Is the situation different globally—in the U.S., the U.K., for example?
Arnold: Most plans have a home-country bias in their equity and fixed income portfolios. Canadians have perhaps lucked out in this regard as Canada, generally, has done well versus other developed countries. I also point out that the kudos the Canadian financial system banking has been getting may have looked very different if Canadian banks were allowed to merge a number of years ago and merge/own insurance companies. If banks bought one another and then started buying up insurance companies, would the Canadian financial system look different than the U.S. and European systems that allowed merger mania? Kudos to the Office of the Superintendent of Financial Institutions and, dare I say, our politicians.
Chepelsky: In the short term, no, each geographic area will have similar risks and opportunities that are hard to predict. In the long term, we believe that geographic diversification remains a legitimate source of risk reduction and a source of different risk-return opportunities (such as small cap U.S. equity, emerging market equity, global bonds, etc.).
Racioppo: We have clients in the U.S., and they are rethinking their models, perhaps more so than their Canadian counterparts. Not only have the average pension funds in the U.S. run with a higher equity content than those in Canada, their equity markets have performed much more poorly over the last decade. In U.S. dollar terms, the S&P 500 has generated a negative return over the last 10 years. There is no suggestion that they are going to abandon or even significantly reduce equity content, but it will certainly not be U.S.-centric. Foreign investing will be more prominent, as will more private company investments. The decline in the value of the U.S. dollar is also spurring them on.
Winch: There is some geographical disparity, but mandate searches and awards are beginning to pick up, reflecting modest improvements in clients’ confidence levels, assisted by rallying equity markets and some stability returning to global economies. However, the experience in the U.S. is that although commitments are being made, the timelines have become considerably longer. More meetings are required, transparency is paramount, and more extensive due diligence is being undertaken, even in respect of low-risk mandates. The uneven recovery in economic performance across the globe is reflected in client activity. The marketplace in Australia is getting back toward business as usual, and the improving economic picture was reinforced recently by the Reserve Bank of Australia increasing interest rates, something that appears a long way off in western economies.
Asia, particularly China, has experienced an increase in activity levels, and the rising oil price has bolstered confidence in the Middle East. In contrast, U.K. clients are heavily influenced by the precarious state of the U.K. economy. Pension scheme trustees are highly concerned about the potential for covenant breaches and the viability of parent companies. This has translated into clients seeking passive management options, and controlling costs remains an ongoing issue for chief financial officers.
Chiappinelli: The urgency in the U.S. and U.K. are more pronounced for a host of reasons:
1) In the U.S., the Pension Protection Act and FAS 158 (accounting change) was a driver of investment strategies. FRS 17 had a similar effect in the U.K. And IASB 19 on the European continent. Canadian plans need to take note of what these accounting changes mean, as the next few years will see a ‘harmonization’ of accounting standards for pension plans.
2) The equity-oriented culture in the U.S. and U.K. meant that these plans suffered more than elsewhere, and their funded status deterioration was more pronounced.
3) The sheer size of these plans versus market cap, book value, etc., is much larger. For some plans in the U.S. and U.K., it is the tail wagging the dog.
What will be the most significant drivers of change for the pension industry, in terms of investing, in the next five to 10 years?
Arnold: The concept or the return of enterprise-wide risk management will be more pronounced in the sponsors that simply ‘have to.’ Invariably, these are the poorer versus richer companies that can afford to either do things the old way or modify at their pace. The investment landscape will also emerge into a revised core/satellite approach where the core is some combination of interest sensitive/fixed income to match specific plan risks and an equity/alternatives component that is low or controlled volatility versus customized benchmarks.
Racioppo: There will finally be a move toward more foreign content by Canadian funds. In the last few years, there has been little interest in increasing foreign content despite the relaxing of rules. The Canadian stock market has been strong in recent years and so has the performance of the Canadian dollar. Now, however, we find our Canadian benchmark, the TSX, dominated by just two sectors, with energy and financial services making up approximately 60% of the index. So it’s not just foreign exposure that is lacking but industry diversification as well. Clients are now discussing the use of global products as opposed to U.S., EAFE and emerging markets separately. There is also discussion as to how much (maximum) can be owned in foreign content while still being comfortable with foreign currency exposure along with the issue of hedging versus not hedging. Most of the lesser European countries (e.g., France and Germany) do not laden their pension funds with local country company shares. If anything, they consider all of Europe their local market. Eventually, Canadian pension fund investing will also have a much broader geographic focus.
Winch: The trend for clients to undertake fundamental reassessments of their structure, their consultant and manager relationships, and their objectives continues to take place. Poor-performing active managers are still under scrutiny, with replacement activity continuing. While clients remain sensitive to risk, alternative strategies continue to gain prominence. The most commonly discussed alternative asset class currently in demand is real estate. In Japan, managers of alternative and opportunistic asset classes are gaining increased levels of penetration with clients and are thought to be among the better-performing competitor groups. In the U.K., client allocations to alternative asset classes are expected to reach between 15% and 20% in the near future.
Chepelsky: Recently, there have been many expert commissions and panels that have suggested ways of improving the pension industry. If some of those suggestions take hold, this would affect pension plans going forward. Demographics should play a huge role as more and more of the baby boomer cohort retires. Not only will this put strains on pension plans, but it will also give retirees a larger voice when, and if, new pension reforms are implemented.
Chiappinelli: Significant drivers of change will take many forms, but in terms of redefining risk and investment strategy, regulatory and accounting standards will be a major force. Study after study has shown that if the accounting standards change in the U.S. (driven by FASB) such that the Income Statement (P&L) of a corporation is more directly affected by funding status or volatility of the pension plan, then significant overhauls of asset allocation, definitions of key risks are to soon follow.
The growing influence of the treasury/finance team. For many decades, the pension committee largely operated independent of the finance/treasury group, and this has been changing over the last few years. There are many implications of this: a) a better alignment of investment strategy to the nature of the liability, b) a greater understanding of the impact that the pension plan could have on operations, cash flow, balance sheet and income statement health, c) a better understanding of how the pension plan could affect corporate debt ratings and cost of capital, and d) a better understanding of how the tools of managing the finances of the business (hedging, derivatives, risk controls, etc.) have a place in the running of the pension plan itself.
Lorimer: There will be an increasing need for members to better understand the risk/return characteristics of their DC pension plan investments. Having said that, risk/return questions come up much less often in situations of positive ROI results versus negative ROI results. I think there is a need for plan sponsors and members to review the risk/return characteristics of their default investment options, and there will be an increasing trend to move further along the investment education/investment advice continuum.
Bélanger: Liquidity risk will probably rank higher.
Brooke Smith is Associate Editor of Benefits Canada.
brooke.smith@rci.rogers.com
