It isn’t that forecasting returns is a useless exercise. The problem is that the time horizon forecasted is too short to be of much use. CNBC and Bloomberg are focused mostly on days, weeks and maybe months at the longest. The long term forecasts directed at institutional investors typically have an annual time horizon. These forecast documents can be interesting to read, but annual is still too short a time horizon for the information to be put to any productive use.

Five years or ten years: now those are useful time horizons. Not necessarily useful from the perspective of tactical asset mix and beating benchmarks, but as inputs to decision-making on more important issues.  A realistic and informed projection of returns for the next decade can be a useful support for decisions about plan design, funding and also asset mix and investment strategy.

In terms of funding and plan design, sustainability and affordability are top of mind issues. Whether discounted at bond yields or expected total fund returns (a debate for another day), the principle question is the same: Will the contributions and investment returns provide enough money to pay pensions, or whatever liability the fund is obligated to pay?

When I look at longer term return forecasts, I am more inclined to give credit to those based on fundamentals. I have less time for forecasts based on opinions, historical returns or a historical equity risk premium. With fixed income, the current yield to maturity is the logical starting point and one can reasonably expect the yield to mean revert to something close to long term nominal GDP growth over time.

Equity return expectations can be built based on current yield, potential GDP growth based earnings growth and reversion to a mean P/E ratio. This type of analysis, performed rigorously by industry participants, comes out with 10-year returns of 2% to 3% for fixed income and 7% to 8% for equities.  A 50:50 asset mix gives an expected return of 5% nominal.

Two things jump out from this analysis:

1. 5% nominal may not be enough return under current scheme arrangements.

2. Equities should outperform bonds by a wide margin over the next decade.

The first challenge is acceptance: get over it. 5% nominal is a reasonable expectation. If it is not enough to pay the bills, then something has to change. Pay out less, collect more, and/or take more risk.

Hedging is all about mitigating risk. If you have a risk and you don’t like the potential impact, and the cost of hedging is reasonable compared to the potential risk, then you might hedge out that risk. When looking at interest rate risk and inflation risk, the next thing I would question is: How big is the risk today?  What is chance that the risk might materialize?

Current Government of Canada bond yields are 3.38% for 10 years and 3.80% for 30 years, at March 3, 2011.  Will they go lower? – maybe.  Will they go higher? – in my opinion – probably!!  Without any sophisticated analysis it seems rather obvious to me that the risk of substantially lower interest rates is a pretty modest risk and the risk of higher rates is rather large.

The latest all items Canada CPI was 1.8%, which is low and leaves room for it to move higher. Central banks are printing money, governments are running huge deficits, and the global economy appears to be getting some positive traction. Energy, food and other basic material prices are rising rather rapidly. While I won’t forecast imminently higher inflation, it seems like the risks are rather large and rising.

The last piece of this puzzle, well the last piece for today’s blog, is about costs.

How can the risks be hedged and what is the cost, or opportunity cost? There is no clear cut answer, as you can’t walk into a 7-Eleven and buy an interest rate or inflation hedge. Of the two, interest rate hedging is easier. Match the duration of fixed income assets with the duration of the liabilities and you’re done. There really isn’t a direct cost as the fees or commissions are minimal and the impact of changing rates will be equal on both the assets and liabilities – that is the point.

Is there an opportunity cost? I would say yes, and a maybe a big yes! Being unhedged, or mismatched, is taking a big risk.  Having an asset duration of 5 years (WCB- Alberta) and a liability duration of 10 years (WCB- Alberta) and 12+ years for most DB pension plans, is a very big mismatch. It is a big exposure to changing interest rates. If rates move lower, there will be economic losses, and if rates move higher there will be meaningful gains.

Bottom line for us is that at this point in time, with interest rates this low, we are willing to take this risk as we believe the risk/return tradeoff is tilted in our favor by a large margin.

Inflation risk is a different situation.  As mentioned above, I believe there is risk out there for inflation to surprise on the upside.  Don’t know for sure that it is coming by any means, but that there is a lot of risk, I have no doubts. This risk is a real cash flow risk that, if it transpires, will mean increases in cash payments out the door. These are cash payments that will need to be paid for with investment returns. This is a risk that we very much want to hedge away if we can. The challenge is in how to hedge.  Canada real return bonds are yielding barely over 1% real and the implementation using other inflation sensitive assets is much more complicated.

Stay tuned – more musings on inflation risk and inflation hedging are on their way soon.

