ED HARRISON: Hi, I'm Ed Harrison here in Toronto for Real Vision. I'm talking to Jim Keohane, he's the president and CEO of the Healthcare of Ontario Pension Plan. Jim, it's great to have you.
JIM KEOHANE: Oh, thanks for having me.
ED HARRISON: I think, when I spoke to you yesterday about this interview, and what I was telling you is that our co-founder and CEO, Raoul Pal, he has a big issue with regard to retirement. And I think it's driven from a personal perspective. He saw what happened to his father's pensions in 2008, and his savings.
And he really thinks that this is a big issue, especially from a demographic perspective, and that, in terms of the democratization of financial information, which he's a big advocate of, he wants to start a series talking about best practices in the industry, Canada being a place where they have them. What we can do to make our retirements better.
Before we get into all of that, let me ask you about your own personal career. Because you are about to retire next month as CEO and president. And you've been at the company now for over 20 years. Tell me about the transition from where you were, which was Merrill Lynch and Wall Street banking, to the pension company.
JIM KEOHANE: Yeah. So actually, I worked at several Wall Street firms, Merrill Lynch being one of them. But actually, the last one was Deutsche Bank, which you mentioned. You worked there yourself. I had an opportunity to come to the pension plan. And at the time, I could see a few things. I mean, there was a shift in-- I think, in power from the dealers. You could see that pension funds are getting very large pools of capital and that's where you wanted to be.
But also, there's a big difference, I mean, in terms of-- I mean, I've found that since I've got there, I mean, when you work at investment banks, I mean, I was doing proprietary trading. Which, today, would be done in the hedge fund world, so when you worked at an investment bank, you're as good as your last trade. If you got a good trade, you continued to work there. If you didn't, I mean, maybe they'd show you the door.
So there was no loyalty given to the employees, and the employees showed no loyalties to the employer. And so it's a bit of a toxic environment. And what it was all about was, if I make a certain amount of money, I may get a percentage of it in my pocket. And that was as far as it went. And also, it really didn't, after a while, it doesn't get you out of bed in the morning. It doesn't really motivate you to continue to work.
Whereas when I got to Hoop, it was a very different environment in a sense of, what we do really makes a difference in people's lives. And it's very tangible. And you actually meet the pensioners in particular, I mean, they're extremely thankful that they've been in the plan, and they're very grateful for what we do for them. So we allow them to retire in dignity with a stable financial future going forward. So people are extremely appreciative of that.
So what we do I think is very important to our members and it's very important to society. So that really is a good motivator to get you to come in and do your job every day as well as you can because it does make a big difference to those people.
ED HARRISON: Yeah, and what you're saying reminds me that we should definitely talk about defined benefit versus defined contribution here, because that's a big part of it in terms of giving people a safety net. This is how much income I'm going to get, irrespective of how long I live for the rest of my life.
JIM KEOHANE: Yeah. So I mean, most individuals, no question, they're better off in defined benefit plans, because for a whole bunch of reasons. But the challenge has been difficult for employers to stand defined benefit plans, because there is a changing environment. We have low interest rates. We have people living much longer. So it is more difficult to actually manage these plans and keep them going.
ED HARRISON: We were talking earlier before the interview about your transition and one of the places where you can make a difference is in terms of fees. And it's interesting in terms of how a pension plan can deal with costs. And we were talking in particular about Nortel Networks. They were 37% of the TSX, the Toronto Stock Exchange index, and huge outsized risk for HOOPP at the time. But you were able to manage that risk in a very positive way. You gave me a big number about of $800 million, $850 million. Talk me through that episode when Nortel had tanked during the tech bust.
JIM KEOHANE: Sure. So we're a very big user of derivatives-- one of the largest in the world, actually. And most people are scared of derivatives, but if you use them properly, they're very powerful risk management tools. And I think we're a very sophisticated user of derivatives.
So what we did at the time-- Nortel became this disproportionate weight in the index and at that time, we had a bunch of outside managers as well. So when you start drilling down in all these portfolios, they all had Nortel in them. So what we did is we did an overlay on top of the thing using derivatives. So I was charged with trying to keep our exposure below 5% of the fund.
