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© Copyright 2000 Rogers Media. The following article first appeared in the April 2000 edition of
BENEFITS CANADA magazine.
Going global
The new federal budget allows pension plan sponsors to invest more of their assets in international
markets. That change in asset mix has to be handled carefully though.
By Andrew Kitchen
Higher expected returns, greater diversification and lower return volatility at the plan level are all
convincing and well-documented reasons to invest a portion of pension plan assets outside of Canada.
Pension fiduciaries want to expand their plan's horizons and explore foreign markets. But first they need
to answer two questions: How much? And where?
An increase in a plan's non-Canadian investments represents a change to the long-term strategic asset mix.
To make the correct change to this mix, plan sponsors must exercise due diligence to ensure that the change
does not compromise their ability to meet objectives--such as maintaining benefit security, controlling
contributions and expenses--within acceptable risk levels.
The volatility of investment returns, as measured by standard deviation, is widely used as the risk measure
of a particular portfolio. However, this gauge provides little insight into the financial risks faced by
plan sponsors in maintaining their defined benefit (DB) pension plans, given that it completely ignores the
plan's liabilities.
Financial risks facing the plan sponsor usually concern:
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The risk of funding deficiencies and additional contribution requirements.
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The risk of solvency deficiencies and consequential solvency contributions.
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The risk of deficiencies in the pension expense assessment of the plan and the associated impact on
annual pension expenses for corporate financial reporting.
In all cases, the risks can only be assessed by linking assets with liabilities to determine the exposure
to any deficiency. The relative importance of the risks will vary from plan to plan and depend on the
situation of the sponsoring organization. This leads to the issue of individual sponsor objectives and
specific pension liability structures, emphasizing the need for each sponsor to develop a unique solution
to determine the level of foreign content in their plan's portfolio.
ASSET LIABILITY TOOL
To help address these issues, the sponsor can use an asset liability study, with emphasis directed on
foreign content. The primary objective of the study is to identify an optimum mix of investments that best
fits the plan's liabilities and the sponsor's capacity to accept risk for added returns. The asset mixes
considered should not only vary the level of foreign content, but also investigate the relative weighting
of assets in foreign holdings, such as U.S. vs. Europe and Australia Far East (EAFE) vs. emerging markets.
The modeling process incorporated in the study typically projects the operation of the pension plan over a
specified period, say 10 years, using a computer program that simulates thousands of possible economic
scenarios and investment strategies. This technique allows the sponsor to see how their plan operates under
diverse asset mixes and market conditions, ranging from persistently bad markets, through average markets,
to persistently good markets. This, in turn, allows the sponsor to assess positive, central and negative
outcomes under various asset mixes for each of the risk variables (i.e. funded ratios, contributions and
pension expense).
DOWNSIDE RISK
Using the modeling process, the sponsor can also conduct a downside risk assessment to examine the
possibility of not meeting a specific objective. Downside risk analysis focuses on constraining the bad
risk (where the client objective is not met) and does not restrict good risk or upside potential (where the
client objective is met or exceeded).
For example, a sponsor may want to limit contributions to a threshold of $15 million over a 10-year period.
If cumulative contributions are lower than $15 million (good risk), the sponsor will clearly be content.
However, if cumulative contributions exceed $15 million (bad risk), the sponsor can compare asset mixes
using a measure that incorporates the probability of the event happening and the magnitude of the
contributions over $15 million. This measure is the downside risk.
By comparing the downside risk of asset mixes with varying levels of foreign content, the sponsor
identifies which asset mix minimizes the risk of not meeting specific objectives. For asset mixes that show
an increasing level of downside risk, the sponsor can determine whether or not the increased expected
returns and subsequent effects on funded ratios and contributions outweigh the additional risk of not
meeting their objectives. The sponsor can then quantify the risk/reward trade-off in specific terms.
HOW MUCH FOREIGN CONTENT?
Let's look at two DB plans to demonstrate the use of downside risk in the context of foreign content. Both
plans are identical, except that Plan A has starting assets equal to 120% of its going-concern liabilities,
while Plan B starts with assets at 90%. Both plan committees have decided that 70% of assets should be
allocated to equities and 30% to fixed-income investments. The committees must now determine how much of
the equity allocation will go to foreign equities, and to which type of equity. In addition, both sponsors
want to constrain cumulative contributions to $15 million over the next 10 years.
