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SPONSORS DISCUSS LDI THREE WAYS MANAGERS SAY LDI MARKET CAPACITY EXISTS HOW LOW CAN BONDS GO?
LDI ON TAP
says MolsonCoors’ Mike Rumley
Employee Benefit News Canada Supplement
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Putting LDI in perspective For most of my career I was one of only a few lawyers in an actuarial consulting firm. I will never forget one of SHERYL SMOLKIN my co-workers, also a lawyer, who firmly Editor-in-Chief stated on many occasions that as lawyers, our forte is words. In contrast, she maintained numbers are reserved for the actuaries and investment consultants. So you can imagine, it was with some trepidation that I approached the development of this issue, which focuses on liability-driven investment. But it suddenly got easier when I took the advice of the I2 Editorial Advisers and started talking to plan sponsors. As Nortel’s Director of Global Pensions John Poos says, it all comes down to writing the cheque: “Once you understand the volatility of your plan versus your liabilities, you realize the impact that can have on contributions. Could you write that cheque? If the answer is that it would be dreadful, then you are a prime candidate for LDI. If you are not concerned about the size of that cheque, then LDI is not for you.” In the articles that follow you will hear from both Canadian and American plan sponsors who are engaged in asset/liability matching, and investment managers who help pension funds to execute these strategies. Our goal in this issue is to help you put LDI in perspective. Let us know if we succeed. And stay tuned for future issues dealing with fixed income and infrastructure, governance, and alternative investments. All articles, and the pdf of this and past issues, can be found at ebnc.benefitnews.com.
CONTENT
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6 FEATURE
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F E AT U R E S A trio of case studies illustrates that when it comes to LDI, "one size does not fit all." Long bonds may be in short supply, but investment managers say there is market capacity to implement LDI.
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Guest COMMENTARY Bond yields are flirting with their cyclical lows. Could a trend reversal be around the corner?
Southern EXPOSURE
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Cross-border LDI implementations reveal markedly different investment brews.
Market WATCH
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A snapshot of current investment trends looks at diversification, portfoliowide strategies and fees. EDITORIAL HEADQUARTERS 1325 G Street, N.W., Suite 900, Washington, D.C. 20005 202/504-1122 • Fax: 202/772-1448 Publisher/Group Vice President: Jim Callan Editorial Director: David Albertson Editor-in-Chief: Sheryl Smolkin sheryl.smolkin@sourcemedia.com 416/227-9025 Managing Editor: Carly Foster carly.foster@sourcemedia.com 647/476-5060 Associate Editor: Leah Shepherd, Lydell Bridgeford, Chris Silva Senior Art Director: Hope Fitch-Mickiewicz Associate Art Director: Robin Henriquez EDITORIAL ADVISERS Gary Grad, VP Institutional and Investments Analysis, Fidelity Investments; Michel Jalbert, VP Consultant Relations, CIBC Asset Management; Janet Rabovsky, Practice Leader, Investment Consulting, Watson Wyatt Canada; Perry Teperson, VP and Portfolio Manager, Leith Wheeler; Keith Walter, Senior VP, Sales & Marketing, MFC Global. ADVERTISING SALES STAFF Account Managers: Peter Craig peter.craig@sourcemedia.com, 65 Barr Cres., Brampton, ON L62 3E3 905/840-3588 Patricia Tramley ptramley@mediajls.com, 14 Wilton Rd., Poite-Claire, PQ H9S 4X4 514/426-9722 Fax: 514/426-4736 Group Production Director: Deborah Kim, deborah.kim@sourcemedia.com Production Coordinator: Ivette Jimenez ivette.jimenez@sourcemedia.com Marketing Manager: Amy Metcalfe, amy.metcalfe@sourcemedia.com Provider Profiles and Benefits Marketplace : Kurt Kriebel, kurt.kriebel@sourcemedia.com
INVESTMENT INSIDER
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Global bonds: How low can they go? BY VINCENT LÉPINE iven that the level and direction of long-term bond yields significantly impact the value of pension plan liabilities and assets, it is not surprising that plan sponsors are closely monitoring global bond markets. Around the world, bond yields have been trending lower for the past 25 years, dropping from more than 12% in the mid-1980s to less than 3% in the mid-2000s. This is due to one crucial development: the world’s central bankers’ victory against inflation in the late 1980s. Following that victory, and during the ensuing decade, central banks remained vigilant and successfully kept inflation at bay, resulting in a gradual decline in interest rates. As
