© Copyright 2002 Rogers Media. The following article first appeared in the April 2002 edition of BENEFITS CANADA magazine.

The question facing executives at Canada's Top 100 Pension Funds as 2001 drew to a close was not whether they could count on a market rebound in the short term, but rather how to negotiate what appears to be an extended softening of international stock and bond markets. Traditional asset classes that helped produce extraordinary returns in recent years hold no such promise in the short to mid-term. Low interest rates, coupled with a still relatively over-valued stock market, have combined to present pension fund managers with a daunting challenge. Toss in the realities of an aging baby boomer workforce looking forward to (in some cases early) retirement, and a startling picture becomes clear. Many of Canada's largest pension funds have had to restart their contributions to the fund. Still more will follow suit. Remarkably, for some funds, even increased contributions will not be enough.

"Real returns throughout the 1990s probably averaged in the 7% to 10% range," says Toronto-based Robert Bertram, executive vice-president of investments at the country's largest fund, Ontario Teachers' Pension Plan Board. "Most pension funds would have a real rate requirement of, say, 4.5% to 5.5%. At the present time, a Canadian real rate bond is 3.75%. So the real rates are insufficient to pay pensions.

"In the past, most people would have approached the equity market as having a 2% or 3% risk premium over a risk-free rate," he says. "Equities still appear to be relatively highly valued. So given that starting point overall, you really can't see that that risk premium is still there."

Daryl Jones, vice-president, policy and research at the British Columbia Investment Management Corporation in Victoria agrees with Bertram's analysis. "We are expecting more subdued returns on a go-forward basis, simply because of the low interest-rate environment and lower economic growth that we've been facing," he says. "People will not be able to rely on exceedingly strong investment returns in order to compensate for a lack of contributions."

IN THE RED
Canada's Top 100 Pension Funds are reporting $490.2 billion in assets as of Dec. 31, 2001. That is a 3.8% decline from the previous year's total. This is the first year-over-year decline in pension assets for the country's largest funds recorded since benefits canada began tracking the community in 1980.

Poor investment returns, combined with pension payouts (some as a result of layoffs), can be blamed for a good deal of the red ink spilled on balance sheets across the country. The average rate of return among the 70 pension funds who provided us those details was -0.3%. That's another first--we've never seen an average negative rate of return on investment among the top pension funds.

Just one of the top 10 pension funds grew its pension assets during 2001. Quebec Government and Public Employees Retirement Plan enjoyed a 1.2% increase, to $51 billion. That fund was one of only 21 in the Top 100 to see an increase in pension assets.

In fact, the average return on investment earned by the 10 largest pension funds in Canada was -1% (based on the responses of seven of those funds). The top 10 funds hold $244.9 billion, which represents 50% of the Top 100 total.

The top five funds hold a total of $184.5 billion. That's 37.6% of the Top 100 total assets.

There is one noticeable fund absent from the top 10--Ontario Electricity Financial Corporation Pension Plan. This is of course as a result of a reorganization in that province that has produced, among others, Ontario Power Generation (ranked No. 17) and Hydro One (ranked No. 23).

THE MIX
Not surprisingly, the portfolios of Canada's Top 100 Pension Funds are still dominated by the traditional domestic asset classes (see "The evolving portfolio," below). Canadian equities represent 27.5% of total assets as of Dec. 31, 2001. There is $99.6 billion invested in domestic equities among the Top 100. That's down $20.6 billion from one year previous.

Canadian bond investments totalled $105 billion, or 31.4% of total assets. That's down from 2000 as well. The total value of domestic bond investments among the Top 100 dropped $16 billion during last year.

Despite market conditions, the value of global equities held by the largest funds increased during 2001--from $20.3 billion at the end of 2000 to $21.1 billion. That represents 4.5% of total assets.

U.S. equities represent 11.8% of assets, totalling $49.9 billion. That represents both a dollar increase (U.S. equities totalled $46.6 billion at the end of 2000) and a percentage increase (U.S. equities made up 10.6% of total assets last year).

Equity holdings in Europe, Australia and the Far East (EAFE) held steady during the year. EAFE equities totalled $36.7 billion, or 9.4% of total assets. While that percentage allocation is up from 9% in 2000, the total dollar figure is down slightly from $36.9 billion.

Derivatives use
The percentage of funds using derivatives to hedge currency exposure grew sharply.

Source: benefits canada's 2002 survey of the Top 100 Pension Funds

ALTERNATIVE ASSETS
The next largest asset class, in percentage terms, is real estate. After a $2.4 billion drop in the value of real estate investments held by the Top 100 Pension Funds in 2000, last year saw strong growth. Real estate holdings totalled $31.3 billion at the end of 2001--representing 4.7% of assets.

This well-established alternative asset class is taking on a new importance for many Canadian pension funds as they adapt to the limited returns expected from traditional stock and bond investments.

