DB Plans Grapple With Volatility
Coverage of the Benefits Canada Benefits and Pensions Summit.
BY Scot Blythe | July 10, 2012
In a world where markets turn on a dime, the underlying economic fundamentals are often shoved to the side. “Diamonds are forever,” noted Avery Shenfeld, senior economist with CIBC World Markets, in an economist panel at the Benefits Canada Benefits & Pension Summit. “But when it comes to global economies, nothing else is really forever.”
Since the economic crisis, governments that ramped up speed in stimulating the economy are now pulling back “to seven lean years of activity,” he said, “as both governments and consumers de-leverage.” The global economy will return to a more normal state, he asserted, but “slow growth will be with us for a while.”
Emerging markets are the bright spot, noted Douglas Porter, deputy chief economist with BMO Capital Markets. While growth is flat or negative in developed markets, thanks to the emerging economies, global GDP growth is expected to hit 3% this year.
But “the European problem is a very long-term problem,” said Beata Caranci, deputy chief economist with TD Bank Financial Group, as more countries come up against Greek-style lending limits. In Canada, consumers worry that their debt could knock half a percentage point off GDP growth, she added.
Shenfeld thinks that while Chinese growth may slow, it has the capacity to spur growth, unlike European central banks. Added Porter, while “the Bank of Canada is warning of higher interest rates, pretty much the rest of the world is going in the opposite direction.”
More locally, the U.S. election cycle is creating a dilemma for the Bank of Canada, added Shenfeld. While it could be poised to raise interest rates as early as September, “the Bank of Canada will have to make a tough call.” The problem, as he noted, is that no one knows what U.S. politicians will do during the “lame-duck” period after November.
In a “multi-speed, multi-differentiated world,” diversification is far from a panacea, said Rumi Masih, senior investment strategist with BNY Mellon Asset Management. Risk management should proceed instead from an analysis of how and why a portfolio is positioned.
Masih described five macroeconomic regimes that will affect portfolio assets differently: perfect, warming, cooling, too cold (deflation) or too hot (stagflation). Yet these investment regimes don’t succeed one another like the seasons of the year. Rather, knowledge of these regimes “should give an appropriate idea of the asset allocation from a risk management as well as a return standpoint,” Masih argued.
But is risk worth taking in the first place? A lot of actuaries once thought so, said Malcolm Hamilton, a principal with Mercer. All of the asset/liability modelling in the 1980s seemed to point in the direction of a 60/40 portfolio “for no apparent reason.” The modeling skipped two basic questions: Whose risk are you managing? and Why are they taking on risk?
Economists provided a partial solution: the lifecycle retirement savings model for individual retirement savings. In other words, assuming that people smooth their capacity to consume over their lifetime, saving when employed to draw down those savings in retirement. DB plans attempted to build on this—but, said Hamilton, “they got it wrong.” Plans assumed that the returns that investments earned were largely independent of interest rates and that pension funds could be treated like individuals with infinite investment horizons (i.e., they didn’t grow old and didn’t need to cut back their exposures to investment risk as they matured).
Unfortunately, at least in the private sector, they forgot about the shareholders. Economists had proven that the cost of a DB plan was essentially independent of the investment policy pursued by the pension fund. Guaranteed benefits should be priced using guaranteed interest rates, not the expected return on a pension fund heavily invested in risky assets. On the other hand, actuaries believed that taking on more risk would reduce funding costs and that short-term risk washed out in the long term. “Unfortunately, things didn’t work out,” Hamilton explained.
In the end, he argued, risk exists and must be shifted from the shareholders to the beneficiaries. “We’re in a very different state than what we thought we would be in, in the 1980s,” he noted. Clearly, risk-taking has a cost. It isn’t free.
Investing for mid-size plans
Over the past decade, Canada’s biggest pension plans have shifted out of public equities and into alternatives such as real estate, infrastructure and private equity. Can mid-size plans imitate this exposure?
Jason Campbell, an investment consultant with Eckler Ltd., says no. The big plans “have structural advantages that can’t be replicated by a mid-size plan,” such as access to deal flow, the ability to command lower investment fees and even access to cheaper financing.
He believes mid-size plans can get alternative asset exposure but will benefit from “heavy lifting upfront,” which involves finding the right managers. But that’s the outcome of a much longer process that entails identifying both objectives and organizational roadblocks, as well as timing and positioning the transition to a new asset allocation.
Mid-size plans must pick their spot in selecting alternative strategies. Should it be diversifying assets or return-enhancing assets? It’s also important to assess a plan’s capacity to tolerate illiquidity. Some assets require decade-long lock-ups—which also means that the plan is married to its manager—underlining the need for due diligence. Finally, there are the fees.
One way to gain access to an important alternative asset class—real estate—is through a commingled fund approach, suggested Katherine Giordano, a portfolio manager with Aberdeen Asset Management. It’s sufficiently attractive that one of Aberdeen’s U.K. clients has reallocated its capital from directly held properties to a commingled fund approach. The investor made this decision to achieve greater diversification and to harness the benefits of professional management over a more global portfolio—all without boosting fees. She estimates that a commingled fund can be had for 30 to 50 basis points, for someone making a sizable commitment.
Fixed income opportunities
Interest rate risk can freeze pension plans like a deer in the headlights. Yet, as Canadian DB plans continue to de-risk their assets and hedge their liabilities, they’ll need to face it head on.
While Canadian interest rates are not far off their long-term average, noted Dany Lemay, a senior investment consultant with Towers Watson, they have wreaked havoc on plan liabilities. Combined with increasing life expectancy and early retirement, these components have made DB plans two to three times more costly than they were in the 1970s.
How can plans create a safety net to protect against funding fluctuations? Most consider their bond allocation their safety net, but it can be a very thin net.
Lemay gave two examples, assuming a pension liability of $100 million. With a plan that is 80% funded and has a 60/40 stock/universe bond allocation, a 1% interest rate fluctuation changes the bond returns by $2.1 million but changes plan liabilities by $15 million (assuming a bond duration of 6.5 and a liability duration of 15). But if the plan, when it was better funded (e.g., 90%), had shifted its fixed income portfolio from 40% to 50% of total assets and into long bonds, a 1% interest rate fluctuation would change the bond portfolio by $6.3 million, with the liability fluctuation remaining at $15 million. The first case has a 14% interest rate hedge ratio; in the second, it’s 42%. Clearly, the first plan, and to some extent the second one, has a fairly thin safety net—yet many Canadian pension plans fit one of these two examples.
As a plan moves to match liabilities, there’s no sense in letting money go to sleep, said Patrice Denis, vice-president with PIMCO Canada Corp. If sponsors want to keep their bond duration low, expecting that rates will soon increase, there are ways to exploit the yield curve.
One way is a swaption, which is a customized derivative that commits the buyer to buying at the long end of the curve when rates do go up. In the interim, for the same duration, the investor receives a 3.39% yield instead of the current 2.27%.
There are also opportunities beyond the DEX Universe, particularly in emerging countries. “I want to be exposed to a country that can aggressively cut rates,” said Denis, adding, “If I’m going to lend money, I want to lend it to someone who has the ability to pay it back.”
Scot Blythe is a freelance writer in Toronto. email@example.com
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