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inflation stabilized, investors stopped demanding inflation premiums, allowing bond yields to move even lower. Now that bond yields are flirt-
For the past quarter century, inflation has been their top concern. However, now that inflation in the industrialized world is well-contained and relatively low by historical standards, the answer to this crucial question is not as clear. At first glance, there seems to be very little reason to believe that central banks could stop worrying about inflation anytime soon. The problem is that central bankers could now become victims of their own success. The continued decline in interest rates has done wonders to consumers’ wallets. Since the early 1980s, the net worth of North American households has almost quadrupled. Unfortunately, declining interest rates also encouraged consumers to take on a lot more debt. According to statistics from the U.S. Federal Reserve, mortgage debt now represents an unprecedented nearly 50% of total real estate equity. This increase in consumer debt loads has been more than offset by the rapid value appreciation of their tangible and financial assets. Since 1985, home prices climbed by more than 200% in the United States (U.S. Census Bureau), and by 120% in
Bond yields have been trending lower for the past 25 years, dropping from more than 12% in the mid-1980s to less than 3% in the mid-2000s. ing with their cyclical lows, one can’t help wondering if a trend reversal is around the corner.
Canada (Statistics Canada.) However, given current debt levels, the prospect of Japanese-style deflation is downright terrifying.
INFLATION VS. DEFLATION The future direction for bond markets could depend on which threat central bankers believe is the greatest threat for the world economy — inflation or deflation.
THE WORSE OF TWO EVILS Japan’s experience with mild deflation since the early 1990s is a constant reminder of how painful deflation can be. A decline in consumer
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prices of less than 1% per year has HOW LOW CAN BOND YIELDS GO? been associated with years of painfulGlobal 10-year bond yields and secular downtrend ly slow growth, rising unemployment, Per cent a multi-year decline in the value of 13 12 tangible assets, and a very long bear Yields have been trending lower 11 for the past 25 years… market in equities due to intractable 10 financial problems in the banking 9 8 and corporate sectors. …is a trend reversal around 7 How did Japan get into this the corner? 6 predicament? It all started in the late 5 ` 1980s with deeply overvalued equity 4 3 and real estate markets. Both home 2 and equity prices started falling, 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 0 M0 M M0 M0 M0 M0 M0 M0 M0 M0 M0 M0 M0 M0 M0 lethally hitting consumers’ wealth. As 85 987 989 991 993 995 997 999 001 003 005 007 009 011 009 1 19 1 1 1 1 2 2 2 1 2 1 2 2 2 the economy plunged into recession, SOURCE: Datastream & CIBC Global Asset Management Inc. the Bank of Japan reacted too slowly, allowing deflation to set in. The result Given the amount of mortgage was a prolonged period of anemic banks’ priorities from fighting infladebt held by households, and the economic growth, persistent deflation tion to avoiding deflation. overvaluation of home prices in many and a very long and strong bull marIn the current context of low regions of the world, central bankers ket in Japanese bonds. inflation, frothy real estate prices and could be very tempted to If deflation starts outhistorically elevated consumer debt preserve a bigger buffer zone side Japan, the long-term burdens, deflation looks more and by letting inflation rates downtrend in bond yields more like the worst of the two evils. accelerate. In other words, will remain in place. We suspect that in situations of from this point on, central However, central banks heightened uncertainty, world bankers could be spending have learned from the central banks will increasingly err more time worrying about Japanese experience. To on the side of inflation rather than deflation than inflation. prevent deflation from deflation. In short, the long-term This implies that the occurring, central banks outlook for bond markets