This produces a puzzled look and I may start a long explanation of the apparent contradiction between ‘doing LDI’ and having a relatively short duration position in our bond portfolios.

It is unfortunate, but common, that terminology and ideas in our industry get taken over by service providers and attached to specific strategies or specific products.

LDI should be a broad concept where the strategies employed are very specific to each investor based on their liabilities, their own risk assessment and the cost of hedging those risks. What has happened, however, is that the acronym LDI has become associated with specific strategies or products aimed at one specific risk: interest rate risk. This approach runs the risk of hedging something that might not be a large risk and missing other risks that may in fact be much more material.

When thinking about LDI, I would suggest that plan sponsors and boards should start the process by looking at the risks first and the hedging strategy or products last. The questions, in order might be: What are the risks? How will the risks manifest themselves? Can the risks be quantified?

At WCB – Alberta the key risks to the liabilities are interest rate risk and inflation risk. Defined benefit (DB) pension plans would add longevity risk and maybe other risks depending on any unique plan or business characteristics.

These risks have been quantified at WCB – Alberta. The expected liability payments have a duration of approximately 10 years and each 25 basis point change in the discount rate has an impact of $140 million. The impact of inflation is seen directly on the cost of actual benefit payments as they are adjusted with a COLA on wage replacement benefits and are directly seen in health care payments.

In 2009 and 2010, with low inflation for both COLA and health care, there was an actuarial gain of $123 million – about $50 million per 1% per annum. This was an impact on cash payments for that year, but if the inflation assumption in the liability valuation is changed, then the impact is much larger; since it impacts the expected cash outflows for the entire future cash flow streams. This would have a similar impact as a change in the discount rate, 25 basis point = $140 million.

How will these risks manifest themselves?

The key issue is that interest risk impacts the value of liabilities by changing the assumed rate of return for investments or discount rate. I would call this a measurement risk as it does not actually change the actual cash outflows that we are trying to fund. It only changes the present value of the cash flows or the measurement of how much we think we need to have set aside today to pay future cash flows.

Inflation can have this type of impact as well, if we experience a period of high inflation, the actuaries may change the inflation assumption and if they change the inflation assumption the expected cash flows will be higher. If the real discount rate is unchanged then this will be offset, but that might not be the assumption used.

More important is that a period of high inflation will actually change the cash flows that go out the door. Wage replacement, health care and operating costs (or pension payments for DB plans) will be higher than expected. As opposed to a ‘measurement risk’ this is a real cash flow risk – real money out the door!

In my next post I will look more closely at that key piece risk puzzle – inflation risk.

At WCB – Alberta we are in the fortunate situation of a funded ratio that is currently around 130%. That may seem high to many and is high relative to most Canadian defined benefit pension plans. The relatively high ratio is a direct result of financial strategies that are derived from goals and objectives with a key direct influence from the legislative framework around funding levels. By legislation (the Alberta Worker’s Compensation Act) the funded ratio cannot go below 100%. This is exactly the opposite of federal regulated pension plans that by legislation couldn’t go over 110% funded.

The good news is that federal legislation is moving this limit from 110% to 125%. This was part of the Jobs and Economic Growth Act that received royal asset on July 12, 2010 and applies to all contributions made after 2009 for pensionable service after 2009.  125% seems like a very reasonable limit for contributions but could even be a little low. Asset-liability modeling performed with our assets and liabilities supports a target range of 114% to 131%. With this target range the probability of becoming unfunded or dropping below a funded ratio of 100% is small, very small, less than 1% per the asset liability model we use.

There are some important aspects of the modeling and of the workings of our funding policy. The reason the probability of going below 100% is near 0% is partly because of our cushion – we are starting near 130%.  That on its own is not enough. The funded ratio is volatile – very volatile – and we have a relatively low risk appetite, with about 40% equities in our asset mix and liabilities with shorter duration (about 10 years) giving less sensitivity on that side.

Some context for this level of volatility is shown in the following statistics. We track our funded ratio weekly: perhaps we do this more often than necessary, but if you believe ‘what is measured gets managed,’ then it is important to keep front and center the fact that we are managing a balance sheet and not just an asset portfolio.

On a weekly basis the funded ratio has ranged from 101.9% on March 6, 2009 to 135.3% on October 22, 2010. A 33.4% move in less than two years. Now, I admit that March 2009 was an extreme, but even just looking at 2010, the funded ratio started at 130.1% on January 1, 2010, went down to 124.9% on May 21^st (remember the European sovereign debt crisis) and then a few short months later it sits at 135.1%. In just six months a move of over 10%.

