Caught In the Cross-Winds – Yet Staying The Course
By: Bruce MacDonald & Joan Johannson
For many years pension plans stayed true to a map which seemed to lead them well. Their co-ordinates to stay on course were the allocation of assets to fixed income and equities and, although relative proportions were adjusted along the way in the interest of increasing the rate of return, they certainly seemed reliable. Progress was well mapped against milestones using performance benchmarks and comparison against peer groups. In combination, these elements seemed to take pension plans from the promise at the outset of the journey to a golden reality. In fact, investments were performing so well that liabilities were hardly given a second thought; a bit like charting a course with consideration given only to latitude and not longitude while letting the flow of the markets keep you on course and off the shoals.
Times have changed. For many plan sponsors, it is not simply common knowledge, but also a stark and personal reality that the pension plans they manage are falling well short of their goals. Assets at their current projected rate of contribution and growth will not take the pension fund to the level of funding required to meet liability obligations. The underlying cause? An asset liability mis-match.
The old means of navigating will simply not take the pension fund where it needs to go. What elements must change to meet these objectives? This is probably the most crucial question facing pension boards today. The traditional elements for managing a plan are those with which they are most comfortable and familiar. Yet, almost every one of these elements must come under review and, quite possibly, change. This introduction of change is very difficult for pension trustees as they are, by nature, conservative in their governance being very aware of their fiduciary duty to manage the plan to their best ability and the plan’s ultimate advantage. Yet, in an era in which the tried and true no longer is effective, how can one do so without venturing into areas not well understood and taking on risks not previously identified, quantified, managed, or accepted? To refuse to consider charting a new course with new tools is likely an even worse breach of fiduciary duty than to avoid them entirely out of concern for less traditional alternatives.
A Familiar Case Study
Let’s look at a case study. The Fictitious Plan managed by its Board of Trustees moved from a 60:40 fixed income to equity mix in the 1970s to a 40:60 mix to grow the fund’s assets. After all, investment models show that equities consistently outperform bonds over time. They considered the fixed income component still to be the fund’s safe harbour and eventually invested in a bond index to reduce costs. They further considered they had ‘matched’ their liabilities, which were entirely domestic, with a domestic bond fund and had controlled costs by not hiring a fund manager to manage what they considered a buy and hold portion of their portfolio.
As the years passed, they reviewed fund managers for the equity portion of their portfolio and consistently chose top quartile performers with a track record of beating their benchmarks. They diversified by maximizing their foreign content exposure as the foreign property rule evolved. They also hired more than one type of manager (although they moved more heavily into growth managers as the 1990s progressed). In the end, they felt comfortable that they were well allocated, well diversified, had controlled costs, and had selected managers on a fair and responsible basis. A few were concerned with the contribution holidays they were forced to take as they knew markets drop as well as rise. However, the plan as a whole was considered healthy and well on course.
In a shocking turnaround, today Fictitious Plan is having a hard time even figuring out what its goal should be let alone an appropriate course to get there. Somehow, liabilities no longer are well funded within the plan and concerns have been raised as to how a plan, introduced to attract and retain good employees to a growing business, might in fact prove detrimental to that very business.
At this point, many of us already can read the diagnosis. The pension committee had lost its way. They were perhaps dazzled by the glittery performance of the stock market and began assuming that liabilities would be met; the challenge was simply to achieve the best over-performance. The need to provide for the plan’s liability obligations had been forgotten.
At the same time, the demographics of many firms shifted in line with the aging of the baby boomers. The actual pay-out date behind their liabilities was coming due sooner and lasting longer than they may have anticipated and the actuarial tables used for predicting life expectancy were still largely driven by old data pre-dating many significant safety and medical advancements. More plan members were retiring and will be living longer creating new pressure on liabilities with increased and longer payout requirements.
