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As DB pension plans approach higher funding levels—with funded ratios jumped from 82% to 94% in the first half of this year, per the Mercer Pension Health Index—sponsors are turning their attention to de-risking their portfolios.
At Benefits Canada’s annual DB Summit last week in Toronto, industry stakeholders discussed ways for DB plan sponsors to mitigate and manage risk more effectively.
To risk or de-risk?
This year’s equity bull run significantly improved the funding positions of DB plans, thereby reducing the necessity for significant risk-taking, said Mathieu Tanguay, a principal with Mercer.
“Typically, the further you are from being fully funded, the higher the incentive to take risk so that financial markets [can] pay for that deficit,” he explained. “The idea is to go from the current state of small deficit and some risk, to a desired state of fully funded and less risk.”
Tanguay said there are two ways that plan sponsors can achieve this: by retaining and reducing risk or by transferring it.
Those that retained risk have been de-risking dynamically as funding ratios climb, typically by increasing their allocation to fixed income or alternative assets.
Those that chose risk transfer strategies favoured lump-sum payments, longevity swaps, annuity termination or buyouts, he added. However, with interest rates edging higher, a significant number of plan sponsors are turning to annuities.
The annuity market in Canada is evolving quickly, said Manuel Monteiro, a partner with Mercer, and annuities are increasingly becoming an alternative to bonds as a hedge against volatility in the equity portion of the portfolio.
“In many cases, [plan sponsors] are finding that, because of a shortage of long corporate bonds in Canada, the effective yield on annuities is comparable to—and, in some cases, higher than—bond yields [that enable sponsors to] match liabilities,” he explained. “They can actually get longevity protection for free. When you buy an annuity, you can hedge your funding and accounting costs at the same time.”
A plan sponsor with a traditional asset mix—60% equity, 40% bonds—makes multiple bets on the direction of the stock market, said Brent Simmons, senior managing director, defined benefit solutions, with Sun Life Financial, who explained that this approach to asset allocation is no longer effective.
“Improving funding position isn’t as important as it might have been a year ago,” he noted. “A plan sponsor should be asking, ‘Am I actually better off taking that risk in my core business or in my pension plan?’”
“The scale is really tipping toward not taking a lot of equity risk,” said Simmons. “There seems to be no great use for the good news that can come from equities [but] a lot of downside to the bad news.”
Citing the current asset allocation trend in the U.K.—40% equities, 60% fixed income—Simmons asserted that “pension plan sponsors should be spending time managing their core business” rather than “making calls on markets.”
“There are £446 billion (C$776 billion) of assets in the U.K. that are deployed in a hedging strategy [to make] assets and liabilities move together,” he said. “The U.K. is certainly ahead of us in de-risking and pension plan management. Maybe, in Canada, it no longer makes sense for plan sponsors to have to call markets and be economists.”
U.K.-based Craig MacDonald, head of investment grade with Standard Life Investments, said the current stage in the economic cycle is a “sweet spot” for credit investment.
The key to exploiting the opportunity set in fixed income lies in two areas, he said: asset allocation and active management of investments.
In particular, packaging “global investment-grade bonds, global high-yield bonds and emerging market debt” will afford pension investors the “benefits of each part,” while their ability to move in and out of these assets will allow them “to fully exploit different parts of the cycle,” MacDonald explained.
That said, there are ways that DB plan sponsors can extract growth from their equity allocations. Denmark-based Bo Knudsen, managing director with Carnegie Asset Management, suggested thematic stock picking as a way to safely seek growth in equity markets.
The company’s strategy, he explained, is to hold no more than 30 stocks in a portfolio. “We try to identify what has changed in the world and find companies with tailwind in those trends.”
Specifically, Knudsen highlighted three key themes that are expected to emerge and may provide opportunities for pension investors: the evolution of technology, the rise of emerging markets and advances in energy efficiency.
Considering the alternatives
Still, a pressing need for alternatives to traditional investments is nudging some plan sponsors to look elsewhere. Wayne Wilson, vice-president with Lincluden Investment Management, proposes U.S. real estate and direct market infrastructure as “two of the most popular alternatives” for DB plan sponsors.
“Real estate and infrastructure do dominate the low-volatility and low-risk strategies,” he said. “They’re not marked to market on a daily basis.”
These assets are illiquid and, therefore, gated. This means, plan sponsors that invest in these illiquids are prevented from selling them at the wrong time, unlike those who hold equities and bonds, Wilson argued.
“This strategy does work best in your local market, because there’s a big income component,” he cautioned. “When you get outside of North America, dividend withholding taxes without the certainty of the Canada-U.S. tax treaties can take a bite [out of a pension portfolio].”
In addition, there are some growth opportunities for DB pension plan sponsors in the private infrastructure market. However, Jamie Storrow, managing director with Northleaf Capital Partners, noted that the bulk of these opportunities exist outside of Canada.
“Most people see the U.K., Australia and the U.S. as the most advanced jurisdictions for infrastructure investments, [as] all of their airports, utilities and ports are private,” said Storrow. “And that contrasts quite clearly to Canada, where we still have provincial ownership bodies for power and utility assets, and the airports are all publically owned.”
In terms of both size and number of deals, Canada is a small market, he concluded.
Vikram Barhat is a Toronto-based business and financial journalist. vikrambarhath@gmail.com
Click here to view photos from the event.