appears Vincent Lépine monetary policy stance preserve a buffer zone for to be darkening. could, on average, be kept the inflation rate. Up until At this juncture, all eyes are now more often accommodative than now, central bankers have generally on the Federal Reserve. With the U.S. restrictive, turning the structural backbeen targeting inflation at around 2%. economy flirting with recession, and drop increasingly bearish for bonds. As However, one can wonder if this realhome prices falling, the risks of a inflation starts grinding higher, longly is sufficient. deflationary bust have significantly term inflation expectations would start When the economy dips into risen. Judging by its quick reaction, drifting higher, putting upward presrecession, inflation typically starts the Fed is fully aware of the risk represure on long term bond yields. decelerating sharply soon thereafter. sented by a multi-year decline in During the last global recession in home prices. The result: higher infla2001, the U.S. core inflation rate tion over the next several decades. —I2 DARKENING LONG-TERM OUTLOOK dropped from more than 2.5% to FOR BONDS Vincent Lépine is VP of research at CIBC Global Asset Management Inc. (www.cibclose to 1% in less than two years. Holding a very bearish long-term cam.com).The views expressed in this artiThis drop happened in the context view on bonds requires a strong concle are the personal views of the author and of rising home prices. In the context viction that the world is heading for a should not be taken as the views of CIBC Global Asset Management Inc. or Canadian of falling home prices, there is a high permanent regime shift from a lowImperial Bank of Commerce . All opinions probability that inflation would to a high-inflation environment. and estimates expressed in this article are as decelerate much more, flirting with Ultimately, this could only happen of Jan. 31, 2008, unless otherwise indicated, deflation. in the context of a shift in central and are subject to change. INVESTMENT INSIDER
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FEATURE
LDI: One
ize does not fit all Pension plans of every stripe embrace customized LDI strategies
By Sheryl Smolkin
O
Open, closed. Small, large. Public sector, private sector. Multiemployer, single employer. No two pension funds are the same, and a liability-driven investment strategy is not the solution for every plan. Yet an increasing number of sponsors of all types of pension plans are striving to better match their assets and liabilities. Speaking at a recent CPBI investment seminar, University of Toronto Asset Management’s Director of Investment Strategy John Lyon, and Peter Jarvis, CIO at BIMCOR, explained why their pension plans have decided against LDI. Lyon said a study was recently conducted by the university, and UTAM ultimately ruled out LDI. “This was no surprise because it was considered too costly, with low returns on fixed income,” he said. INVESTMENT INSIDER
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MANULIFE vie Charest Manulife’s VP S yl Global Pensions & Benefits Sylvie Charest is applying LDI principles to the management of two small company plans. In one case there was a partial windup involving 150 employees and $16 million in assets, which were carved out into a separate fund for the benefit of these members only. It is expected that the wind-up will be completed within two years and all funds will be transferred out. As a result, the portfolio was fully immunized through the purchase of provincial and corporate bonds that, as much as possible, match the liability flow. The second plan is a legacy plan that is closed to new members, with no further accrual of defined benefits. Of the $50 million in assets, a large portion is surplus. “We have approved going to an LDI strategy for this plan when the time is opportune,” says Charest. “In order to fully match the liabilities, we’ll get more heavily into bonds when market conditions are more favourable.” For the surplus, a multiasset targetreturn strategy is planned, comprised of fixed income (45%); Canadian equities (23%); alternatives such as commodities, natural resources, real estate invesment trusts (15%); foreign equities (11%); and cash (6%). One reason Charest says they are able to go to a somewhat more exotic approach with the surplus is because the assets are managed internally by MFC Global. “This is our business at Manulife. Senior management understands the issues, so it was not a long, drawn-out discussion.”