Using an asset liability study, the plan is projected over a 10-year period under a full range of economic
scenarios and a variety of asset mixes. For the purposes of this example, foreign equities have been split
evenly between U.S. and EAFE equities, and the level of foreign content is varied from 0% to 45% of total
assets. In reality, further investigations might also be carried out, varying the weighting of holdings
within foreign content (i.e. U.S. vs. EAFE).
The projected outcomes illustrate the distribution of funded ratios under each asset mix, as well as
cumulative contributions and cumulative pension expense, allowing the sponsor to see each of these items in
positive, central and negative market conditions.
How well do the varying levels of foreign content meet the sponsor's contribution objective? A closer
examination of Plan A and Plan B demonstrates the downside risk of not meeting these objectives (see "A
tale of two pension plans," above). The y-axis on the chart shows the expected returns based on the
projection assumptions of each asset mix on the curve. The x-axis records the downside risk--the expected
excess contributions over $15 million for economic scenarios in which the sponsor's objective is not met.
For Plan A, the risk of not meeting the sponsor's objective decreases as the level of foreign content
increases. This pattern continues until the foreign content reaches 25% of total assets. Afterwards, the
benefits of the additional expected return, as well as the diversification provided by the foreign content,
are outweighed by the foreign content's additional volatility and inability to match movements in the
liabilities.
MANAGING RISK
For Plan B, the downside risk is minimized when foreign content reaches 30% of total assets. Since Plan B
starts with a lower funded ratio, the benefits of the additional expected return are experienced over a
longer period of time when assessed against the plan's ability to meet the contribution objective.
If the sponsor's risk is defined in terms of not meeting the contribution objective, retaining any
portfolio with a level of foreign content below the level where downside risk is minimized results in a
less than optimal portfolio. This translates into a minimum foreign holding of 25% for Plan A and 30% for
Plan B.
The sponsor should also assess the impact of retaining even greater foreign content. Trading additional
contribution downside risk for higher returns is assessed by identifying the effect on the distribution of
the projected funded ratios, cumulative contributions and pension expense. If the sponsor decides that the
positive effects on these key distributions outweigh the additional downside risks on plan specific
objectives, a higher foreign holding may be appropriate.
MULTIPLE OBJECTIVES
A plan sponsor will typically have multiple objectives surrounding minimum funded ratios, contributions and
pension expense. While the analysis can be applied to all these objectives, it's unlikely that a single
asset mix will simultaneously minimize the downside risk of all objectives. Therefore, the adopted mix may
be dominated by the primary objectives and generally satisfy secondary objectives.
The optimum asset mix is unique to each plan and depends on many factors--the liability profile, the plan
funding position, the sponsor's objectives and more subjective issues such as risk tolerance. Two plans can
be identical and have the same objectives, but adopt different asset mixes given the individual risk
tolerances of the sponsors.
In the case of Plan A and Plan B, the risk of not meeting sponsor objectives is minimized at a point where
the foreign content exceeds 25% to 30% of the market value of plan assets. Other plans, however, may need
even greater foreign holdings to establish an optimum policy. In cases where the optimum level of foreign
content exceeds the maximum foreign content allowed under legislation, alternative solutions can be put
into action to implement the desired policy (see "Getting around the rules," page 88).
CAUSE FOR CONCERN
Current statistics show the average foreign content in pension portfolios is approximately 19% of the
market value of assets. This level has been rising over the last few years (see "Average pension plan
foreign content," right). The recent federal budget increases the allowable level of traditional foreign
content that a pension plan may hold. This may entice sponsors to futher raise their foreign holdings. The
important issue, however, is to identify the appropriate amount of foreign holdings for the individual
plan. Experience indicates that a plan's most efficient foreign content level often exceeds the current
average pension plan foreign holding. Given the lack of formal asset allocation planning against
sponsor-specific objectives and risks, it's likely that many plans will retain unnecessarily risky asset
allocations. In a business environment that demands performance and efficiency, sponsors should treat this
as a cause for concern.
Andrew Kitchen is director of asset allocations with SEI Investments in Toronto.
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