In parallel, the markets changed. An unusual combination of factors resulted in an economic environment where interest rates dropped just as returns for publicly traded equities plummeted. The ‘tech bubble’ had burst and even some of the most widely respected blue chip investments had dropped like a stone. How can those pension plans which were caught in the cross winds hope to fund the aging boomers, some of whom are beginning to retire now? Clearly a change in strategies and tactics for managing pension plans is now called for.
First point of action for Fictitious Plan is to determine the size of the problem. Here again questions have been raised as to the appropriateness of traditional levels of returns projected.
Recently, the Ontario Teachers Pension Plan moved its long-term real return estimates from 4.35 per cent to 3.1 per cent. The impact on its liabilities is dramatic. Simply by predicting a lower, and hence more reasonable, rate of return going forward, Teachers has moved from a 2003 surplus of $1.5 billion to a 2005 deficit of $19.4 billion. This is one of the most widely respected plans in Canada, having returns well in excess of inflation consistently over the past 15 years. As a particularly well run plan, it is, perhaps, not surprising that Teachers leads the way in a more conservative approach to return expectations. This is, admittedly, even more of a hurdle for those managing plans for publicly traded companies answerable to shareholders and the market. In such cases, it is very much a corporate issue to increase the liability of the firm with more conservative valuations. However, it may also be the only true way to chart a course where actual liabilities are planned for and met.
Other alternatives include various means for reducing the liabilities themselves. This could include a change to the pension promise going forward. For example, the overall benefit could be lowered for new members, the members themselves might be asked to contribute more towards the plan, perhaps within a Defined Contribution program, or members could be asked to work longer. Another alternative, that the firm itself might have to contribute more, could be staggering to most firms. In fact, most of these alternatives would be considered a last resort. The remaining option is to revisit the investment structure in order to best meet the plan’s liabilities.
Changing Course, Changing Tactics
One can foresee a major shift in pension portfolio management from meeting or exceeding benchmarks to meeting or exceeding liabilities, which, in fact, was always the only real goal for the pension. While benchmarks are handy tools relative to measuring competence against the efficiencies of the marketplace, they in no way help the plan’s management with determining if the plan is well structured to meet its primary purpose: funding the pensions of the members. There is no satisfaction in having funds which outperform their peers only to fall far short of the required funding for the plan.
With this fundamental goal once again more clearly in mind, plan sponsors are reevaluating other assumptions within their plans, not just the actuarial projections and the role of benchmarks.
One of the cornerstones of pension plan investment strategy up until recently has been the 60:40 split between the equity and fixed income asset classes. Many plans have evolved further by adding absolute return or alternative investment components although in so doing have treated these investments as a third asset class. At this point, we need to question the very nature of this asset allocation foundation for pension structures. Let’s take a quick look at these two models.
The traditional 60:40 Model was designed to provide both stability, through the less volatile fixed income component, and growth, through the more volatile but also higher performing equities assets. Unfortunately, although pensions are longterm commitments, the actual liability to be funded is not static and is now overwhelming within a shorter time span than such a model can accommodate.
Today’s Evolving Asset Allocation Model has been designed to decrease the volatility of the portfolio while adding more kick to its performance by taking advantage of inefficient, less traditional markets with alternative investments. However, in some cases, the portion allocated is not sufficient to create enough upturn in overall performance. In some cases as well, the inefficiencies are quickly exhausted creating lower performance than hoped.
There is a further inaccuracy built into the Evolving Model. This is the treatment of alternative investments as a third asset class. This was likely a matter of convenience, requiring the least adjustment to traditional thinking, and quickly evolved into common usage. However, these investments often do not represent a separate asset class but, instead, a different means, or strategy, of investing which often cuts across the traditional asset classes, for example: hedge funds. As such they are the first step in the further evolution of pension planning; pursuit of a targeted risk level or rate of return as opposed to an abstract ideal balance of assets.