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“It’s a very poor use of company capital, because you are basically locking in at those lower rates,” says Jarvis. “The question really becomes, how do we get more LDI-like in our asset structure? That’s what I believe
is driving the movement to a much more diversified portfolio structure by funds across the board.” In contrast, the Colleges of Applied Arts and Technology Pension Plan, Manulife and Operating
OPERATING ENGINEERS LOCAL 955 The Operating Engineers Local 955
ner Semler R ai
cash flows and make other investments that will
pension plan’s
result in asset growth.
administrator
Nevertheless, the
Rainer Semler is an
portfolio is primarily
LDI veteran. This collectively bar-
domestic Canadian bonds. “If our investment
gained, Alberta-registered,
manager used a strategy like
specified multiemployer plan has
derivatives it would be OK with
been managing assets ($500 mil-
us, providing it is within the risk
lion at the end of 2007) against
parameters,” says Semler. “But I
liabilities for over 10 years. It is
don’t want you to think deriva-
fully funded on both a solvency
tives are a big part of this. The
and going-concern basis. “I don’t
investments are primarily inter-
think it has ever fallen into deficit
national bonds, maple bonds and
while the LDI strategy has been
some mortgages — all relatively
in use,” says plan actuary Tony
high quality fixed income invest-
Williams, president of PBI
ments.”
Actuarial Consultants Ltd. Semler believes that, “Probably
The benchmark is constructed based on a projection of cash
the most important thing for any
flow that is shared with the
pension plan is to maintain the
money managers, who develop a
pension promise for beneficiaries
benchmark for that year and
(4,800 active; 1,600 retired). LDI
then build a portfolio that match-
allows us to manage risk into the
es the cash flow.
future, so we know we have a
“Without letting the cat out of
series of pension cash flows each
the bag, we are certainly looking
and every month.”
for more alpha. We’ve got risk
Another advantage of LDI,
under control and the benchmark
says Semler, is that it allows the
returns, but we haven’t got a lot
plan to consider the amount of
of added value,” says Williams.
risk they are going to assume, so
“So I’d say we are actually
they can both invest in bonds or
approaching phase 2 of this LDI
fixed-income products to match
approach.”
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Engineers Local 955 are three of many very different pension plans that have concluded a customized LDI strategy is the best way to manage funding volatility and risk. CAAT CIO Julie Cays says she brought LDI alive to certain trustees by showing them, “If we have a certain asset mix, or take a certain amount of risk, this is the probability that you will reach a certain funding level and have this amount of surplus or deficit.” “Be clear on your commitments, how you price them and what kind of risk you are ready to take to meet these commitments,” says Manulife’s VP Global Pensions and Benefits Sylvie Charest. “Once you have some clarity on these three things, and you are also clear on what rewards you as a risk-taker get for taking these risks, I think the fog will start to lift on the LDI strategy you are about to embark on.” And plans of all sizes can successfully implement LDI, says Tony Williams, the Operating Engineers Local 955 plan actuary and president of PBI Actuarial Ltd. “Even at a half-billion dollars, it was relatively easy to execute LDI for the Engineers’ plan. I’m working with an $80 million plan, and I’m also not having any difficulty,” he says. “It just gets more complex if you try for derivatives, swaps, overlays and those more esoteric things. If you keep it simple you can have LDI down to a relatively small plan.” MolsonCoors Director of Global Pensions and Risk Management Mike Rumley agrees. “Any smaller pension plan is going to pay higher fees, but we do not see that as an impediment to implementing LDI.” It all comes down to writing the cheque, says Nortel’s Director of Global Pensions John Poos.
