In the early days of 2020, no one could have foreseen the social and economic havoc the coronavirus pandemic would wreak on the world.
Nearly two years later, as markets and economies continue to recover, Canadian pension plan sponsors are looking to their money managers to help light the way to a brighter financial future. To start that conversation, there are a few key questions plan sponsors should be asking as the world re-emerges from these turbulent times.
How much is inflation expected to increase and how should pension plan sponsors prepare?
For Terry Taylor, general manager of the group benefits and pensions division at the Newfoundland and Labrador Municipal Employee Benefits Inc., one of the biggest questions is around increasing inflation. In August, Canada’s inflation rate jumped to 4.1 per cent, up from 3.7 per cent in July and ahead of a market forecast of 3.9 per cent, according to Statistics Canada.
“I rely on the investment managers to try and anticipate what problems may be coming down the road and whether or not we’re invested properly to handle anything that may happen. There’s no magic formula and you can’t [expect money managers] to have a crystal ball, but you do expect them to be able to anticipate and say, ‘We’ve got roughly four per cent inflation now. What do we do to counter that?’”
With the case to be made for both low or high inflation moving forward, Jafer Naqvi, vice-president and director of asset allocation at TD Asset Management Inc., suggests plan sponsors take a flexible approach by having a well-balanced portfolio with a diverse set of inflation hedges.
“There’s been large levels of government spending while central banks keep rates low. There’s also a run-up in housing prices and we’re seeing the case for long-term inflation, but you can just as easily make the case for low inflation. We’re not seeing broad-based inflation [and] some of those headwinds that have kept inflation low for the last 20 years are still in place. . . . That’s really the key — looking at the toolkit that can help you in those different environments.”
Liam Hartigan, vice-president and portfolio manager for asset liability management at TD Asset Management, says the approach toward managing inflation risk will depend on a pension plan’s investment time horizon. “Those concerned with short-term volatility should perhaps be looking towards real return bonds, which provide a more precise hedge. Plans with a longer time horizon can stick with equities and real assets to provide longer-term inflation protection. Most plans will fall somewhere in between and should utilize both methods.”
However, a little inflation can be a good thing for pension funds — with one caveat, says Eric Menzer, global head of outsourced chief investment officer and fiduciary solutions at Manulife Investment Management Ltd. “[Inflation’s] not the worst thing in the world, unless you have your benefits indexed to inflation. When you have to adjust benefit payments to inflation, then you can be a little more sensitive to it. But if your liabilities aren’t indexed, you’re going to see the flow through to higher discount rates which will ultimately lead to lower liabilities and better funding levels. It’s not the worst thing in the world to have a little inflation work its way into the portfolio.”
How can pension plan sponsors use fixed income to their advantage amid low interest rates?
Low interest rates aren’t a new story. With Canadian rates trending downwards since 1990, the World Health Organization’s declaration of the pandemic resulted in a further dip overnight on March 11, 2020, from around 1.25 per cent to 0.75 per cent and, by the end of the month, to an historic low of 0.25 per cent.
In mid-April 2021, the Bank of Canada said it would maintain that rate until inflation returns to two per cent, which it forecasted for later in 2022.
The search for yield in fixed income allocations will continue to be an important theme in the coming year, says Chris Boyle, senior vice-president and head of global institutional and strategic partnerships at Mackenzie Investments. “[Investors] have moved well beyond core fixed income allocation and they’re looking at core plus and how they can add or push the envelope on the plus component of their allocation.”
Daniella Vega, vice-president of multi-asset class solutions investment at Fiera Capital Corp., suggests pension plan sponsors ask their investment managers to clarify the role of fixed income in their portfolio and how they can get more out of these allocations.
“Is it for hedging liabilities, income generation or liquidity? It’s also maybe time to get more out of fixed income assets — if you’re looking at bond overlay strategies, there are concerns around rising interest rates and duration risk, but if you’re looking at that, it’s important to keep that in an asset liability context. Bond overlay strategies could also improve capital efficiency by taking advantage of low financing rates in the current environment.”
With interest rates expected to maintain their sustained downward trend, Menzer says it’s advantageous for pension plan sponsors to position their portfolios in a more conservative manner. “Overweight equities, underweight fixed income and more credit-heavy. We still see quality in credit — default rates are still low and there’s no major fears there. You see a little more credit in portfolios and depending on where your liability is and how your liability measures are picked up, you’ll have credit there against the liability as well.”