"Increasingly, pension funds will be looking at getting investments that generate a cash flow that matches their liability," says Jones at the British Columbia Investment Management Corporation. "We've been strong supporters of good high-quality real estate as a good income source for our pension portfolio."

But just as Canada's large and mid-sized funds look favourably at real estate, it has become clear that some of the more esoteric alternative investment strategies deserve examination. And that is exactly what is under way among pension fund executives across the country. Having come to the conclusion that a commitment to alternative investments is necessary to fill the void left by vanishing risk premiums in the traditional asset classes, hedge fund and other alternative investment managers find themselves in the spotlight.

"I'm hearing considerable interest in alternative strategies," says Bob Adams, senior manager at the Bank of Montreal Pension Fund Society in Toronto. "There's less linkage to the markets. There's more of an absolute return expectation. People are still exploring those, rather than [there being] mass movement into them. But the interest level is quite high."

The performance of some hedge funds through the most recent bear market has been impressive. Adams has it right though; the industry for the most part is at the exploration phase for the time being. There is a steep learning curve on many of these strategies, one that pension fund executives, their trustees and consultants are working hard right now to climb. Canadian fiduciaries are learning before they leap.

The numbers

• Top 100 Pension Funds report assets of $490.2 billion for the year ending Dec. 31, 2001. That represents a 3.8% decrease from the previous year.

• The average rate of return on investments for 2001 was -0.3%.

• Total market value of the Top 100 Canadian equity holdings as of Dec. 31, 2001 was $99.6 billion, down $20.6 billion from 2000.

• The Top 100 report total market value of U.S. equity holdings of $49.9 billion, up $3.3 billion from the previous year.

• EAFE equities declined for the second year in a row, to $36.7 billion, from $38 billion in 2000.

• Global equities came in at $21.1 billion on Dec. 31, 2001, up slightly from $20.3 billion the year before.

• Canadian bond holdings among the Top 100 Pension Funds totalled $105 billion, down from last year's $121 billion.

• Total number of plan members--among the 71 funds that reported this information--is 2.1 million Canadian workers, and over 971,000 retired (or deferred) plan members.

• Investment returns among the Top 100 range from a high of 11.1% to a low of -6.1%.

• The average rate of return among the top 10 pension funds was -1%. The average return among the top 5 funds was -2.8%.

• Average asset mix: Canadian equity (27.5%); U.S. equity (11.8%); EAFE (9.4%); emerging markets (0.5%); global equity (4.5%); Canadian bonds (31.4%); international bonds (0.2%); high yield bonds (0.2%); real-return bonds (2.3%); hedge funds (0.5%); managed futures (<0.1%); private equity (0.4%); real estate equity (3.3%); mortgages (1.4%); balanced (0.3%); GICs (<0.1%); private placements (0.4%); venture capital (0.1%); cash (2%); non-marketable government debt (2.8%); and other (1%).

• In-house managers were responsible for $191.8 billion (43.9%) of the Top 100 pension funds. Specialist managers come in at $139.4 billion (31.9%). And balanced managers are reported at $106.1 billion (24.3%).

• The average total cost of running the Top 100 Pension Funds in Canada was 27.7 basis points.

• Average fee paid for active management: Canadian bonds (15.3 basis points); Canadian equity (26.7 basis points); U.S. equity (36.6 basis points); and non-North American equity (48 basis points).

• Average fee paid to active balanced managers: 15.7 basis points.

• Average fee paid for passive management: Canadian bonds (5.1 basis points); Canadian equity (5.6 basis points); U.S. equity (5.3 basis points); and non-North American equity (11.4 basis points).

• The Toronto Stock Exchange 300 total return index dropped 12.6% during the year.

• The Standard & Poor's 500 total return index dropped 11.9%.

• The Morgan Stanley Capital International EAFE total return index dropped 21.2%.

• The Scotia Capital Universe Bond index rose 8.1%.

Total Canadian pension assets

There was $714.9 billion in Canadian pension assets held as of Dec. 31, 2001. That is based on the amount of pension assets managed internally by the country's 100 largest pension funds ($191.8 billion) and an estimation of all externally managed Canadian pension assets as of Dec. 31, 1999 ($523.1 billion).

Active vs. passive
The majority of Canadian pension assets are still managed actively.

Source: benefits canada's 2002 survey of the Top 100 Pension Funds

NO EASY WAY OUT
Back at Ontario Teachers', Bertram has to deal with the retirement plans of thousands of the province's teachers in addition to the challenging capital market conditions. He predicts that his fund's payroll will increase 25% to 30% before levelling off. The only offset he and his team have, besides returns on investment, will be increases in the number of teachers and real pay hikes. Given the political environment in Ontario, neither are sure bets.

So then what lies ahead? Will the incredible shrinking risk premium reverse itself yet again? If the outlook for traditional asset classes doesn't improve, will alternative investment strategies provide the returns necessary for pension fund managers like Bertram to keep up with their liabilities? Stay tuned. BC