With 2013 well and truly over, a number of us begin to prepare for committee meetings—if they haven’t already been held—to discuss performance. Supported by extremely strong equity market returns during 2013, the average Canadian DB pension plan earned in excess of 14%. In combination with the increase in bond yields over the course of the year, this has many Canadian pension plans approaching funding levels not seen since before the financial crisis began. Suffice it to say, these will be pleasant meetings.
While many DB plans are nearing full funding, not all plan sponsors are seeking to reduce investment risk. Many are trying to better define risk as it relates to their pension plan and sponsoring organization.
For those plan sponsors that are interested in taking some risk, the general view is that equities are at fair value and returns will be more reliant on corporate growth. With improving economic fundamentals in the United States, Canada and many European countries, corporate profitability is expected to remain reasonably strong in the coming years.
Corporate credit, which has benefited from spread tightening, remains attractive relative to sovereign debt but is also fairly valued. Intermediate bond yields across the developed markets now appear to be pricing in future cash rates, which are reasonably in line with the economic outlook. Even though bonds were perceived to be fair value in the fall 2013, many plan sponsors remained (and continue to remain) reticent to increase fixed income allocations given continuing low rates and the prospect of further increases in long yields. With the recent yield declines in January and February 2014, investors that are more dynamic in their asset allocation may wish to remain underweight.
For those plan sponsors considering further de-risking, a likely action will be to consider increasing bond allocations. In prior years, this likely would have meant purchasing long bonds or creating a matching bond portfolio. However, with yields still relatively low, and continued supply/demand pressures, plan sponsors are digging much deeper into their tool box when considering their options. Some plan sponsors are considering infrastructure debt and commercial mortgages for a portion of their fixed income portfolio. Non-Canadian sovereign bonds and corporate credit are also being considered.
Bond-like substitutes are also receiving some airtime. Real estate and infrastructure allocations have increased in the past few years. With regard to real estate, plan sponsors are certainly considering Canadian allocations but are more open to non-U.S. investments given the sector and, in some cases, the economic diversification they provide. Some plan sponsors are considering risk mitigation strategies to limit the downside risk of their equity positions. These include risk parity products and certain hedge fund strategies.
Despite the strong financial position of many DB plans, we are seeing a greater divergence of action than in prior years, and not all of it is related to governance capability and constraints. While the performance discussions at this round of committee meetings will be pleasant, discussions around risk and asset mix may be less so.