Canada’s defined benefit plans are allocating more to alternative investments as a result of a two-decade period of low inflation, according to a new study from the Bank of Canada.

It found sustained decreases in interest rates from 1998 to 2018 have threatened to erode private DB plan solvency surpluses. According to the authors — Bank of Canada analysts Sébastien Betermier, Nicholas Byrne, Jean-Sébastien Fontaine, Hayden Ford, Jason Ho and Chelsea Mitchell — this, in turn, led the majority of DB plans to make larger allocations toward bonds and alternative assets in order to improve portfolio solvency resilience.

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In the late 1990s and early 2000s, interest rates fluctuated between four and six per cent. Between 2002 and 2008, rates averaged at about three per cent. Since the 2008/09 financial crisis, rates have averaged at about one per cent and never risen above two per cent. The Bank of Canada’s current rate is just 0.25 per cent. As the level of interest rates declined, according to the study, 64 per cent of DB pensions transitioned away from a traditional 60/40 split of assets between public equities and government bonds.

Using anonymized data on the assets and liabilities of 128 private DB plans regulated by the Office of the Superintendent of Financial Institutions between 1998 and 2018, the researchers found the plans followed one of three broad strategies. Some 36 per cent of DB plans maintained a business-as-usual approach, transitioning less than 10 per cent of their portfolio allocations. About 30 per cent transitioned more than 30 per cent of portfolio allocations. And a somewhat smaller percentage (24 per cent) took a more moderate approach, transitioning between 10 and 30 per cent of assets.

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Among pension plans that transitioned assets, portfolio allocations tended to shift toward alternative investments and away from public equities. Allocations to private equity and real estate reduced solvency risks because of the comparative stability of these assets compared to public equities.

Likewise, fixed income sources have shifted away from traditional government bonds and toward corporate bonds and alternative assets, offering fixed income as a way to hedge against liability fluctuations resulting from shifts in interest rates. The researchers suggested this strategy has allowed pension plans to partially offset the diminishing returns offered by government bonds during the period.

The authors concluded the pensions that made more significant changes in asset allocations did so in order to diminish solvency risks. According to the OSFI data, the group of plans that switched more than 30 per cent of total assets saw solvency ratio volatilities average 30 per cent lower than those in the group that didn’t make reallocations.

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Throughout the period, the DB plans with the fewer changes to their asset mixes saw returns average about 25 basis points above those plans in the group that made the most changes. Despite this, the authors found that, at the end of the period, the majority of plans in this group had solvency ratios below 100 per cent. Among the plans that made the most significant changes to their asset mixes, the solvency ratio averaged above 100 per cent.

“Despite the decline in interest rates, most of the plans that overhauled more than 30 per cent of their portfolio returned to 100 per cent funded status by 2016 and their solvency ratio volatility declined by 30 per cent,” wrote the authors. “In contrast, most plans that kept the 60/40 portfolio mix ran a solvency deficit in 2018. Allocations to private equity and real estate reduced solvency risks because of the comparative stability of these assets compared to public equities.”

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