And so I used what we call a costless collar to do that transaction, which is effectively buying put options-- to sell a stock at a fixed price for a period of time. And to pay for that, we sold call options about 50% above the market, which would cause you to actually force you to sell a stock if it went up by more than 15%. So it effectively capped our exposure within our range. And we did that in very material size, because of the size of the exposure we had.
And so I think it was right around 2000, Nortel warned, and stock went down 30% one day. And so in that one day, that offset gained us about $850 million.
ED HARRISON: $850 million, right. And the thing is that what you're talking about is reducing the volatility. You still have exposure, but you capping upside and downside. And that's part of the profile that you're talking about in terms of risk. This is something that you can do that individuals can't do. That's something that we're going to be talking about going forward.
JIM KEOHANE: Yeah, so individuals just wouldn't have the credit worthiness to do with strategies like that. Because of our size, we're an extremely credit worthy counterparty. So Wall Street banks are very willing to deal with us knowing that when it comes time to pay, we'll pay. Whereas individuals, they would never do that strategy because you know people could go bankrupt and they can't get their money from them.
ED HARRISON: So how have you changed HOOPP and how has the pension industry in Canada in particular changed in the time when you first came in 1999 to now, when you're leaving?
JIM KEOHANE: So there's a few big things. We've pretty much insourced all our activities. So we have our own in-house investment management staff that runs virtually all of the money. We still have some partnerships outside, but most of the money is run directly by our own staff. And that has huge advantages in the sense of it's much more cost effective. So paying people to run money for you is significantly more expensive.
Just to give you an example. When I first became the chief investment officer, we had about 15% of our money run externally. And so when I insourced that, that 15% cost more to run than the other 85%. And actually, the returns were not as good. And one of the other intangibles is that you sacrifice control of your risk management, because when you give money to other people, they're going to do what they want with it. And your choice us you can take your money back or leave it with them.
And so whereas internally, if you're not comfortable with the market, we can dollar risk up and down quite easily.
ED HARRISON: And you say 15% was more expensive than 85%.
JIM KEOHANE: That's right.
ED HARRISON: That's astounding. Because again, one of the key things-- we'll talk about your framework of how you look at the pension industry-- but one of the things that I thought was extraordinary is about the cost versus an individual-- that is a cost savings that you can't make as an individual, if you're investing on your own.
JIM KEOHANE: Yeah, so our investment costs are about 20 basis points or 0.2% percent per year. And when we looked into what individuals pay, and it's typically somewhere between 2% and 3% per year. So 10 times as much.
ED HARRISON: Right.
JIM KEOHANE: And that difference of 180 basis points-- I mean, it doesn't sound that much annually, but you start compounding that over 40 years, and you actually end up with half as much money.
ED HARRISON: Right.
JIM KEOHANE: So I mean, when I first saw that, I thought, that can't be right. And I did the calculation myself, and in fact, that is true right.
ED HARRISON: The magic of compound interest.
JIM KEOHANE: Yeah. It does make a huge difference over time.
ED HARRISON: And what other things have you seen? Because I think that the industry has changed a lot. I mean, essentially, you came in from an industry, you brought your expertise. My sense is that in order to have people of that capability, you have to pay them the going rate. What staff do you have in terms of trading and risk management and things of that nature?
JIM KEOHANE: We really have top notch staff-- really, some of the best people in the world. And we pay them market rates. And I think that's one of the big challenges that the US funds have-- is the governance structures don't allow them to do that. And so there's some very large pools of capital you ask that could be run the way we run our money. So all in in-house staff.
But the structure of most US plans is not independent. I think a lot of the state plans, they have politicians sitting on their boards and stuff. And it's politically unacceptable to pay people in-house-- you have to write a check to an outside manager that's 10 times as much, because it depoliticizes the payment. So even though you're paying more to have the same thing done, it's not politically acceptable to write a check to somebody internally. But no problem writing to somebody outside.
ED HARRISON: You mentioned governance. It actually reminds me that we have-- I was looking at your website, and you talk about advocacy at HOOPP. And there were five drivers of that. And I think maybe this is a good framework for thinking about this conversation. The five drivers you talked about were savings, fees and costs, which we already mentioned, investment discipline, fiduciary governance, which is what you were just mentioning. And then risk pooling. I want to go through those one by one and then get a sense of how much that makes a different in terms of how much I as an individual need to save if I were to be with a defined benefit plan like HOOPP versus if I would try to replicate that on my own.