The funded ratio is very volatile, even with only 40% equities, but the modeling still shows a near 0% probability of becoming unfunded. The main reason is that our funding policy requires large levies if the funded ratio drops below 114%. These levies are added to employer premium rates, they are essentially the same as pension contributions that are above the cost of service in order to pay for an unfunded pension liability. The difference is that we start charging at below 114%. This might seem a bit too conservative but it is necessary to stay over 100%. Staying over 100% ensures that future employers aren’t unfairly paying for the cost of old accidents. An unfunded WCB or an underfunded defined benefit pension plan is a transfer of cost from one participant to another: employer or pension plan member.

To bring it back to legislation, there were also changes made recently in Ontario. Bill 236 Pension Benefits Amendments Act 2010 received royal assent on May 18, 2010 and had its first reading on October 19, 2010. One of the changes is to not allow contribution rate holidays when the funded ratio is below 105%. As these were previously allowed below 105% it’s a step in the right direction. But it’s only a small step. If a funded ratio can move by 30% in two years, and 10% in the last six months, then I would question whether a contribution holiday at 105% makes sense. A plan could start to conduct a valuation, and actually have an unfunded liability before they even finish it — they could then make a decision to have a contribution holiday. A 5% buffer is simply too small given the amount of volatility and funding risk that is being assumed by most pension plans.

In summary, I would give two thumbs up to a federal change that raises the allowed surplus from 110% to 125% and two thumbs down to contribution holidays when at 105% funded ratios.

Investment management practices are developed from ideas, research and experience.  The GFC was a great test for our theories and practices, a real test, better than a back test or a financial model, a real life stress test with real results to examine. Some practices worked well, others were challenged, and some are being questioned and replaced.

The first step was to reflect on what worked and what didn’t work. Step 2 was to celebrate the things that worked – this step often gets skipped but celebrations are always important. Step 3 is to closely examine what didn’t work and hypothesize on improvements. My eight previous blog posts really only got this far.

Going forward I will continue to post on these topics and I plan to share the results and ideas from the next steps. What are the possible improvements? How can we test them? Will they help going forward or are they only a solution to yesterday’s problems?

Some of this is leading to meaningful changes that we are implementing to policy and practices at my fund and, as they unfold, I hope to share them here.

If you read the lessons, I sincerely hope you got some value for your time spent. I appreciate the feedback I received on the eight lesson blogs.  Most has been positive, which was nice, but I have also appreciated the opposing views and have gained from the thought that they provoked.

The experience of 2008 and 2009 did not provide a clear answer. The policy of hedging certainly didn’t reduce the short-term pain in 2008 as returns on unhedged foreign equities for Canadian domiciled investors were much better than hedged (MSCI World Ex- Canada unhedged vs. hedged was -25.8% vs. -41.0%).  Was this a one-time random event or is there a fundamental reason this might be a lasting relationship?  A recent Harvard business school paper (Global Currency Hedging, published September 5, 2007, revised January 2009, John Y. Campbell, Karine Serfaty-de Medeiros, and Luis M. Viceira) may offer some insight into this question.

The authors make the argument that hedge ratios should differ between reserve currencies and non reserve currencies and it is a very convincing argument with a lot of intuitive appeal.

The basic idea, from a Canadian perspective, is that the hedge ratio vs. the U.S. dollar should be lower than the hedge ratio on other major currencies. This is because the U.S. dollar is the global reserve currency, at least for the foreseeable future, and it will always get a flight to quality, or risk aversion rally when there is stress in global financial markets. This makes the global reserve currency unique when setting an optimal hedge ratio.

The lesson learned is that for Canadian investors, there may be a strong case for a lower hedge ratio on the U.S. dollar than other foreign currencies. In times of financial market stress a strengthening U.S. dollar will partially offset negative equity market returns.

The timing of any change in hedge ratios is a tactical decision and should be done very carefully, but very much as a separate decision from the long-term policy hedging decision.

During the financial crisis, plan sponsors  learned at least three important lessons learned about asset mix rebalancing.

The first and most important lesson was that rebalancing works – it is a time-tested method that can add significantly to total portfolio returns and risk management.  Rebalancing forces you to buy equities when it is very uncomfortable (the news flow is terrible and the sentiment is that equities will continue to fall) and sell equities when it is psychologically and politically difficult to do so (the news is great, the economy is great, profits are great, sentiment is overwhelmingly positive).

