The removal of the foreign property rule (FPR) in 2005 was big news among tax-deferred retirement plans. No longer were these plans shackled to the Canadian market—which represents a small percentage of the world’s economy—for 70% of their assets. They could stop paying additional fees to gain foreign equity returns through derivative products. And they would no longer have to closely monitor the 30% limit and rebalance assets to avoid penalties.
Canadian tax-deferred plans could now diversify outside of the country to their hearts’ content. But while many expected the rule’s removal to kick ownership of foreign assets into high gear, that’s not how things turned out. Today, most Canadian pension assets are still heavily invested in Canada.
Safe at home
Of the eight large pension plans interviewed for this article, all continue to invest at least half of their assets in Canada. Most agree there are two key reasons why Canadian DB plans are
still significantly invested in Canada: home-country bias and asset-liability matching. “Don’t underestimate the effect of home-country bias,” says Jeff Norton, president and CEO of Teachers’ Retirement Allowances Fund Board (TRAF) in Winnipeg. TRAF’s foreign content has increased to 33%, up from 25% in 2004.
Norton cites a few reasons for this bias: the cost of hedging currencies, especially illiquid ones; some tax inefficiencies with foreign real estate and infrastructure; and higher fees for certain foreign asset classes. “You need to weigh diversification against these higher costs and tax inefficiencies.”
Foreign content holdings in the United Church of Canada’s pension plan have increased slightly since 2004. But the total sits at 24%, still below the old ceiling. “It’s not a priority to move out
of Canada,” says Dan Foster, the fund’s investment manager. He explains that the church’s investment committee has not expressed a strong comfort level in directing a more significant percentage
of its assets overseas.
According to Tanya Lai, vice-president, public markets, with the Ontario Pension Board (OPB), home-country bias is definitely a main reason why Canadian plans don’t invest more heavily internationally. At the same time, since plan liabilities are in Canadian dollars and move with Canadian interest rates, keeping a higher level of exposure to Canadian bonds helps protect part of the portfolio since assets and liabilities will move somewhat in tandem.
At the Royal Bank of Canada (RBC), “we are conscious that our liabilities are mostly in Canadian dollars, so our fixed income allocation will remain heavily weighted in Canada,” says Toza Siriski, manager of pension investments. The plan’s foreign content has doubled following the rule change, from about 20% before 2005 to about 40% now, with global equities and alternatives making up the bulk of those assets.
Focused on risk
Paul Malizia, a partner with Aon Hewitt, says that as plans start to take pension risk more seriously, changing their focus from return generation to risk reduction, there has been significant interest in liability-driven investing (LDI). “This
has resulted in a stronger allocation to long-term bonds, which has necessitated a shift in investment dollars away from equities, both foreign and domestic,” he says. This is based on what he’s seen his clients do and what he’s heard in general in the industry.
Foreign investments represent about one-third of pension assets at Hydro-Québec, though that is up just slightly from 30% in 2004. According to Charles Doucet, general manager of the plan, the small increase is due to the need to keep assets in the same currency as liabilities. “It is important to keep in mind that Hydro-Québec’s long-term obligations are primarily in Canadian dollars,” says Doucet. “This fact limits the foreign currency exposure that we take on.”
The implementation of an LDI strategy has also had an effect on foreign content at the Healthcare of Ontario Pension Plan (HOOPP). That plan
has actually reduced its foreign asset holdings in recent years, from roughly 30% in 2003 to about 25% today. According to Jeff Wendling, senior vice-president and chief investment officer, equity investments, the initial phase of HOOPP’s LDI strategy “involved reducing exposure to Canadian and international public equities and increasing fixed income (primarily Canadian) exposure to better match
plan assets with the pension liabilities.”
Wendling says he doesn’t expect his plan’s foreign content to drop any further. “The main adjustment has been done,”
he says. In fact, he expects foreign real estate holdings to increase from comprising about 9% of the plan’s approximately $5-billion real estate portfolio today to 15% to 20% in the coming years, depending on where opportunities are identified. Private equity—a $2-billion portfolio at HOOPP now comprising 60% foreign holdings—is under review, and its foreign exposure may also increase.
