Why the decision to boost alternatives in your pension portfolio?
The decision was driven by a need to dampen volatility, especially the volatility of pension contributions. We’re also seeking some inflation hedging, because our liabilities are partly hedged. What makes this really important for us is the relative size of our liabilities. They’re roughly $1.7 billion for a business that has an operating budget of half a billion dollars. It’s a huge liability for the corporation, so we are open to alternatives to help protect the corporation from the pension risks.
You have a strategic allocation goal of 15% for alternatives. How did you establish this target, and when do you think you’ll hit it?
We established that target in 2005 and right now, we’re sitting at roughly 10%. It’s a function mainly of private equity funds and infrastructure funds that are closed-ended, so it will take years from the time of commitment to become fully allocated. The pension fund has kept growing as well, in terms of its overall asset base, so that has also slowed the pace. This past fall, we became fully committed, with another two to three years to realize that commitment.
What alternative investments do you currently hold?
We have private equity, hedge funds, commodities and infrastructure.
What role does infrastructure investment play?
It’s very new. We committed to a closed-end fund in the fall, so we haven’t yet deployed any capital. From a theoretical perspective, it’s about inflation hedging—I look at it as low-volatility private equity. A lot of products are being marketed with 12% to 20% expected rates of return. We are going into it with a much more conservative expectation of 8% net. If we’re able to achieve that with modest volatility, we’ll be happy.
Do you have a real estate allocation as part of your alternative investments?
No, actually. We exited the space in the second half of 2006. We had only a small allocation left (about 1%) and at the time, when we had a discussion with the investment committee, none of us was particularly optimistic about the short-term outlook for real estate. We recognized the merits of real estate for a pension plan from a theoretical standpoint (some inflation hedging and liability matching), but we did not feel the timing was right to be increasing our allocation, based on the valuation levels. We wanted to increase our allocation to a meaningful amount or eliminate it completely, so we opted for the latter.
I can say we are happy with this decision now, after having seen what global real estate investment trusts did in 2007. Our solvency situation would be much worse today. As with every policy decision, nothing is ever permanent—we may choose to revisit real estate at some point in the future.
Have you faced any particular challenges in building your portfolio of alternatives?
Being a mid-size plan is always challenging. We’re not like the Ontario Teachers’ Pension Plan or one of the other major plans that does deals internally—we had to wait for packaged products to be available in the case of infrastructure, for instance. On top of that, you want to wait until there are more than two or three products out there. Offerings in the marketplace can force you to wait a bit longer.
In terms of the commodity exposures we gained, we also wanted a packaged product. We didn’t want to get into swap contracts at the fund level; we preferred to gain exposure through a pooled fund. So again, there weren’t that many available in the marketplace with long track records, depending on what index you want to track or base your strategy on (exclusive of the major Goldman Sachs Index). We opted for a product that was built around the Dow AIG, but we didn’t know of that many providers offering it.
What’s next for VIA Rail Canada when it comes to alternatives?
We’ll be conducting another asset-liability modelling in early 2008. We just finalized an actuarial evaluation, so we’ll have fresh liability data to use in simulations. What’s going to be driving everything is the increasing maturity of our plan. We have a plan that has net cash outflows of about 6%—it’s very mature, and getting more mature. As a result, allocating more assets to illiquid strategies becomes more difficult with time.
Based on your experience, what should other plan sponsors keep in mind on the alternatives front?
You need to look closely at the fine print. You don’t buy alternative products like you’d buy a bond pooled fund. You’ve got to be very careful and analyze all those legal agreements that come with the commitments for hedge funds, private equity and infrastructure. They might all look the same based on representation by the marketing people, but when you read the fine print, sometimes there are major discrepancies in terms of how fees are calculated and what kind of rights you’re giving away.
It always starts with education. We took our time and did our research beforehand, and it wasn’t until we fully understood the idea that we took it to [the board]. It took about six months—two or three meetings, bringing information to the table, meeting with managers, answering questions—not wanting to rush them in any direction. What also makes the arguments easier is what others are doing, and using major plans as a reference point. How have they done it? How good has it been for them? Who’s doing it, and to what extent? The pension investment management world is a relative game.
Also, try going in with a very small allocation to alternatives just to try it out and learn more. It’s one thing to learn from the outside, but when you’re invested, you learn much more than by just reading documents here and there about what it’s like to be invested. If, after a few years, you realize it’s for you, it’s going to be far easier to convince your board based on a favourable experience and facts that pertain to your own experience.
Do you see more Canadian plan sponsors moving into alternative investments in the coming years?
The wild card will be the defined contribution trend. For Quebec-regulated DB plans, I would expect most of the privately sponsored plans to close down in future years. That will put the focus on plan design, rather than [on] changing the investment mix.
For public plans or plans that evolve under other jurisdictions focused on going-concern valuation rather than solvency, there appears to be some level of interest in alternatives in general. But the transparency in many alternative investments is a major issue for many. Perhaps some of the new products that are coming out, such as 130/30 strategies, will be the furthest that some plans might consider when it comes to alternatives. The important thing is to be comfortable with an investment. Because, at the end of the day, we have a fiduciary duty. And if you’re not able to exercise an acceptable level of oversight on these products, then maybe you shouldn’t invest in them.
Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com
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