What role will private equity play in the coming year?
For pension funds, 2020’s bumpy ride highlighted the power of diversification.
“There shouldn’t be only two drivers of return moving forward,” says Hartigan. “Real assets like real estate and infrastructure have the ability to diversify the growth portfolio and lower funded status risk.”
Private assets can also offer diversification benefits, as well as the ability to provide high absolute returns or high risk-adjusted returns, says Vega. “Private asset classes really diversify the portfolio because they have low correlation to traditional asset classes. Looking at risk factor exposures, they’re exposed to different economic forces than traditional asset classes. It may also be time to take a closer look at the sources and uses of liquidity, which ties into the conversation about private asset classes and identifying less liquid private asset classes to improve risk-adjusted returns.”
And while some types of real estate and infrastructure took a hit during the pandemic, Naqvi suggests plan sponsors look beyond the headlines to the continued importance of these asset classes.
“Real estate is more than that. If we look at certain sectors like multi-residential, it’s going to play a critical role in supporting a growing population. It has done really well through the pandemic. Logistics, too — you need a lot of warehouses and they need to be close to highways. We think there’s more room to meet demand. Those trends were in place before the pandemic and have just been accelerated. Office real estate may have higher future demand, too, as companies may require more space between employees [post-pandemic].”
How can pension plan sponsors take advantage of the transition to cleaner energy?
As more governments and industries embrace the concept of clean energy to combat climate change, this global shift is generating additional considerations and opportunities for institutional investors.
While the transition to cleaner energy still poses many questions — including the impacts of an orderly versus disorderly transition, as well as the effects on inflation, interest rates and yields — it’s a good time for plan sponsors to look at stress or scenario testing from a strategic asset mix perspective, says Vega.
“One thing I’ve seen in the past is creating plausible overall scenarios for how different climate change models can impact those risk and return scenarios and understanding how the portfolio performs in those different situations.”
The role of environmental, social and governance factors in investment decisions is also growing unabated, says Menzer. “[ESG] isn’t a new phenomenon, but if you look at the market over the last five years, it’s like night and day. Investors care a lot more now and it’s written into plan sponsors’ investment policies. The industry in and of itself still has a lot to learn about what the value creation is. It’s about being green and investment returns.”
As more solutions are developed to combat climate change, this progress is bringing capital into productive areas of the market, says Boyle. “It’s clear everyone’s moving in that direction and it’s moved beyond governments imploring people to take action. People — whether they’re in plans, companies or individual investors — recognize the gravity of the situation and their power to affect positive outcome. We’re seeing a lot of activity within that space. Harvard [University’s endowment fund] is eliminating fossil fuels from their multi-billion dollar portfolio — it’s happening and it’s only going to accelerate.”
Are pension plan sponsors underappreciating risk?
Similar to the aftermath of the 2008/09 financial crisis, the market crash in March 2020 put a spotlight on “the real pain” of risk, says Naqvi, noting this is often forgotten by institutional investors during long periods of reward.
“You often find, in times like after the depths of the sell-off in 2020, there’s a big focus on risk, but it happens after the fact. It’s just a question to keep in mind, recognizing we’re in one of those periods where we may underappreciate risk. You want to have an eye towards risk and your objectives.”
And with many pension funds on track or ahead of their objectives, Hartigan says it’s important for plan sponsors to determine whether or not to take on as much risk going forward. “As a result of tailwinds from the equity market, plans are in a strong funding position. Sponsors should revisit their objectives to ensure they’re taking on the right amount of risk and once the risk budget’s been evaluated, we’d encourage sponsors to broaden their opportunities to take advantage of private and derivative market instruments. This would be especially true in the current low rate environment.”
For instance, bond overlays can be used to increase liability-hedging exposure and, at the same time, free up capital to invest in growth assets.
“Funded status can revert very quickly,” says Hartigan. “Sponsors should realize that achieving high asset returns will be likely very challenging in the future, given the pull forward of returns. They should consider moderating their expectations and those sponsors that increase their allocations to riskier assets purely on the basis of an expected return may be underappreciating the risk involved.
“If those increases are done without properly assessing the impact to funded status risk, it could compromise benefits security.”
Blake Wolfe is an associate editor at Benefits Canada.