LDI has also led Imperial Tobacco Ltd. to reduce its foreign content holdings over the past decade. Algis Janusauskas, manager of pension investments and insurance, says foreign content limits never drove the plan’s
asset allocation but affected how it was implemented. Imperial Tobacco won’t be changing its proportion of foreign assets unless the fixed income allocation changes dramatically, says Janusauskas. Such a change would affect the amount invested in Canadian and international equities in the portfolio.
Staying the course
Imperial Tobacco is not alone in sticking with current foreign content levels. Half the plans interviewed said they don’t expect to change their allocations to foreign assets in the near future.
At OPB, Lai expects foreign content to stay within a range of 32% to 35%, up from 25% in 2004. In her view, it’s not the total foreign content that is important, “it’s what’s inside [the foreign content] that makes the difference.” In 2007, OPB conducted an asset-liability study of the plan. “We took the opportunity to rethink the sources of future global growth, and we believe that growth will likely come from the developing nations as their economies industrialize, populations move toward middle income and domestic consumption increases,” explains Lai. OPB is looking for emerging market investment managers that have capital preservation embedded within their process to dampen downside volatility, she says.
OPB’s strategic asset mix calls for 15% of its entire portfolio to be invested in emerging market equities, a level recently reached. The emerging market mandates are broad based, not dedicated to region or country, Lai says.
Other plans interviewed indicated that while they don’t expect substantial shifts, their foreign allocations could jump a little higher. TRAF has no current plans to materially increase foreign content, but “we are more likely to increase our foreign content than to decrease it,” says Norton.
TRAF has a large real estate portfolio that is currently based entirely in Canada. Norton says this is an area where the plan may explore opportunities to diversify internationally.
At RBC, where foreign content is now 40%, “we could move up a little bit higher,” says Siriski, “perhaps another 5% to 10%.”
The United Church is changing its investment policy to allow for more foreign assets, and Foster expects that foreign content will increase by 3%—all in emerging markets. In addition, he says there is a possibility that 5% to 10% of Canadian fixed income asset holdings could be reallocated to foreign fixed income markets in the next year or two.
While the FPR’s elimination may not have resulted in a dramatic shift of DB assets to markets outside of Canada, Malizia says the change helped usher in the move toward alternatives, many of which are foreign, such as private equity, infrastructure, global real estate and hedge funds. “When Canadian plan sponsors could not invest more than 30% of their fund assets outside of Canada, they weren’t as interested in these types of products, and the foreign firms that managed and offered them weren’t as likely to market them in Canada,” he says.
For example, the Scotiabank Group Master Trust Fund, a plan for employees of the Bank of Nova Scotia, Scotia Capital and Roynat, recently revised its investment policy to allow for up to a 10% allocation to alternatives. The previous investment policy did not allow for any alternatives.
Scotiabank believes that alternatives provide the portfolio with excellent diversification benefits, according to Wayne Yeung, manager of pension assets. “The primary driver toward these alternatives is to reduce risk without necessarily giving up return,” he says. “We generally define risk being the volatility of outcomes relative to our pension liabilities.”
To accommodate this increased focus on alternatives, the percentage of investment dollars allocated to foreign holdings will be reduced from 47% to 40% over the next two to three years. Yeung adds that, at least initially, alternatives added to the portfolio will be domestic, because it’s difficult to exercise proper oversight on alternatives far from home.
Eight years on, the removal of the FPR has resulted in “the best of both worlds,” suggests Colin Ripsman, senior consultant with Eckler Ltd. While pension plans that wanted to increase their foreign allocation were able to do so, “it’s a good thing for Canadian markets that so much pension money is still here.”
George Haim is a writer and financial services marketer based in Toronto. george.haim@gmail.com