What macroeconomic trends mean for pension plan managers

This is not to say the forecast is bleak, just that for too many investors it looks persistently uncertain. It’s a new world, one that is profoundly unfamiliar to policy-makers, regulators, business leaders and institutional investors.

And handicapping the markets based on economic trends is, arguably, a tougher game than ever. Institutional and individual investors who were badly scarred in the financial crisis are still profoundly risk-averse; meanwhile, monetary easing and other policy actions since the crisis have created an artificial market environment. Together, these factors have created a wide, perhaps growing, disconnect between economics and markets.

This could hardly come at a less desirable time for Canadian pension plans, which are already facing an uphill climb to make up for lost returns. According to the BlackRock model, the funded ratio for DB pension plans hovered below 80% at the end of 2012, which represents only a modest recovery from its mid-70% range at the height of the financial crisis in early 2008. As if low fixed income yields and volatile equity markets weren’t enough, pension plans must also confront the realities of changing demographics in Canada, where life expectancies are rising steadily. When interest rates hit zero and people live forever, saving for retirement is going to be expensive.

But while this new economic and market landscape is unfamiliar to many, its outlines have been taking shape for several years now. These outlines might not give pension plans much comfort, but at least they’re beginning to be seen. And the good news is that leading institutional investors are attuned to the new realities and managing their portfolios accordingly.

There are a handful of fundamentals at work in the current environment that are relevant to the challenges and opportunities pension plans face today.

First, the prospects for risk assets and for economic growth stabilizing (though at low levels) are relatively optimistic. The private sector deleveraging that has been the rule since 2008 continues, but it is moving toward running its course. While economic growth looks to remain sluggish in much of the developed world, it’s a different story in developing economies. Fears of China’s hard landing don’t look as if they will be realized, and monetary conditions across Asia (except Japan) are easing. So there will likely be an uptick in industrial production, improved economic conditions and stronger equity returns in emerging markets going forward. Finally, the “nemesis” risk—a cataclysmic event that would rock economies and markets, such as the collapse of the euro—seems to be waning.

There are also opportunities for downside surprises, as fiscal tightening in the developed world could dampen growth and as the risk of inflation increases. On the plus side, the “correlated world” that has persisted in equity markets for the past six years—turning rules of thumb about the benefits of diversification upside down—has begun to weaken. Global stock correlations have declined in recent months along with returning investor confidence and rallying equity markets. So, on balance, investors are in a more upbeat state of mind, even in a world of lowered expectations.

For the last few years, pension plans have been living through an era of low yields as many government bonds and short-term debt instruments return what is effectively negative interest after factoring in inflation. The extreme risk aversion and loose monetary policy are conspiring to make it very expensive to park cash, leaving managers with few options. They can accept paying for cash as a cost of protecting wealth; they can invest in longer-term securities in search of yield and take on duration risk; or they can invest in non-AAA credit and take on credit risk. Many investors have been following the second option, taking on more and more duration for ever-lower returns. One good indicator, the DEX Universe Bond Index, had a duration of seven years and a yield of 2.3% at the end of 2012. This asymmetry between yield and duration risk leaves these traditional risk-free assets vulnerable to any rise in interest rates.

Meanwhile, regulatory changes are working their way into financial markets around the world. These changes are prompting banks to off-load risk and increasing their demand for low-risk assets. In the meantime, pension plans and insurers buy and hold safe bonds to hedge liabilities and fulfill their own regulatory requirements. This has increased demand for “safe” instruments even as supply is limited. At some point, this landscape should trigger a shift toward risk taking. But developed countries remain mired in debt—government, consumer and corporate—and it will likely take a long time for the deleveraging process to run its course.

Emerging economies are in much better shape. Debt-to-GDP ratio over the past 10 years has declined in emerging markets even as it has risen in developed markets to the point where there are spreads of 50-plus percentage points between them—divergences not seen since the 1980s debt crisis or the Second World War. This suggests that investors should be exploring opportunities in developing economies, particularly since China’s feared hard landing will be soft if economic growth there settles into the 7%-plus range. (For what it’s worth, Chinese president Xi Jinping recently said that while the period of “ultra-high” growth might not be sustainable, “relatively high” growth still is.)