CAAT PENSION PLAN other derivatives and overlays, The Colleges of Applied Arts C e but not necessarily from and Technology Pension a i l y u s J an LDI perspective,” Plan has assets of $5.4 she says. billion and, at the Other inflation-linked beginning of 2008, investments are infrashifted their asset mix structure funds and the from 60% equibrand new allocation to ties/40% bonds real estate. “We are still (including 5% in infraresearching how to implestructure) to a 57% returnment the real estate mandate. enhancing/43% liability-hedgUltimately there may be some direct ing portfolio (including 10% infrainvestment, but that would not be structure and 5% real estate). As of 1/1/07, the plan was 98.8% managed in-house.” Direct investfunded on a solvency basis, and the ment in real estate and infrastructure assets by large Canadian pension going-concern funding ratio was funds, like the CPPIB and Ontario 91.3%. Teachers is very much the exception “I’m not using LDI a lot as a rather than the rule, both domestiphrase with my trustees because it cally and on a global basis, Cays seems to mean so many different points out. things to different people,” says Assets are managed against a CAAT CIO Julie Cays. “I’ve also market benchmark that simulates hammered home the message that the liabilities. “Our liabilities pretty you can’t really match liabilities or well look like a 13-year duration mix perfectly hedge against liabilities.” of 70% real-return bonds and 30% Cays says her goal is to control surplus at risk and variability of con- nominal bonds. We use a mix of bond indices and hypothetical tributions — which, by 2010, are bonds to get us to this mix, and already slated to increase to 12.1% we’ve asked one of our managers to for both employers and employees. price it each quarter.” Nominal bonds are benchmarked Cays says implementing the against the long-bond index, and one of the CAAT bond managers is buying strategy is a multi-year process and acknowledges that finding product strip bonds outside the long-bond at an affordable price can be a chalmandate to extend them even further. lenge. “But we have the framework “Also, we have been building an laid out. We’re measuring our inflation-linked component by opportunities relative to what they opportunistically buying real-return do for us and our surplus at risk bonds every now and then. In addiframework,” she says. tion, we are getting into swaps,
“Once you understand the volatility of your plan vs. your liabilities, then you realize the impact that can have on contributions,” he says. “Could you write that cheque? If the
answer is that it would be dreadful, then you are a prime candidate for LDI. If you are not concerned about the size of that cheque, then LDI is not for you.” —I2 INVESTMENT INSIDER
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HALF FULL, NOT HALF EMPTY ecent research from Greenwich Associates reveals that portfoliowide strategies are gaining in popularity. Of plan sponsors surveyed, 11% say they are currently using some form of LDI strategy, while a further 18% expect to start using this approach. “LDI is a framework that allows plans to continue their focus on their raison d’etre of paying benefits, rather than compare themselves to a market benchmark; many Canadian pension plans take much more benchmark risk than active risk,” says Claude Turcot, senior VP of Standard Life Investments in Montreal. “And as managers, we bring market experience and can explain to sponsors how realistic it is to have certain objectives.”
R
BUILDING A BENCHMARK “Assets should be benchmarked to liabilities,” says Zainul Ali, a senior consultant at Towers Perrin. “It is conceptually correct, and it’s also relatively easy to build that benchmark.” Yet the devil is in the details. The plan sponsor — often in consultation with a consultant and/or one or more investment managers — still must identify the plan’s larger objectives. For example, benchmarks derived from solvency vs. going-concern considerations will differ drastically because of the way liabilities are valued. “When using a solvency liability benchmark, it may be necessary to
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Investment managers say market can meet demand for LDI By David Adler
leverage the fund to buy the long-term products necessary for an optimal solution,” Turcot explains. One alternative is to move the fund’s benchmark toward a public index that matches its liabilities more closely — e.g., a long term bond index — as opposed to the frequently used DEX Universe Bond Index, with its short duration of 6.5 years. Other possibilities are custom benchmarks or a blend of existing benchmarks.
