Rapid Investment Management Changes For Canadian Pension Plans
By: Keith G. Smith
Although some industry observers may still characterize the pace of change in investment management as gradual, it has clearly quickened in recent years and should continue to accelerate due to three key catalysts that are driving change for Canadian pension plans.
The first catalyst is regulatory change. The elimination of the foreign property rule for Canadian retirement plans has opened up a huge window of global investment opportunities.
Another push has come from the Canadian government, which recently offered solvency funding relief for federally regulated Defined Benefit pension plans. A similar move from provincial regulators would be welcome news for many DB plan sponsors.
The UK has already adopted mark-to market accounting rules and similar provisions are being discussed in the U.S. This could precipitate a major shift from equities towards fixed income. The recently signed U.S. Pension Protection Act may further encourage the shift in the U.S. from Defined Benefit to Defined Contribution plans.
The second catalyst for investment change is the underfunded situation in which many Canadian pension funds find themselves as a result of dramatically lower interest rates, correspondingly increased pension liabilities, and lower investment return expectations.
The third catalyst driving investment shifts stems from demographic change, especially the pending retirement of baby boomers who are likely to demand more protection from risk and inflation, as well as more income. The needs of both DB and DC members confronting this dynamic imperative will undergo significant change.
Resulting Changes In Investment Management
The first and most obvious change stimulated by the catalysts cited above is the accelerated shift towards globalization. The Canadian equity market represents about two per cent of world market capitalization and is heavily concentrated in the financial service and resource sectors. Canadian plans are increasingly looking for global mandates whose investment managers are empowered to seek out the worldʼs best companies, often accessing sectors not well represented in the Canadian marketplace.
A corollary to globalization is the heightened interest in niche strategies offering the perception of higher growth and/or alpha generating opportunities. Emerging market GDP growth rates are predicted to be more than double those of most developed market countries. Emerging market countries represent 81 per cent of the worldʼs population and just 12 per cent of world market capitalization. China and India together represent more than 35 per cent of the worldʼs population and they are clearly asserting their economic influence. Emerging market demographics are also dramatically different, which should enable them to sustain much higher GDP growth rates going forward. Only 32 per cent of the population of emerging markets are over the age of 35 in contrast to 68 per cent of the population in developed countries. If stock prices over the long term correlate to GDP growth rates, pension funds should consider a more proactive approach to investing in emerging markets.
The underfunded situation confronting many Canadian pension plans, together with an aging population, will demand a more focused approach to risk management and liability-driven investing (LDI) will assert its importance. Pension plan sponsors are beginning to realize that relative return, style boxes, and peer performance are less relevant than generation of absolute, consistent, or inflation-hedged returns that meet the pension planʼs liabilities and fulfill its promise to its beneficiaries. Liability-driven investing is an important consideration for pension funds, but regulatory initiatives in the UK and U.S., such as mark-to-market legislation, may have unintended consequences not in the best interests of most DB pension funds.
Fixed income returns have historically lagged equity returns over longer periods. A major shift from equities to fixed income in order to fund long-dated liabilities may lead to funding shortfalls and, ultimately, closure for many DB plans. Their underfunded situation also encourages pension funds to seek asset classes that can provide higher expected returns and lower correlations than traditional asset classes.
A popular theme that has received much attention recently is the separation of alpha from beta. This interesting approach, which has its merits, may not be appropriate for many pension funds. The packaging and pricing of some alpha-seeking strategies may simply be a mixture of alpha and beta masquerading as alpha. The implementation costs of portable alpha programs in which plan sponsors invest in fund-of hedge funds, with compensation structures of three and 30 (three per cent fees and 30 per cent carried interests), present very high hurdle rates for generating attractive returns on a net-of-fee basis.
A review of recent mandates shows that Canadian pension plans are pursuing many other trends. Private equity allocations have increased recently and this will probably continue given their expectation of higher and uncorrelated returns compared with more liquid public markets. Currency, tactical asset allocation, commodities, and real estate are also popular investment trends.
Another evolving investment class is infrastructure which can offer several attractive features for pension funds. Infrastructure assets are often a good match for pension liabilities based on their long duration, inflation-hedging attributes, relatively high cash yields, and low correlations to other asset classes and to the business cycle itself.
The elimination of the foreign property rule has accelerated the move to foreign bonds. Significant migration in this direction has been observed over the past year, which should continue as Canadian plans seek new opportunities in Canada-plus, global, emerging, and high yield debt.
Although these observations relate primarily to DB plans, another emerging trend is the institutionalization of retail and DC products as investors seek access to institutional products with better fee structures.
The profusion of a bewildering array of options in a climate of dynamic change is creating an opportunity for thought leadership and strategic partnering. Plan sponsors are seen to be seeking advice from investment managers who align their interests with their clients, providing value-added research and guidance as trusted advisors.
Keith G. Smith is president of GE Asset Management Canada.
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -