This is the second post in a three-part series about the shift among Canadian institutional investors away from the traditional 60/40 asset mix and into alternative investments. In the first post, we examined several recent trends in asset allocation and what they mean for asset managers. In this post, we look at some of the economic and social factors that led to those very trends.

By nature, pension plans face long-term time horizons. As a result, their focus has historically been on total, absolute returns with less importance placed on short-term performance and volatility. The notion has been that since equities outperform in the long run, less emphasis can be placed on short-term investment performance.

Read: The evolution of asset allocation: Trends and implications for asset managers

There are two potential issues with such a focus on long-term performance.

1. It works in theory only if we value a pension plan based on the assumption that it will live in perpetuity. However, there are two important methods to pension plan valuation. The first, described above, is known as the “going concern.” The second is known as solvency and assumes the pension plan ceases to exist at the time of valuation. For both methods of valuation, the proportion of a pension plan’s assets to its liabilities (known as the funded ratio) is calculated using the following formula.

Under the solvency method, assets are valued as if sold immediately for their fair market value and the resulting ratio is called the solvency ratio. This ratio gives a good indication of a plan’s ability to match its assets to its liabilities in the short term. A solvency ratio less than one indicates a plan would not be able to meet its obligations with its current level assets. A ratio greater than one indicates a plan would be able to meet its obligations with its current level of assets.

Read: How Air Canada’s pension took off as Canada Post’s plan sank into deficit

2. The focus on long-term performance alone ignores the path dependency of asset allocation decisions. That is, short-term performance and solvency can drive long-term asset allocation decisions. A plan that moves from a solvency ratio less than one to greater than one is more likely to implement a liability-hedging strategy (including alternative investments) than a plan that moves in the opposite direction.

Relating this back to asset allocation, a plan’s asset mix can heavily influence its solvency. A traditional mix with a 60 per cent allocation to equities and 40 per cent allocation to fixed income will exhibit good solvency during times of economic growth. In a best case scenario, this could result in an increase in the amount of benefits being paid. However, the same mix will exhibit poor solvency during times of economic downturn and the shortfall between assets and liabilities will need to be covered. In a worst case scenario, this could result in increasing contribution rates or the sponsor may potentially explore reducing future accrued benefits.[1]

The recognition that solvency is an important measure of a pension plan’s financial health and that short-term performance can influence decision making — and ultimately performance — has been reason to look for asset classes that offer good returns without the same volatility as equities.

Read: Plan sponsors considering options amid market volatility

In addition, we cannot overlook the changes in the Canadian demographic environment over the last half century that have created the perfect storm for pension plans — people are living longer. The median age in Canada has increased from 26.2 years in 1971 to 40.5 years in 2015.[2] At birth, life expectancy has increased from 78 years between 1992 and 1994, to 81.1 between 2007­ and 2009.[3]

One of the key factors pushing up the median age is the large cohort of baby boomers growing older and steadily moving toward retirement, as shown below. In 2011, the first wave of baby boomers turned 65. As this generation retires, pension plans have an increased need for steady and reliable cash flows.

Alternatives help to meet pension plans’ needs as a result of the change in focus from long to short-term investment performance, and the change in Canadian demographics, a concept we will explore in Part III of this series.

Demographic Chart

Source: Greystone, Statistics Canada

[1] Accrued benefits under defined benefit plans are protected by legislation and cannot be reduced in this situation. Only future benefits that have not been accrued yet may be reduced.

[2] Statistics Canada CANSIM Table 051-0001

[3] Statistics Canada CANSIM Table 102-0512

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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Raphi Zaionz:

Regarding the solvency method, how are liquidity factors related to alternatives considered, especially as rates remain low and allocations to alternatives is increasing across the asset owner universe. This is compounded further by lock-ups pertaining to hedge funds and private equity funds. Do you simply accepts the NAV’s from the asset managers? Thanks

Friday, May 20 at 1:15 pm | Reply

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