Looking at the current DB landscape can help to define the future in DC investing
Most discussions on evolution involve an investigation into the catalysts for change. DC plan sponsors, then, can look to DB investors’ evolutionary path to gain insight on future trends.
The future of DC investments is witnessing three key shifts occurring within the DB environment:
- an increasing exposure to alternative investments (i.e., real estate, mortgages, infrastructure);
- an increasing focus on risk management; and
- a mental shift toward objective-based investing.
The Past: Equity Shifts
U.S. Federal Reserve records from as far back as the 1940s reveal that pension plans invested almost entirely in fixed income markets at that time. These first pension flows reflected a world licking its wounds from the Great Depression and the preceding 1929 market crash. Equity investing resumed in the early 1950s as memories of the Depression faded and pension plans faced a need for higher returns to help fund obligations. As a result, pension allocations to equities steadily increased.
In 1985, Canadian pension plans gained additional comfort for equity exposures with the Pension Benefits Standards Act, which introduced guidelines for plans to make investment allocations based on the “prudent person rule.” This rule provided pension investors with the opportunity to look beyond the riskiness of an individual asset and instead focus on its role within a total portfolio. This resulted in a greater use of stocks within pension portfolios due to the diversification benefits when combined with bonds. Data from the Pension Investment Association of Canada show that equity allocations by the largest Canadian pension plans increased to a peak of 58% in 1999 from approximately 37% in 1992.
At the same time, pension plans began to look beyond Canadian borders for opportunities. The prudent person rule, as well as diversification benefits and fewer foreign property restrictions, led plans away from Canadian equities over this time. Increasing foreign exposures were a result of attractive correlations between Canadian and foreign equities. Correlations between asset classes are a key measure of diversification, as lower correlations point to less-similar assets. This can reduce overall portfolio risk when combining diversified assets. The lower the correlation between two asset classes, the higher the diversification benefit. Two highly correlated asset classes will have a correlation close to 1, meaning that their performance typically moves concurrently and in the same direction, thereby offering very little diversification.
A Canadian investor looking to global equities in 1994 would have seen a correlation of 0.51 between the two regions. Adding global equities at the time would significantly reduce portfolio volatility when compared to investing in only Canadian equities.
Another environmental change that caused a shift from domestic to foreign equities was the foreign property rule. Foreign property restrictions were historically in place for Canadian pension plans, but these limits eased over time, increasing from 10% to 20% in 1994, to 30% in 2001 and finally removed entirely in 2005.
DC investment programs have also embraced increasing exposure to foreign equities. In its 2012 CAP Benchmark Report, the Canadian Institutional Investment Network reported that 63% of DC plans in Canada offer a global equity investment option. This represents almost the same percentage (68%) that offer a Canadian equity option.
Pension plans can look to present-day shifts in the DB landscape that may transform future DC investments, similar to past equity shifts.
Evolution in Alternatives
After decades of rising equity allocations within portfolios diversified across bonds, domestic stocks and foreign stocks, rapid change is now occurring. Asset mixes are shifting from these traditional asset classes, particularly equities, toward alternative investments (see chart below). Given the need to match long-term cash flows—and the more conservative nature of Canadian investment practitioners—increasingly, there is an alternative flow into yield-oriented investments such as mortgages real estate and infrastructure where the underlying asset is easy to understand.
The catalyst for this shift is the continued search for assets with low correlations, which can diversify portfolio returns. In particular, the ability to diversify within equities today is significantly less than in the early 1990s. The correlation between North American and global equities has steadily risen since the turn of this century, from lows of approximately 0.5 to current levels of 0.8. The higher correlations have led pensions to seek out alternative sources for the diversification they need to reduce the portfolio risk.
Some DC investors have sought refuge in alternative investment options through “listed” alternatives. A real estate investment trust (REIT) is the most familiar listed alternative within Canada. DC plans find REITs attractive because they offer liquidity versus direct holdings in real estate. However, to understand REITs’ diversification ability, it’s critical to understand that they are simply stocks of companies with real estate exposure.
In other words, REITs are simply a sub-sector of Canadian equities.
Given that listed alternatives, including REITs, trade on an exchange, investors are still exposed to market ups and downs. Historical return patterns reveal that REITs have provided essentially the same level of risk (standard deviation of returns) as Canadian equities. This is not in line with the true diversification found in direct real estate, which has exhibited significantly lower volatility.
Direct alternatives represent ownership of the underlying physical asset. (In real estate, for example, ownership of an office tower would represent direct real estate investment.) Where pension plans lack the scale for direct investment teams, they can gain exposure through a private fund. Direct alternatives provide a purer exposure with significantly lower correlations.