STRUCTURING A SOLUTION Implementing a portfolio based on the new benchmark is the next step in the process. But with the increasing demand for long bonds, there is a perception in some quarters that instruments capable of matching plan liabilities are in limited supply. Managers interviewed generally agree that capacity constraints in Canadian markets are still hypothetical and would not derail any LDI moves by a small plan. But the size of the Canadian swaps market remains an issue. Although swaps are not a necessary component of an LDI approach, they are commonly used in an overlay strategy to reduce interest-rate risk. “The lack of depth of the Canadian swaps market is quite significant,” says Damon Williams, VP at Phillips Hager & North. “If large plans wanted to implement a swap portfolio, it would create significant bottlenecks.” However, Williams is quick to point out that although potential capacity issues related to swaps are a
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FEATURE
CLAUDE TURCOT
DAMON WILLIAMS
STEPHEN FOOTE
Senior VP Standard Life Investments
VP Phillips Hager & North
VP Northwater Capital
consideration, it doesn’t imply large plans won’t be able to pursue LDI strategies. Williams says, “There are many other implementation solutions, including use of repos (repurchase agreements) and cash bonds to reduce interest rate exposure relative to liabilities.” Turcot agrees that implementation is linked to marketplace availability. “Large Canadian plans might someday encounter problems, including year-long delays, if they wanted to implement relying heavily on swaps. But even for these plans there are other routes, such using bonds plus futures,” he says. And looking to the U.S. market is always an option, although he concedes this could be expensive because of the necessary hedges. “Hypothetical lack of product or depth of instruments for large plans is more of a function of lack of demand than supply,” suggests Jacques Prévost, CIBC’s VP of global fixed income. “The market needs grease to get the wheels running.” He believes pension funds should worry about the overall risk of the strategy — the surplus at risk — and how everything fits together, while leaving the practical concerns of products and market considerations to the manager. Similarly, Northwater Capital’s VP Stephen Foote says any hypothetical thinness in products can be easily overcome by an experienced manager. “We have been running portable alpha and LDI programs for over 10 years, and we haven’t run into any capacity issues to date. If presented with a two billion trade, we could execute and implement, but over a reasonable period of time that any plan sponsor would be comfortable with.” “There is still a liquid market that is sizeable enough to build customized fixed-income portfolios to better
match defined benefit pension liabilities using cash markets or overlay strategies employing leverage,” says John Ellis of TD Asset Manageement Inc. His firm offers a number of solutions including pooled funds, which can be used by pension funds of virtually any size to extend the duration of their fixedincome portfolio. Some of these funds seek to add value through the use of portable alpha.
SOONER RATHER THAN LATER The availability of these and other solutions notwithstanding, Ellis still urges plan sponsors seriously considering LDI to move sooner rather than later. “Capacity remains a prime motivation, but because of price rather than availability,” says Ellis. “The bond can always be bought, the swap can always get done but it’s a question of price. If you are the last person in, the solution will be more expensive.” —I2 David Adler is a New York-based freelance business writer who frequently contributes to Investment Insider and other SouceMedia publications.
Understanding “swaps” When bonds are purchased through a swap, the plan sponsor enters into a “swap arrangement” with a financial institution. The financial institution pays the plan sponsor the long-bond return, while the plan sponsor pays the short-term interest rate — e.g., the overnight rate. As a result, the plan sponsor does not have to advance funds. The arrangement is a contract that, at the end of the quarter or the end of year, the parties will settle up. The net result, says Towers Perrin investment consultant Zainul Ali, is that the pension fund is using leverage. “They don’t have to spend any money to buy the bond. They use an overlay, while still preserving their 60% equity/40% bonds asset mix.”
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Photograph of Mike Rumley & MolsonCoors/CoorsLight by David Pahl
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LDI on tap in Canada and the U.S. BY SHERYL SMOLKIN olsonCoors and Nortel say LDI is on tap in both their Canadian and U.S. defined benefit plans, but their cross-border implementations reveal markedly different investment brews. Development of liability-driven investment strategies in the two countries has been influenced by individual plan designs, availability of product and regulatory requirements.
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Here’s a look at how the strategies are unfolding.