So what should pension funds do to adjust to this brave new world? Following are six actions pension plan managers can’t afford to ignore.

1. Beware of fixed income asymmetry

The asymmetry in fixed income leaves low-risk assets vulnerable to any rate reversal. And while the timing and extent of such a reversal is hard to predict, investors need to be prepared for the strong possibility. And, as they do, they need to decide whether the next 30 years of fixed income investing will be like the last 30 years. Chances are, it won’t be the same, so what are leading pension plans doing? They are revisiting guidelines, using more appropriate benchmarks, using overlays and advanced screening techniques, or adopting absolute return strategies. Others are seeking out wider opportunities in terms of asset allocation. Given debt realities in the developed world, some are turning to emerging markets debt, where, in general, Canadian investors are underexposed. As well, continued bank deleveraging is creating new debt opportunities that combine regular long-term cash flows with higher return potential—in other words, behaving pretty much as they should.

2. Demand more from beta strategies

Institutional investors are increasingly allocating to indexed managed assets, but many have yet to take full advantage of the efficiency, risk management benefits and versatility that beta strategies can deliver. Minimum volatility index investing, for instance, can help limit downside. Beta strategies can also provide cost-effective, diversified exposure to emerging and frontier markets, with the potential to deliver alpha-like returns through careful allocation based on region, market cap and momentum.

3. Strengthen allocations to emerging markets

Emerging markets are growing faster and are keeping their houses in better fiscal order than developed economies, and their financial markets are deepening as sovereign credit quality improves. So why do so many pension plans still avoid emerging markets? Although there have been crises in the past, the long-term structural story for emerging markets is a strong one. And, as these markets are growing more sophisticated, it’s easier than ever to adopt strategies that are both concentrated and diversified with a mix of active/index, long/short and debt/equity exposures.

4. Re-engineer alternatives allocations

Investors trying to find non-correlated returns in a correlated world are moving into alternatives—real estate, infrastructure, private equity and hedge funds. Successful implementation will have both top-down and bottom-up elements. This means digging deeper into the individual strategies and asset classes to understand the underlying risk and return drivers and seek out true differentiation and opportunity. It also means a careful assessment of the chosen strategies’ liquidity profile and the potential illiquidity premia they offer, and then matching them more closely to specific liquidity requirements.

5. Focus on outcomes with multi-asset approaches

Along with optimizing the individual building blocks, investors must remain focused on how their portfolios behave as a whole and ensure that their risk budget is aligned with the risk factors that matter. In uncertain markets where even safe fixed income assets are vulnerable to potential shocks, asset allocation plays an even more crucial role in driving returns. Asset allocation approaches that allow investors to capture returns across a wide range of asset classes, while mitigating exposure to unrewarded risk, are optimal. These can take several forms, but they will usually involve a greater use of medium-term and tactical asset allocation views, along with careful risk management processes.

6. Harness scientific techniques

Investors looking for consistent, superior risk-adjusted returns might find the answer in scientific, or quantitative, investing techniques. Scientific strategies experienced a shakeout during the financial crisis, but the practitioners that persisted and redoubled research and innovation have outperformed in recent years. Techniques have evolved to incorporate dynamic exposures and target alternative risk premia. In a world transformed by higher volumes and rapid trading, scientific investing has an edge in processing large amounts of data, and anticipating and interpreting market flows.

In all of these actions, two key themes emerge. One, pension plan managers will increasingly look beyond traditional asset allocations—and, indeed, beyond traditional assets—to find consistent, superior risk-adjusted returns that will compound over time and deliver the needed outcomes. Two, managers will do so in a much more dynamic way, adapting their strategies to new realities by shifting their focus, employing new tools and revising their guidelines to be quicker, smarter and more outcomes-oriented.

In doing so, investment managers might find that although the world has changed, perhaps forever, it hasn’t necessarily changed for the worse.

Eric Léveillé is a managing director and head of the Canadian institutional business with BlackRock Asset Management Canada Ltd. eric.leveille@blackrock.com

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