Split Decision

Canadian defined benefit plan sponsors are looking for new ways to manage risk, but they are divided on which path to take.

It’s been a wild ride, but many plan sponsors in Canada spotted early warning signs. According to the results of the Pyramis Global Advisors 2008 Canadian Defined Benefit Survey, defined benefit (DB) pension funds were well funded and solvent as of June 2008. But plan sponsors saw clouds building on the horizon, expressing concerns about volatility and risk management.

In particular, plan sponsors are concerned about risk management as it relates to the Canadian equity allocation. They’re apprehensive about the recent market volatility but also keenly aware of the long-term prospects for Canada in a global economy. They see opportunities in alternative investments, but they are watchful about unfamiliar risks. In other words, they are at a crossroads on many fronts.

Testing the Limits

Let’s start by looking at where DB pension funds stood as of June 2008. The survey results found that plans were in good shape, with average funding levels hovering at around the 100% mark. However, risk, volatility and the low-return market environment still ranked highest on plan sponsors’ list of concerns.

While they are universally concerned about risk management, plan sponsors are divided on where to focus their efforts. More large plan sponsors said they are shifting their focus from market volatility to funded status volatility, yet only 31% of mid-size plans are moving in that direction.

Plan sponsors’ attitudes toward risk management are also being tested by the desire to move into alternative investments and the gradual movement away from traditional asset classes such as equities and fixed income. They are seeking to significantly boost allocations to private equity, infrastructure, real estate and hedge funds.

This is where plan sponsors reach a crossroads: they are drawn to alternatives for their absolutereturn orientation and diversification potential, yet they realize that more sophisticated risk management tools will be required to invest in this area.

When asked whether or not their plans are taking on more risk than two years ago, not many said yes—just over one-quarter (26%) of sponsors of large plans compared to only 14% of mid-size plan sponsors. And they were mixed in their responses on the hurdles that alternative investments present from a risk management standpoint. Most large plans (83%) said they find alternatives more challenging to deal with from a risk perspective, while 60% of mid-size plans said this is so. Moreover, most don’t think that current risk management tools are adequate when it comes to alternatives.

The survey results also show that plan sponsors have conflicted views on allocations to Canadian equity. With the removal of the Foreign Property Rule, plans had intended to move large chunks of their Canadian equity to more global allocations. But this year’s survey found that they have been hesitant to actually do so, with allocations to Canadian equity still hovering around a relatively high 24%—indicative of the long-term bullishness that plan sponsors feel toward Canadian companies.

Moving Forward

So where should plan sponsors go from here? They should consider size, status, solvency and psychology when making investment decisions. And they should work with consultants, actuaries and investment management staff to closely examine each of these elements.

First, consider the size of the pension fund relative to different metrics such as market cap or equity on the balance sheet. Then look at status: what is the plan’s funding status and solvency ratio? Strength is the next consideration for corporate or public plans. Is the industry strong or weak? Is the tax revenue base solid or declining? Finally, consider the “softer” metric of psychology. How much volatility can the plan withstand? How is it staffed and resourced? Does it have the tools to properly measure risk?

Every plan sponsor will have different risk management methods and priorities. However, asking these questions is key to finding the right approach to mitigate the risks of this storm and any challenges down the road.

Peter Chiappinelli is senior vice-president, investment strategy and asset allocation, with Pyramis Global Advisors, a Fidelity Investments Company.

peter.chiappinelli@pyramis.com

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