MOLSONCOORS In Canada, MolsonCoors has a fairly mature salaried plan that was closed to new workers in the 90s and an ongoing, collectively bargained plan for hourly workers. The company also has a single defined benefit plan for U.S. employees, with different formulas for salaried and nonunion hourly workers. The U.S. plan
was closed to new entrants at the start of this year, but existing members are still accruing benefits. Director of Global Pensions and Risk Management Mike Rumley says that in the early part of the decade, with an asset allocation of 70% equities/30% bonds, the funded status in the Canadian plans deteriorated. “Like many plans in Canada, we have to fund under various provincial rules to a solvency basis. We realized that as plan sponsors, we don’t want to have to ‘re-fund’ if there is a further deterioration in the equity markets or if the interest rates fall further. At the same time, our beneficiaries are interested in having the benefit promises locked down.” As a result, the Canadian salaried plan has been almost completely invested in bonds that — to the extent possible — mirror liabilities. “Where bonds are not available, we will definitely do a futures overlay or swap strategy to close the gap, but we are not really interested in an overlay strategy or portable alpha,” he explains. Because the funded status of the active hourly plan is not yet as good as in the salaried plan, Rumley says the 70/30 mix was retained. But the company took the 30% in normal bonds and extended the duration to also make them look more like the liabilities. The equity allocation in the U.S. plan has been reduced in the last few months as well, so the asset mix is now 45% equities, 10% core real estate and 45% long-duration bonds. However, with a greater universe of bonds and other credit products available south of the border, the company wants to retain the ability to generate alpha by looking at relative returns among a fairly broad asset class.
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to something else, there is going to be some mismatch. The question is whether, in today’s world, we are prepared to accept that, as opposed to no match.”
A TOTAL MINDSHIFT
MIKE RUMLEY
JOHN POOS
The Canadian salaried plan has been almost completely invested in bonds that mirror liabilities.
There are not as many counterparties that will take the “swap” risk in Canada when it comes to bonds.
“The decision was made not to extend duration so far out in the cash market that it will eliminate these opportunities or significantly lower them,” he says. “In the U.S. space, there is much more opportunity for managers to demonstrate alpha while still doing a pretty good job managing liabilities.”
NORTEL John Poos, director of global pensions at Nortel, says the company moved approximately $3.5 billion in defined benefit assets in Canada and about $1 billion in the U.S. into a long-duration portfolio three years ago. Both plans had “hard” closes effective Jan. 1, 2008, and no further service is accruing. The asset mix in both countries has been shifted from 60% equities/40% bonds to a 50/50 split. “What we’re doing now, in terms of our specific LDI position, is just enhancing it further in terms of some leverage in order to even further match our liabilities.”
However, he acknowledges there are more challenges in completing the Canadian implementation because of both the size of the plan and the fact that liabilities are indexed to inflation. “The answer is real-return bonds, but 30% of a $3.5 billion plan would monopolize the market, so we need to
Both Rumley and Poors agree that, at the onset, one of the biggest challenges in both countries was getting stakeholders to think about pensions differently. “A total mindshift was required from how well our assets are doing vs. the external world to how well our assets are doing vs. our liabilities. Once people got their head around that, the process of getting from where we were to where we are today got much easier,” says Rumley. “One of the things that will happen when you embark on any kind of LDI strategy is the volatility of assets will increase materially because interest rate volatility also affects liabilities,” comments Poos. “If your committee continues to be programmed to measure performance as against peer groups, at the first diver-
At the onset, one of the biggest problems in both countries was getting stakeholders to think about pensions differently. look at other options.” Not only are there a larger number of bond issues in the U.S., says Poos, “but even if you do find the bonds you need in Canada, there are not as many counterparties that will take the ‘swap’ risk.” Investing Nortel’s Canadian pension funds in the U.S. market and hedging the risks is certainly something to consider but, he says, “All our liabilities are measured against the Canadian long index, and if we move
gence from the peer group they could have a knee-jerk reaction, and you could be out of a job!” Poos also does not believe that low interest rates necessarily make it a bad time to embark on LDI. “The question really is, are you concerned today for the liabilities in your plan if interest rates drop another 25 or 50 basis points? You won’t get the upside of the market with LDI, but you will be protected from the downside,” he says. —I2 INVESTMENT INSIDER
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A snapshot of current pension investment trends Greenwich Associates’ recently released “2007 Canadian Investment Management Research Study” presents a fascinating snapshot of how Canadian institutional investors are investing, and what they are planning going forward. It also takes a look at trends in investment management fees, the growing demand for portfoliowide strategies, plus the current and
expected share of assets in defined benefit and defined contribution plans. In this issue of Market Watch, we are pleased to share with you excerpts from the Greenwich study, which is based on data collected in interviews with 257 corporate and provincial government pension funds, endowments and foundations.
