How Air Canada Retooled Its Structure for Better Returns and Lower Pension Plan Risk

CIO: You are in charge of a major enterprise. Air Canada’s pension plan assets are significant in size when compared to its market cap. Tell us about this situation and the challenges it presented at the outset.

Morin: Air Canada Pension Plans, with $20 billion in Canadian dollars in assets, are enormous in size compared to the plan sponsor, mainly due to the relatively generous plan design inherited from the early days when they were a crown corporation. Pension liabilities were and still are a multiple of Air Canada’s market cap.

Pension plans became a significant enterprise risk management issue and pension financial risks had to be reduced. However, long-term expected return needed to be maintained to keep long-term costs reasonable, as the plans were still mainly open in 2008.

Before joining AC in 2009, I was with a large consulting firm, working to develop strategies that would better manage the risks associated with pension plans, while keeping the expected return at a reasonable level. AC had virtually outsourced all investment activities at that time and they asked a couple of key individuals to join them to help build an investment team and the necessary systems to implement the strategy.

CIO: How did you go about doing that?

Morin: The first big innovation was the strategy in itself: Moving from a traditional 60-40 allocation, completely outsourced, to a very sophisticated, mostly internally managed active strategy.

The strategy required a decent use of leverage, so we needed to convince our stakeholders that leverage didn’t necessarily imply increasing risk and could also be a good risk management tool. However, we had to build everything from scratch. From governance, IT, systems, risk management, trading capabilities, operations, reporting, etc., it all needed to be created, as no out-of-the-box system was available to implement our structure and ideas. We were also working on a relatively tight budget.

We had to enter into agreements to trade derivatives—using International Swap and Derivatives Association Master Agreements, or ISDAs, and Global Master Repurchase Agreements, or GMRAs, and ask for credit lines to counterparties. This was just after the financial crisis, which was not an easy task for a company that came close to bankruptcy and needed to negotiate special regulations with the federal government to reduce pension deficit payments. Nevertheless, we gradually convinced them to work with us. We now have ISDAs with 23 counterparties globally and 16 GMRAs, and we trade with 35 executing brokers.

CIO: No doubt you had to win over Air Canada’s management.

Morin: Educating and convincing our board that their primary focus should be on managing the asset versus liability risk, and not only focusing on absolute performance of the assets, was a very long-term process.

Prior to implementing the strategy, we worked on the governance structure to clearly define the roles and responsibilities of the board and the Management Pension Committee, composed of AC executives reporting to the board. They delegated to me and my team the authority for all investment activities. This provided us with much needed flexibility and agility in executing the strategy.

CIO: Then there’s the matter of risk management.

Morin: We are strong believers in alpha and, although beta risk is often the driver, alpha risk is usually too small, over-diversified, and not well-balanced with beta risk. We believed that added value coming from active management could be a strong driver in improving the financial situation of the plans over the long-term, even though our strategy had a very significant allocation to fixed income.

To do so, we had to be very nimble. Therefore, we had to work on our investment structure and governance process to allow for such nimbleness, while keeping risks at a reasonable level. We worked for many years on our risk budget framework and developed investment polices to achieve the desired process.

CIO: How did you do that?

Morin: We needed to ensure we had the best toolbox possible to implement a very dynamic strategy, while also developing internal risk systems and hiring specialized staff to allow us to trade virtually anything. We now use a toolbox similar to many hedge fund managers, and we manage almost 80% of the portfolio internally with a team of close to 50 individuals, versus a 100% outsourced model nine years ago.

We use most of the complex instruments—from traditional interest rate swaps to the most complex variations of variance swaps—to reduce our risk or build hedges to our more traditional positions. We also now run multiple quantitative strategies developed internally and we execute over 2,000 trades every month.

CIO: Do you have an allocation to private markets and, if so, what is your approach?

Morin: We have a significant allocation to private markets(real estate, infrastructure, private equity, private debt, etc.) which we manage with a very dynamic and opportunistic approach. We set an overall target of 20% of plan assets in private markets without a fixed target at the sub-asset class level, allowing us to move around within the latter according to market opportunities.

In addition, we invest significantly in co-investments and niche investments to improve returns, enhance diversification and reduce fees. This is supplemented by risk management models emphasizing embedded leverage—a big challenge in private markets—and some dynamic hedging overlays that are used to manage undesired risks.

CIO: How are you structured for collaboration?

Morin: We have a unique portfolio management approach/team structure, which manages the plans as one team and one book, to avoid the creation of silos and to foster idea generation and discussions. This resulted in a very flexible approach where, for example, a real estate investment can easily be compared to a high-yield bond investment to ensure we invest our capital where the best return expectations by unit of risk reside.

CIO: How has that worked out in terms of performance?

Morin: Ending September 30, our team has added value relative to the benchmark for the last 25 quarters in a row, that’s over six years now. This results in an annualized performance for the plans of 12.1%, versus 8.9% for the benchmark, ranking us first in the universe of large Canadian plans over the nine years ending June 30, both on a total return basis and on a value added relative to the benchmark basis.

The deficit of the plans on a wind-up basis went from a $4.2 billion deficit in 2012 to a $2.6 billion surplus in 2018, while reducing our overall risk compared to liabilities by more than half. Air Canada has been in contribution holiday mode for the last three years.

CIO: Now that you are in surplus and have significantly reduced the risk of the plans, what’s next in your strategy?

Morin: This year, I convinced the board of Air Canada to innovate even further in reducing the risk of its pension plans by gradually purchasing annuities for its pension plans in a whole new way. Air Canada is in the process of creating a new wholly-owned life insurance subsidiary which will be registered with the regulators. That structure will allow us to provide additional capacity in the Canadian market to purchase a significant amount of annuities which will help secure pensions paid to our members and, at the same time, create a new line of business for Air Canada.. My team leads this unique project—to our knowledge, a first worldwide—which is still ongoing.