The Next Five To 10 Years In Pension Portfolio Management
Some of the most advanced thinking, globally, is beginning to be adopted by our much more conservative Canadian institutional investors. This is similar to the gradual introduction, in the 1960s, of equities into pension portfolios which were previously completely reliant upon fixed income. We are now experiencing a further change in the types of investments and strategies being adopted by some of the largest plans with the increased use of alternative investments. These strategies are more widely employed south of the border and around the globe. It is expected that as these strategies evolve and gain comfort in the minds of Canadian plan trustees, we will see a similar trend in Canada.
This fundamental change is represented best by the swing away from asset allocation structures (and their attendant benchmark measures) to a thorough analysis of the actual funding needs of the plan and how best to deliver to these plan requirements. Having a firmer grasp of liabilities and anticipated earnings for traditional investments, plan sponsors will likely adopt strategies designed to meet their liabilities plus deliver a degree of excess returns to guard against future swings in the market. But which types of investment strategies best meet the needs of the plan? Only after this decision is made can a reasonable analysis be undertaken of the fund managers, their depth of experience in a variety of markets, their performance in those markets, and their ability to customize investment and risk management strategies to meet the needs of the Canadian pension market.
Here we have received some help from the government with the elimination of the foreign property rule. No longer are plan sponsors restricted to investing the lion’s share of their portfolios in a market which represents no more than three per cent of the world’s potential. Early reports indicated that the traditionally conservative Canadian institutional investor would make only modest moves into foreign fund management. However, with an increased understanding of what this potentially represents for their portfolios, many are taking the approach that their fiduciary duty demands a better understanding of this much wider array of opportunities. Foreign equity markets provide a fully diverse set of opportunities for finding inefficiencies and, hence, greater opportunities for excess returns.
A further development is the increasing interest in foreign fund managers for fixed income strategies. The Canadian bond market is very thin when it comes to sufficiency of supply of long bonds to meet the outstanding liabilities represented by Canada’s pensions. Experienced foreign fixed income managers, usually coupled with currency hedging strategies, are now finding increased opportunities in Canada as institutional investors reach for alternatives beyond those in the domestic market. The potential for a mismatch may often be largely offset with a currency hedge leaving the investment decision on par with its domestic counterparts.
And so we return to the strategic evolution of the pension’s investment structuring in future. These strategies will be better designed to help plans stay the course despite the advent of cross-winds and other adverse conditions. They will be developed to meet the unique needs of the plan.
The Objective of the pension plan will consist of a combination of the policy (benchmarks) and the selected strategies (means of achieving out-performance of benchmarks) in order to both meet the plan’s liabilities and deliver a small cushion of additional returns.
In this version of the model (see Figure 1), the policy represents benchmark indices for bonds, the S&P, the TSX, EAFE, and real estate with most of these elements specific to the plan. Unfortunately, as recent history has shown, this alone will not likely deliver sufficient performance to meet the obligations of most plans.
The plan must adopt specific strategies, as delivered by investment managers, to outperform these benchmarks by delivering performance (Alpha) significantly above the benchmark (Beta), ideally to the extent where a cushion of surplus is provided for the plan. Such strategies are unlikely to be simply finding the best long manager. It is anticipated that in future investment committees will be introduced to strategies that will include absolute returns, leverage, and alpha porting.
As you can see, the asset allocation model is embedded within this model without being the primary driver of either the objective or the strategies. By adopting this model, plans may structure their investments to meet the over-arching objective of their plan: to meet the liabilities of the plan and deliver a margin of surplus. What will drive Canadian pension plans to change to a new model?
The first steps are already in place with the dangerous underperformance of the old models combined with the new opportunities accorded by the elimination of the foreign property rules. The next steps require motivation on the part of the plan sponsors and their boards to meet their fiduciary obligations by developing a higher level of knowledge and comfort with this increased range of investment strategies.
Given this model, what is the next step? It’s to define which strategies, given the policy of the plan, will allow plan assets to meet and exceed the plan’s liabilities.
Bruce MacDonald is a partner and Joan Johannson is senior vice-president at Integra Capital Management Corporation
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