Canadian pension plans rapidly diversify
Portfoliowide strategies could revolutionize plan management
Freed from past regulatory constraints on foreign investments and driven by a desire for diversification and higher returns, the Greenwich study shows that Canadian pension plans, endowments and foundations are adding international assets to their investment portfolio at a rapid rate. Key findings include: • International investments now make up 30% of all institutional assets in Canada, including nearly 60% of institutional equity portfolios. • More than one quarter of large Canadian firms have started using currency overlay strategies to hedge risks associated with their exposure to nondomestic investments.
• When seeking out alternative investments, Canadian institutions prefer real estate and private equity to hedge funds. • Strong funding ratios have enabled Canadian pension plan sponsors to avoid closing defined benefit plans and slowed the growth of the defined contribution market. Nevertheless, Greenwich Associates consultant Chris McNickle says: “In other markets, we have seen that the implementation of mark-to-market accounting rules has prompted a sudden and decisive shift by corporate plan sponsors out of DB into DC. When and if Canadian regulators move the market in that direction, we could expect the same.”
Canadian institutions are in the early stages of a strategic shift that could ultimately transform the way pension assets are managed. Greenwich Associates reports that 25% of 2007 study participants say they have adopted some form of asset-liability matching strategy in their portfolio, and another 19% say they have plans to do so. Slightly more than 10% have taken the next step and implemented liability-driven investing strategies — more complicated approaches that use derivatives to more accurately match assets to liabilities in their portfolios. Another 18% of funds say they expect to incorporate LDI strategies into their portfolios. At the same time, 20% of Canadian funds say they are using
absolute-return strategies, and another 13% say they have plans to adopt absolute returns. Funds that have adopted asset-liability matching devote an average of 77% of total assets to the strategy. Users of LDI include 55% of total assets in that approach, and among users of absolute returns, the strategy amounts to 59% of assets. “The growing use of these strategies has major implications for the Canadian investment management business,” points out Greenwich Associates consultant William Wechsler. “The typical Canadian fund currently uses about seven asset managers. But under this new model, a single manager controls 55% or more. The rest get squeezed.”
Fees on the rise for Canadian Funds Investment management fees increased in most asset classes for Canadian plan sponsors from 2006 to 2007, after dipping the previous year, according to data collected by Greenwich Associates. Overall, Canadian funds paid an average 35.1 basis points (bps) to all outside managers. By asset class, fees paid to active managers of: • Domestic equities increased modestly to 30.8 bps in 2007 from 29.5 in 2006. • Fixed income rose to 20.7 bps in 2007 from 18.1 bps in 2006. • EAFE equities jumped to 56.6 bps in 2007 from 53.7 bps in 2006.
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• U.S. equities declined slightly from 2006 to 2007. The Greenwich report also notes that only 11% of Canadian funds use performance-based fees to compensate investment managers. Among those that do, performance fees are used most commonly for active U.S. equities and active income. Usage is much higher among funds with more than $1 billion in assets, about 20% of which pay managers performance fees. Canadian funds also saw an increase in fees paid for regular consulting services, which increased to an average of $105,000 in 2007 from $95,000 in 2006, and for fees for traditional actuarial services, which rose to about $158,000 from $140,000.