The recent pressure put on Canadian pensions plans from private managers and governments to re-discover an investment home bias has been met with little enthusiasm, despite special interest by both federal and provincial governments to potentially tap pension fund capital for infrastructure given that current expenditure eats up a large share of the budget.

Infrastructure is a key liability hedging asset for Canada’s pension plans that was initially introduced as a less than perfect inflation hedge that offered the promise of some capital gain, largely because there weren’t enough real return bonds to begin with. That long-lived shortage has now been made critical by the feds’ decision to end real return bond issuance.

Read: Real return bonds support pension risk management, provide liability data: ACPM

Real return bonds are an essential risk management tool for index-linked, defined benefit pension plans and are the ideal discount rate underpinning the investment planning process. Beyond their inflation protection properties, real return bonds narrow the gap between the interest rate sensitivities of assets and liabilities. As real return bonds mature and drop out of the debt stock, their effective interest rate sensitivity falls and their contribution to risk reduction falls away.

The removal of these tools not only takes away the best inflation-protection asset, but it also works against effective balance sheet management, putting risk management on the back foot at these organizations and depleting the effectiveness of the Canadian pension model. The more a plan reduces the asset-liability mismatch, the more active risk it can take to ensure benefit security at a reasonable cost. Ask casual observers to rank risks to future benefits from greatest to smallest and active management risk usually leads that list. It usually is closely followed by equity drawdown risk, even though asset-liability risk sits at the top.

Reducing asset-liability risk creates more scope to take active risk that can reduce overall risk and add to investment return. A reduction in balance sheet risk empowers skilled managers to maximize the diversification benefit that reduces risk and adds return.

The ability to manage assets and strategies actively, sits at the heart of the so-called Canada model of pension plan management that’s earned so much admiration around the world. This model combines good governance with best-in-class active management. The insertion of risk calibration and budgeting to the heart of the investment management process was a necessary condition to both the pursuit of active management and the greater weight of private, illiquid, alternative assets on the balance sheet that helped make the Canadian pension industry a global leader.

Read: Ontario Infrastructure Bank to leverage public sector pension investments

What gathers less attention in superior investment performance from these investors is the use of leverage, which has contributed to building superior funding ratios relative to other countries. Use of leverage in professionally managed plans, where risk is viewed as both a resource and a constraint, boosts return and is a perfectly acceptable contribution to pension affordability.

Many of Canada’s most sophisticated pension plans have about half of their assets allocated to managing liability risk, so nearly all their return comes from active management of the remaining assets. This creates a burden on the assets and strategies that managers pursue to meet annual return targets.

If asset-liability risk creeps up as the availability of real-return bonds declines, then pension plans’ ability to take active risk may decline in the absence of an effective substitute. The less active risk that Canada’s pension managers can take, the less powerful the Canada model is. The hunt is on for real-return bond substitutes that can fulfill the dual role of securing inflation protection and hedging liability interest rate sensitivity.

One emerging solution is to pursue U.S. Treasury Inflation Protected Securities, given similar inflation trends between the U.S. and Canada. However, there are challenges with this solution because of the significant differences between the consumer price index in each country as they aren’t harmonized and the two don’t directly map, introducing some basis risk.

Read: PIAC urging feds to open consultation on cessation of real return bonds

Like infrastructure and real estate, U.S. TIPS introduce less precise Canadian inflation protection, despite having sufficient interest rate sensitivity. But unlike infrastructure, these assets don’t come with the same potential for capital appreciation, nor can they be managed to boost investment return in quite the same way since the assets are subject to mark-to-market valuation.

Canada also has an independent monetary policy and at times, U.S.-Canada interest rate differences and volatility can be significant. Moreover, monetary policy divergence is facilitated by a flexible exchange rate and the Canadian dollar can move over a wide range when there are significant economic differences between the two countries.

The call for Canada’s pension plans to invest more at home, especially in infrastructure assets, came after the decision to end real-return bond issuance. While the search for substitutes may whet the appetite for more infrastructure, the federal government has made it more difficult for pension plans to manage their single biggest risk.

Read: Withdrawal of real return bonds could financially impact DB pension plans: CIA