Looking at Morningstar and IPD data from December 1998 to December 2012, direct real estate has provided a correlation of 0.11 versus Canadian equities, while REITs have had a higher (less diversified) correlation of 0.53.
As a result, DB plans have favoured direct alternative exposure as opposed to listed exposure. The future of alternatives in DC, then, has the potential to follow a similar path toward direct alternatives—if providers can make them available. In order to account for infrequent trading, it will be important for direct alternatives to be integrated into portfolios by way of target date funds (TDFs), asset allocation funds or balanced funds rather than be offered as a stand-alone investment option.
Evolution in Risk Management
DB practitioners have witnessed heightened awareness and dialogue around portfolio risks. Plan sponsors, asset managers and consultants are all investing significant resources into risk management systems and personnel. The investment lexicon is littered with concepts such as value at risk, tail risk, factor risk and black swans. In fact, risk management encompasses so many concepts that most risk managers will struggle to provide a single definition of risk.
This trend toward risk management, as with most evolution, has been a function of changing environments. Simplified assumptions for asset returns and risk classify past shocks (e.g., the tech crash and the financial crisis) as low-probability events. The reality is, however, that markets are more prone to these unexpected events than historical models have anticipated.
Despite increased awareness of risk with DB investors, the DC industry’s use of risk management techniques remains primitive. Looking at TDFs, for example, the primary and often only measure of risk used (when reviewing a TDF’s glide path) is equity allocation. That said, leading DC plan sponsors are now looking toward a more holistic understanding of portfolio risk. As the market matures, the depth of investment risk management will undoubtedly follow into smaller DC plans and a greater number of investment solutions.
Evolution in Thought: RDI
The third and perhaps most profound shift is a focus on outcomes and objectives. Increasing equity exposures witnessed over a half-century focused on maximizing risk-adjusted returns. However, this focus on risk-adjusted returns had a disconnect with the overall objective of DB plans—to fund pension obligations (liabilities). Not managing to the objective created a disconnect in recent years. The growth of liabilities has outpaced assets invested in a traditional 60% stock/40% bond portfolio. This disconnect is a result of falling interest rates (which increase the value of liabilities) and weak equity markets (which reduce the value of assets).
Given that a DB plan’s objective is to fund liabilities, the lessons learned are currently rotating practitioners toward liability-driven investment (LDI) strategies. LDI methodology calls for reducing the risk of assets falling relative to liabilities. The key is the focus toward end objectives, funding pension liabilities versus maximizing risk-adjusted returns.
Again, there is a parallel with DC investing where the majority of investment solutions are structured for maximizing risk-adjusted returns. Asset allocation and TDFs can offer varying levels of risk but can struggle directly answering the actual objective: how much money is needed in retirement?
In order to align investments with objectives, DC investing needs to use a retirement-driven investing (RDI) framework. This framework will set asset mixes based on how much is being saved and how much will be required in retirement. From the lens of meeting objectives, asset allocation will evolve from simple portfolio optimization to approaches that incorporate savings horizons, income needs and retirement spending. Just as DB plans are looking to reduce the risk of their assets vis-à-vis liabilities, risk management will play a greater role in RDI, which seeks to increase the probability of accumulating sufficient retirement balances to meet spending needs. RDI investors will keep an eye toward the primary risks faced by members: saving enough for retirement, minimizing the probability of outliving assets and reducing the probability of significant losses at or near retirement.
Most of today’s DC investment solutions do not use an RDI framework in their development and management. While TDFs have been a welcome addition to the DC investment industry by automatically tailoring portfolio risk to a member’s investment horizon, not all of them follow an objective-based (RDI) framework. A common challenge with TDFs is determining the shape of the glide path, which dictates the rate at which portfolios de-risk. In an RDI framework, asset assumptions, savings rates and retirement spending are directly modelled to maximize the probability of sufficient retirement funds.
Just as DB investors have embraced non-traditional (alternative) asset classes, DC portfolios in an RDI world will also look to incorporate alternatives, annuities and inflation-protecting securities.
The roller coaster of capital markets and the need to generate returns in a low-growth environment have been a catalyst for change in pension investing. There’s a shift in mentality within DB plans toward a focus on objectives (a liability-driven framework). DC plans can also refocus on retirement objectives (an RDI framework)—which includes increased risk awareness and the use of alternative asset classes—to help meet the challenges of an ever-evolving investment landscape.
Zaheed Jiwani is senior vice-president, client strategy, with Greystone Managed Investments Inc. zaheed.jiwani@greystone.ca