset mix should stop at 66 per cent equity and real estate in 1995, which was above the allocation to equities for the average Canadian pension plan, or whether it should continue to some higher amount. What will follow is a detailed analysis followed by our recommendation.
Brief History

The Ontario Teachers' Pension Plan was a defined benefit plan with both the Province and teachers contributing equally. Benefits were calculated as two per cent of the average annual salary (calculated using the five highest annual earning years) multiplied by the number of years in service. Benefits were then indexed to inflation at 100 per cent of the increase in the Consumer Price Index (CPI). The fund contained well over $30 billion in assets (ranked as the largest funded pension plan in Canada) and 200,000 members. Since its inception, the OTPPB's returns had averaged almost 14 per cent (5.6 per cent in 1990, 19.6 per cent in 1991, 8.9 per cent in 1992 and 21.7 per cent in 1993).

Objectives

A six-step process was used: 1. The primary objective of the fund manager is to Secure and deliver expected benefits at current or lower levels of contribution (as a percentage of earnings) within an acceptable range of costs (i.e., contribution rates). This meant that: Contributions + Investment Returns >= Liabilities (Benefits) or PV [Available Funds] >= PV [Benefits (net of contributions)] The OTPPB had an explicit target to obtain a minimum real (i.e., adjusted for inflation) rate of return of 4.5 per cent on the overall portfolio on a four-year moving average basis. The current debentures held in the portfolio, however, continued to be non-marketable and would have to be held until maturity (the last debenture matured in 2012). 2. Identification of three key financial risks facing the plan: a. short-term volatility real rates of return b. long-term potential decline in real rates of return and

c. unexpected increases in teachers' real salaries 3. Revision of the historical performance of three key economic variables a. Inflation b. Equity returns c. Interest rates 4. Evaluation of the impact of alternative asset allocations in an "asset only" risk/reward framework. The asset classes constituted the following: a. North American Equities b. Small Cap Equities c. International (E.A.F.E.) Equities d. Real Estate e. Canadian Mid-Term Bonds f. Canadian Long-Term Bonds g. International Bonds h. Cash/Short-Term Securities (T-Bills) 5. Evaluation of the impact of alternative asset allocations in an "asset/liability" framework. 6. Finally, a recommendation for an optimal long-term asset allocation and the evaluation of the impact of alternative transition scenarios.

The following issues must be addressed: Determine whether the shift in asset mix should stop at 66 per cent equity in 1995 or continue to higher amount (80%) Within equities, whether allocation between Canada and other countries was appropriate Whether to increase RRB allocation and if so, what asset class would be reduced Whether leeway should be allowed around equity targets Determine how to allocate assets within each asset class Determine how varying some of the assumptions used in 1991 analysis would have affected the conclusion Determine an appropriate risk measure for the pension plan o The average Canadian pension plan has an associated risk measure (standard deviation) of 11.52% o The current asset allocation (1993) has a standard deviation of 10.88% o Standard deviation of Interim Policy is 12.14% o

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