For many Canadian pension investors, the Canadian dollar has been a source of tremendous volatility in recent years. After reaching a post-financial crisis high of $1.06 in July 2011, the loonie followed a more or less steady slide, down to just below $0.69 in January 2016.
With weakening growth in China, and plunging energy and commodity prices, the Canadian dollar depreciated by more than 16% in 2015 alone. This weakening has also occurred at a time when many Canadian pension plans have been decreasing their exposure to Canadian equities, in favour of the broader and deeper foreign equity markets. For unhedged pension fund investors, the depreciation represented a significant bonus to total plan returns measured in Canadian dollars.
Read: 5 ways low oil prices and the falling loonie can affect the federal books
Between low bond yields and negative returns on Canadian equities, the depreciating dollar was one of the only sources of positive returns above the long-term going concern discount rates assumed by plan actuaries. Despite many plan sponsors benefiting from the currency’s decline, few were prepared for, or inclined to capitalize on, these gains and would have been positioned to give them back in the event of a strengthening loonie.
This reversal is exactly what has transpired in recent weeks. The Canadian dollar has been on a tear since the Bank of Canada rate announcement on January 20 as investors wait to see if federal deficit spending will be enough to create conditions for stable or possibly tighter monetary policy (i.e. no further reductions in overnight interest rates from the Bank of Canada).
Read: Bank of Canada lowers rate to 0.75%
So what can pension plan sponsors do about all of this? Irrespective of how they arrived at their current hedging policy, plan sponsors can, and should, review their approach to hedging – if for no other reason than to at least validate that the existing hedging policy continues to make sense in today’s economic environment.
There are several ways to implement currency hedging programs – passive or active, full or partial – to suit the needs of a wide variety of plans. Another, less common, implementation approach that some plan sponsors are considering today is a more dynamic plan, which changes the hedge ratio as the level of the Canadian dollar fluctuates.
The concept is to increase the amount of currency hedging when the Canadian dollar decreases, potentially all the way to fully hedged as some level at which the Canadian dollar is considered to be undervalued. Conversely, a dynamic hedging program would reduce the amount of hedging as the Canadian dollar appreciates.
Read: Ignore currency risk at your own peril
In support of unhedged policies, many have argued that currency is a zero sum game, and that over long periods of time currency movements are expected to “wash out.” However, the magnitude of currency movements today and the resulting impacts on pension plan funded status, can completely dominate the impact of active management, and even the selection of asset classes. For this reason we believe that a review of currency hedging policy should be a regular part of most plan sponsors’ oversight.