With consultants and their pension clients back at their desks in January, it’s a good time to reflect on the past year, review what went right and wrong, and challenge one another on what can be improved. It is also a good time to take stock and develop action plans—dare we say, resolutions—for the new year.
2011: Annus horribilis
The past year was a difficult one for Canadian pension plans. Equity markets experienced heightened volatility due to increased uncertainty from macro events around the globe. Between Middle Eastern regime changes, the Japanese tsunami, the European sovereign debt crisis (or was it crises?) and continued U.S. political dysfunction on debt ceilings, it’s easy in hindsight to see why investment in growth assets was not rewarded.
Figure 1
As Figure 1 highlights, global equity markets posted negative returns, with the MSCI World Index declining 2.7% in Canadian dollar terms. U.S. equities, as measured by the S&P 500 Index, posted modest returns plus currency gains (up 4.6%). However, Canadian equities fared worse than foreign equities, with the S&P/TSX Index falling 8.7% as the risk-on/risk-off trade was mostly risk-off on the year.
From an asset-only perspective, Canadian fixed income markets mitigated some of these losses, with the DEX Long Term Bond Index up 18.1% and the DEX Universe Bond Index returning 9.7%. Investors in Canadian real return bonds were also rewarded with a solid 18.3% return while investment in Canadian corporate bonds, as measured by the DEX Corporate Bond Index, provided a return of 8.2%. As a result, investors who protected the financial integrity of their pension plans by implementing interest rate hedging strategies via levered bonds were suitably rewarded for their liability driven investment approach.
However, pension plan liabilities also grew more than expected as they were negatively impacted by interest rates declining. The discount rate used to calculate solvency liabilities for a typical DB pension plan at the end of 2011 was more than 1% lower than it was at the start of the year. If a pension plan had an average sensitivity to interest rates of 15 years (duration), this translated into an increase in solvency liabilities of more than 15%.
Figure 2
Combined with the fact that many pension plans were already underfunded at the beginning of the year, 2011 will add to the deteriorating funded position of most pension plans, as illustrated in the Mercer Pension Health Index (Figure 2).
The challenge is that it is difficult to predict what the future holds. However, this should not be a call to inaction. For at least a decade, people have been saying that interest rates will rise. As such, most plan sponsors have delayed implementing valuable interest rate hedging or de-risking strategies; however, plan sponsors could benefit from more specific analysis and action steps.
As you develop your agenda for 2012, we believe that taking more concrete action steps would be helpful. Following are the Top 10 resolutions to consider in 2012.
1. Have a plan
If you have not done so already, develop a plan for transitioning the management of your pension plan from an asset-only framework to an asset/liability framework. You are managing a significant financial obligation within your corporate structure and need to manage it accordingly. Relying on a more normalized equity market won’t help much if liabilities grow faster.
2. Understand your risks
It is important to understand the dynamics of your risks. Use financial modelling tools such as stress testing, which can help you to better understand the range of potential outcomes. Don’t forget to test extreme adverse scenarios, as opposed to just typical scenarios such as inflation, deflation and growth.
3. Speed it up
Most pension plans have missed opportunities to de-risk in the past because they are not set up to identify or capture opportunities as they arise. Consider speeding up the process by incorporating a dynamic approach into your plan’s investment strategy to better capture market opportunities as they arise. This could involve implementing interest rate hedging strategies if rates reach specified thresholds or using funded status triggers to gradually de-risk your plan. The increased market volatility that we are currently experiencing could provide opportunities to de-risk at more favourable times than approaches that de-risk on an ad hoc basis or at specific points in time. Delay of execution can be costly.
4. Re-evaluate
Within an increasingly complex investing and regulatory environment, re-evaluate whether or not your internal employees have the appropriate resources and skill sets to manage plan assets. Has your organization changed its resourcing levels or lost experienced staff due to retirement? If your needs have changed, delegate some duties to external providers who can complement your internal resources and provide changing and flexible support that meets your needs.
5. Review
Review your governance structure to make sure you have best-practice approaches in place to reduce decision-making delays, mitigate inertia and help improve your probability of capturing market opportunities as they arise. The financial obligation of a pension fund is essentially a pension payment business that needs dedicated attention—more than the usual two to four times a year that most committees meet.
6. Manage your time
Ensure that your time is spent efficiently. Many committees spend too much time on manager selection and monitoring and not enough on more strategic issues such as asset allocation policy and investment strategy. Long-term performance variability is more impacted by policy than manager choice. If time is limited, consider outsourcing some of the traditional committee tasks such as manager selection by using implemented services.
7. Strategize
If your plan is frozen or closed to new entrants, equities will some day have to be sold to pay benefits. Talk to your advisor about planning the endgame strategy of reducing equities. Consider whether or not a dynamic de-risking approach would help capture times when stocks are expensive and bonds are cheap.
8. Understand accounting standards
Review the impact of new accounting standards and how these changes will affect the information disclosed in your financial statements. For many pension plan sponsors in Canada, 2012 will be the first year that all pension plan gains and losses are immediately recognized in the financial statements.
9. Diversify
Within your growth portfolio, diversify into less-correlated asset classes in the alternative space, but be cognizant of liquidity needs when doing so and how long your de-risking timeline may be.
10. Rearrange
Rearrange equity allocations to favour growth. Consider reducing home-country bias by reducing Canadian equity content in favour of other regions. Canada is a small equity market representing approximately 5% of global equities. Consider combining U.S. and EAFE management into a global mandate and diversifying this core with strategies biased for growth such as emerging markets and global small cap, coupled with a global defensive allocation such as global low-volatility strategies.
Whether you are a believer in New Year’s resolutions or not, planning is still a worthwhile pursuit. Based on the Chinese calendar, January 23 is the start to the Year of the Dragon. The dragon is a symbol of power, and people born in the year of the dragon are identified as doers who achieve power by getting things done. So as you get back to your office and finish sorting through the thousands of emails you received over the holidays, reach out to your advisors to help you start planning for the new year. Dragons are not passive creatures, so prepare for another volatile year and fight fire with fire.
Heather Cooke is a partner and leader of implemented consulting and dynamic de-risking solutions with Mercer Global Investment Canada, Ltd.