JIM KEOHANE: Yeah.
ED HARRISON: So let's talk about the savings and how people save. And why that's one of the five.
JIM KEOHANE: It's one of the big items, actually-- savings patterns. And what we see-- so if you're in our plan, it's taken out of your paycheck every two weeks. And it's automatically done. So people don't even notice it. So they just live off their take home pay, and it's automatically taken off, and they don't have to think about it. And the other thing is it's locked in. You can't take it out.
ED HARRISON: Right.
JIM KEOHANE: What we see in individuals trying to do it on their own is it becomes an afterthought. They are dealing with their kids' education, cars, paying for their house. And at the end, do I have any money left to save? If I do, I'll put some aside. And here, we have an instrument called a registered retirement savings plan, which is similar to your IRAs, right? So the deadline is February 28. People rushing in February 27 to the bank and put whatever it is and by the flavor of the day, right?
And so it's no real thought given to what should put the money, and they put in wherever they happen to have at the time, which is usually very inadequate to provide you with a decent pension. And the other thing you see is that when they have a crisis, a financial crisis in life, they withdraw that money. So essentially, when you just look at the stats that people have in individual savings accounts, most of them have actually no money at the time of retirement. So it's so not just they don't save enough-- they don't save at all.
And so unless people are in workplace pension plans-- and it doesn't necessarily have to be a DV plan, but in a workplace pension savings vehicle, they don't save it all. And so unfortunately, what we've seen in the last few years is this trend away from workplace savings plans. And we need to think about ways to stem that tide and move things back in the other direction.
ED HARRISON: Even though I want to go through these step-wise, that when you mentioned the fact that we've seen this move away, the immediate thing that I think about is the what you told me about the accounting issues and why this happens. I want to go straight to the solutions thing here, because basically, the solution is defined benefit is my understanding And what we're already talking about in terms of savings on a regular basis. But the reality is that in a private company, it's not on an accounting basis, a good thing to have that on your balance sheet. Like, you mentioned GM in particular as an example of that.
JIM KEOHANE: Yeah. And this goes back to the Sarbanes-Oxley legislation, which happened after the Enron and WorldCom bankruptcies, where they had always off balance sheet entities that masked a bunch of risk that was there. And so that legislation essentially said you have to put all these things back on your balance sheet, which included the defined benefit plan.
So in the past, a defined benefit plan was one line-- was off the balance sheet. But just if you get swings in interest rates, you can get very material swings. And you've got 50 year assets there that very small changes in interest rates for example, can change a lot. So once you get that back on the balance sheet in the [indiscernible], it creates a huge amount of noise.
And so companies have big pension plans and GM is an example of that. I think the pension plan is about five times the size of the company. The pension plan affects your earnings more than anything. And so the joke in the financial markets was that GM is a pension plan that makes cars and it's true, in a sense. And also, if I put my investor hat on and I want to invest in a car company, I look at GM and think, well, I'm going to get too much exposure to its pension assets, so I'm going to go buy some other car company instead.
So it's a huge amount of pressure from shareholders for GM to get out of the pension business. So that's where it comes from. If the accounting was not bad, if you went back to the previous accounting, that probably would alleviate that issue. So employers are looking to have defined contribution account. In other words, all they have to put in their earnings statement is the contribution they make in the employee's account that year. And then any future risk is the employee's, actually.
ED HARRISON: Right.
JIM KEOHANE: So the risk doesn't go away. It just got shifted off the company's books to the employee's book.
ED HARRISON: You used defined contribution accounting, though.
JIM KEOHANE: Yes, our employers do. The reason is that HOOPP is a different structure. So we don't just manage the money on behalf of the employers. The obligation for the pension is actually HOOPP's obligation, not the hospital's obligation. So in effectively, we not only take on that management money, that pension is guaranteed by HOOPP-- it's not guaranteed by the hospital.
ED HARRISON: Right.
JIM KEOHANE: So from the hospital's point of view, they really just make a contribution into the plan. And the only future obligation it could have is we could raise the contribution rates.
ED HARRISON: Right.
JIM KEOHANE: But they have no obligation in the future to fund it. If we had gotten into a situation where we're underfunded or something, they have no future obligation that way. So their accounting is DC accounting. So our structure, actually, it's an interesting structure that could be brought into the private sector that may encourage employers to