Tomorrow’s forecast: Caution

What will it take to slow down this train down? And if an energy correction does occur, what will be the consequences to Canadian institutional investors?

Higher fuel prices will be paid directly by consumers when they heat their homes and fill up their cars with gas. This may diminish their capacity to make other discretionary purchases, leading to an overall decline in demand. Also, higher fuel prices will increase the costs of production and capital, which will both reduce corporate profitability and erode consumer purchasing power.

The outcome: a correction in energy sector returns, curtailed demand by consumers and lower corporate profits. 2006 may be a challenging year for Canadian investors.

INTEREST RATES AND DB PLANS
But it’s not just higher energy prices that will affect institutional investors. More traditional investments that are usually a benchmark of a pension portfolio will have some impact as well. Rising bond yields are the hint of sunshine that many defined benefit(DB)pension plans have been waiting for over the past five years. But it can be sunny and rain at the same time when it comes to interest rates and returns.

Looking forward, the AA/AAA Corporate Yield Curve at the end of September 2005 indicates that DB pension plans could be facing a discount rate as much as 50 to 75 basis points lower than the discount rate used in 2005 disclosures(typically at Dec. 31, 2004). This is not what DB plan sponsors want or need to hear, but it will likely be a reality for their 2006 disclosures.

A drop in the accounting discount rate of 75 basis points will result in an increase of about 9% in the projected benefit obligation for a typical DB pension plan. This is in addition to the increases in liabilities that occur each year as a result of the additional service and the aging of the workforce.

EQUITIES
The energy sector has grown to a point where it now represents about a quarter of the S&P/TSX Composite Index. The only other sectors with strong performance in 2005 are also relatively small: utilities and telecommunications services, which have respectively returned 31% and 21.1%. If energy and financials are excluded, the return attributable to the other eight sectors has only been 2.5%. From this observation, it is apparent that the Canadian market’s stellar performance in 2005 is the result of relatively few stocks.

Since that time, investment style has performed a key role in recouping investment losses arising from the “tech wreck.” Investment managers employing a disciplined value investment style have performed very well over the past five years; returning an average of 14.6% ending June 30, 2005. On the other hand, managers with a defined growth style(not GARP) languished over the same period with an average return of 1.5%. However, for the first two quarters of 2005, the two styles were neck-and-neck: the value managers averaged 8.4% while the growth managers had a mean of 8.6%.

It would be remiss to discuss equities without looking at their full potential on a global scale. And this year marked a milestone for investors who were looking to increase their foreign property holdings. With the removal of the FPR, there was anticipation that plan sponsors might be inclined to increase their exposure to foreign equities. After all, Canadian markets are a small percentage of global market capitalization, foreign equities are a good diversifier, and there was a risk premium to be earned for investing outside of Canada. However, if there was an urgency to move in this direction, it was tempered by the strong performance of the Canadian markets and the rise of the Canadian dollar for unhedged investors(see “A world view,” right).

And if plan sponsors find equities a difficult sea to navigate, the income trust market in Canada can also be difficult to read. However, one thing is certain: Canadian companies have favoured the trust design over investment in public equity. The reason: they want to take advantage of the lower cost of capital available in an income trust vehicle.

GENERAL CONSIDERATIONS
It is very important plan sponsors research and determine whether allocations to non-core asset classes, such as global bonds or emerging markets, will be managed on a strategic or tactical basis. A strategic allocation involves the inclusion of a benchmark allocation subject to minimum and maximum ranges in the Statement of Investment Policies and Procedures(SIP&P). A tactical allocation only provides minimum and maximum ranges in the SIP&P and has no benchmark allocation. Sponsors need to decide which approach is right for their plan.

There are two fundamental issues that institutional investors need to ensure are part of their investment programs going forward: aligning manager skill with the plan’s appetite and tolerance for risk and investment policy constraints. Sponsors should be careful to hire and retain investment managers with a defined investment skills set that aligns with the risk appetite of the plan. Liability management may be a key risk issue for a plan that operates in a cyclical industry but not necessarily for a cash rich plan. Cyclical industries are typically better off with liability-driven investment management programs.

Aligning investment policy constraints is a more subtle issue but an equally important consideration to aligning manager skill with risk appetite. In practice, a constraining SIP&P only permits investment managers to manage their portfolios within very tight minimum or maximum asset allocation ranges around a benchmark or in terms of security and sector restrictions versus a benchmark.

Through the SIP&P, a plan sponsor should consider allowing those investment managers that have demonstrated skill sets that produce better risk-adjusted results to invest in an unconstrained environment.

GOING FORWARD
Globally, high prices for energy will erode profits in those sectors that are manufacturing-based. Coupled with a continuing rise in interest rates in the U.S., a worldwide economic slowdown may be inevitable. Given this, it is expected that foreign equity markets will perform well below long-term projections on a local dollar basis in 2006.

In the U.S., a growing number of small- to mid-sized public companies will convert from being public companies to private companies to escape the onerous corporate governance demands of Sarbanes Oxley. By providing additional opportunities, these buyouts will address one of the principle concerns in private equity investing: that all the good deals are already done, and that growing cash allocations will remain uninvested. This will also create some volatility and opportunities in U.S. small and mid cap public markets, which are not areas that many Canadian institutional investors are widely invested.

Plan sponsors need to differentiate the long-term expectations for a plan versus the current environment in which it operates. This is the view that standards cannot always be applied to all plan sponsors in terms of defining what long term means to them or what risks they can afford to assume. Asset allocation and implementation ranges needs to be determined with the pension plan’s tolerance and appetite for risk in addition to the time horizon in mind. At the same time, a plan’s investment managers should be allowed and even encouraged to take advantage of their assessment of the near-term environment to mitigate risks that the plan cannot afford to take.

Peter Arnold is a national practice leader with Buck Consultants in Toronto. peter.arnold@buckconsultants.com.