Whither the moderate institutional investor?

I have been looking at the pension system quite a bit recently, as everyone in the system seems to be making submissions for change. We are bombarded by working groups inside and outside of Canada on pension sustainability, systemic risk, and accounting changes. Even the federal government has waded in; their most recent outline regarding DC plans not needing Statement of Investment Policies and Procedures (SIP&Ps) seems short sighted when it comes to DC plan governance.

All this system activity has made me think about one of my first introductions to behavioural management, The Peter Principle, the 1969 book by Laurence J. Peter and Raymond Hull. Their principle states that people who are typically good at what they do at a certain level are promoted to the level where they are no longer competent. This doesn’t mean that the people were incompetent to begin with, but they end up in positions where they lack the knowledge and abilities to competently do their jobs. The more general principle is to use the same solution over and over again despite the demand of increasingly sophisticated uses, until the solution doesn’t work anymore.

Has this happened to the pension system? No. Can the system be improved? Yes.

It’s understandable for the layperson to question the integrity of the system, when so many capable people from accounting, actuarial, investment, legal and other professions are not able to help plans meet their pension obligations. We who spend our days devoted to helping clients try to pay their pension obligations know that it’s anything but simple. Interest rates have been declining for decades; their persistence in remaining low is a bigger culprit in the mismatch of assets and liabilities than investment returns. The direction and trend of interest rates has presented an impossible headwind for the most reasonable and prudent risk/return strategies.

We cannot control interest rates, and hedging interest rate risk, like any investment strategy, has to consider the plan’s sensitivity factors based on the plan’s current status. This means if your plan is in the hole, the only way you are going to get out is through contributions (a pretty tough order for some sponsors today), returns (we know the story here if too much or too little risk is assumed), and increased interest rates (time will tell).

The pension system is a complex system, and all systems are subject to systemic risk. The systemic risk of the pension system is also highly dependent on the systemic risk of the capital markets and as noted above, the direction and sustainability of interest rate levels. Capital market risk is a very complex system to accurately model. The purpose is to see not only how the components of the capital markets operate independently, but also how they combine in aggregate. This is very similar to what pension plans have been doing all along: how does everything add up at the total plan level? We clearly have more work to do here but I see two camps of institutional investors emerging from the traditional three camps:

1. You are an aggressive investor: you are prepared to take the risk that your return profile will be higher in the long-run at the risk of severe losses at points in time; or
2. You are a conservative investor: you remove risk and lower return expectations at every opportunity.

The concept of a ‘moderate’ institutional investor seems to be a thing of the past in today’s investment lexicon of LDI, low volatility and absolute return solutions. The disappearance of the moderate investor may also be due to the rate of change related to volatility in the markets. In other words, the ‘volatility of volatility’ also appears to be increasing. During the last 40 years, financial crises have grown in magnitude and complexity. This is not surprising, given that the growth of some corporations through M&A mania has lead to massive and complex ‘global’ companies deemed ‘too big to fail’. Global companies are connected like never before in terms of technology, and it’s the global banks that finance these companies. Governments are willing to act as a ‘lender of last resort’, where and when they can (think Iceland) in the event that a global bank or corporation fails. And of course governments have been/are willing to subject themselves to considerable financial strain.

Just as Canadians should be encouraged to manage their own healthcare needs, Canadians need to manage their own finances and retirement planning. It’s much more than whether or not your plan converts from DB to DC. It’s about knowing how to manage the pieces that form an individual’s retirement planning process. A company or industry pension plan is probably going to be a smaller part of this equation going forward. The next generation of DC participants may be the best placed for successful retirement planning, as these participants will be subjected to much stronger education resulting in higher levels of financial literacy.

Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company.

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