Being contrarian is difficult and looks like it should have been easy after the fact. But putting in large buy orders for equities in February 2009 and watching the equity market continue to slide lower and lower was mentally punishing for plan sponsors. It involved a lot of second guessing.

Then market sentiment suddenly changed and on March 9^{th –} 2009 equities began a rally of approximately 40% over two months.

The second lesson is that rebalancing needs to walk a fine line between mechanical procedure and professional judgment. It should be both art and science. The mechanical targets force doing something but professional judgment is also necessary as the conditions are unique in every situation and there are other considerations, most obvious through this cycle was liquidity and the potential cost of blindly forcing fixed income managers to sell credit into the cash market that had very limited liquidity and would have been very expensive to transact in.

Judgment was also necessary because of the extreme volatility and the severity of the drop in values.

A blind, mechanical process that could execute quickly, perhaps with futures contracts, would have made continuous purchases of equities right through September, October and November resulting in increased losses compared to a static strategy.

The third rebalancing lesson is that the ability to rebalance using derivatives (futures and currency forward contracts) is essential for all mid- to large-sized funds. With limited liquidity in the fixed income market, a derivatives overlay allows for rebalancing with simplicity and at a low cost. Without this ability, the choices are to do nothing or force an expensive liquidation into an illiquid cash market.

Both alternatives were expensive and sub-optimal.

In the fallout from 2008, we witnessed events that have reinforced the importance of alignment of interests and the value of smaller, employee-owned firms. Large publicly-traded firms and subsidiaries of large financial institutions have had a consistent response to declining assets under management due to negative equity market returns — trimming staff or even putting entire investment management businesses up for sale. The smaller, employee-owned firms are stable, gaining new business and many are taking advantage of the available talent and adding new people to their teams.

There are many factors and beliefs involved in the art of external manager selection but one more lesson learned of late is that there may need to be a much higher value placed on independence and widely dispersed employee ownership.

2008 returns are shown in the table below.  Canadian government bonds returns were +11.5% and it was the only asset class that gave a meaningful offset to equity returns.

* Asset class data from Dex, S&P/TSX, MSCI and IPD.

The lesson learned is that diversification still works, but there must be assets in portfolios that are diversifiers in times of financial stress. Government bonds were that asset class in 2008 and will likely repeat as the top asset class in future periods of financial market stress. Going forward the return for assuming credit risk may look attractive, but abandoning government bonds (real or nominal) may not be a good idea. All assets should have a purpose and not all should be for generating excess returns. Government bonds might play an important defensive role in most funds.

• Settlements on derivative overlays used for rebalancing and portable alpha,

• Private equity and infrastructure contractual fundings,

• Hedge funds with formal lock ups and unplanned closures,

• ABCP, SIV’s and other short-term securities that stopped trading,

• Almost all OTC fixed income securities except government issues.

The only instruments and markets that had liquidity were government bonds and exchange-traded equities and derivatives. Nearly all other OTC fixed income and derivatives were completely illiquid in the fourth quarter of 2008 and first quarter of 2009. With market values down significantly, equities could have been sold, but they were one of the only assets that institutions didn’t want to sell.

Policy allocations to cash equivalents are typically 0.5% or 1% with some at 2% but very few above this level. Over the last decade the typical allocation to less liquid alternatives and the allocation to non-government bonds in fixed income portfolios have increased while the allocation to cash equivalents has been steady or even declined. The result was that plans gradually had less and less liquidity. For a long time nobody noticed because liquidity had not been challenged.

A simple rule of thumb may be that there needs to be at least 1% cash equivalents for each 10% allocation to less liquid assets.  For example, the WCB – Alberta fund is moving to an allocation that is 25% less liquid assets (real estate, infrastructure, mortgages) and therefore the cash equivalents allocation may need to increase to 2.5% of total assets.

Individual circumstances such as liquidity needed for benefit payments and the extent to which derivatives are used to manage asset and currency exposures should also influence the policy allocation to cash equivalents.

The lesson learned is that there can be a huge benefit to having more liquidity and better liquidity planning. Portfolios may need a higher cash allocation and perhaps a higher policy minimum allocation to government bonds. Investors also need to do a better job of knowing their future commitments to less liquid asset classes (private equity, infrastructure, real estate, and hedge funds), which will help avoid getting into a position where cash is not available to fund commitments.