Since the Canadian Broadcasting Corp. (CBC) was founded in 1936, the organization has played a defining role in connecting Canadians through news and entertainment programming that reflects the country’s history and diversity.
Likewise, the CBC/Radio-Canada Pension Plan, launched a half-century ago, became something of a pioneer when it adopted a liability driven investing (LDI) approach in 2005.
The strategy has led the plan—which pays defined benefits to 9,131 retirees and collects contributions from 8,156 employees—to lower its exposure to equities and increase its exposure to bonds, compared to a pension plan’s traditional 60/40 asset mix of equities/bonds.
The implementation of the strategy owes much to the leadership of Debra Alves, appointed as the plan’s managing director and CEO in mid-2007 following senior pension and treasury management positions with the Canada Mortgage and Housing Corp. and the Farm Credit Corp. Of her public sector career path, she says: “It’s been a fortuitous experience.”
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Whither the equity risk premiumFor the most part, the plan’s LDI approach has been successful. As of Dec. 31, 2011, the plan had a going-concern ratio of 123% and a solvency ratio of 91%. And its rate of return was 14.9% in 2011, outperforming the asset benchmark of 13.2% and marking the third consecutive year of double-digit returns. The fund’s four-year return of 8.1% also exceeded the benchmark return of 7.7% over that period.
Trail-blazing through LDI
Despite the plan’s positive experience with LDI, its adoption was no easy feat. The change in strategy resulted from the plan’s triennial review of its asset/liability model in 2005.
“One of the considerations is always the risk tolerance of the plan sponsor,” says Alves. “We told our advisor not to just tweak the traditional 60/40 asset mix that most pension plans followed. We really wanted a more substantive review.” The plan was seeking ways to reduce the volatility of the plan contributions. The advice it received was to adopt LDI.
“For a pension plan,” Alves explains, “the biggest risks are interest rate risk, because our liabilities are long-dated, and inflation risk, because our benefits are linked to the CPI [Consumer Price Index]. There was also the need to start looking at assets in the context of liabilities.”
Based on the LDI proposal, the plan moved to a 50/50 mix. Within its public equity portfolio, it reduced its Canadian equity (now 12%) and global equity (now 22%) holdings and increased its holdings of alternative investments (now 16%). [The pre-LDI asset mix (prior to September 2005) was 28% Canadian equity, 27% global equity, 34% fixed income and 11% alternatives.] In the fixed income portfolio, the plan moved from holding universe bonds (which track the DEX Universe Bond Index) to holding long bonds, as well as adding a significant weighting of inflation-indexed real return bonds.
The transition took 18 months, including preparing the board of trustees (a mix of representatives from the CBC, including the chief financial officer, and employee and retiree members) for the shift and its implications.
“We spent a lot of time in terms of education,” says Alves. “It’s a big part of our governance program. We wanted trustees to make an informed decision. We had four or five meetings specifically on the LDI concept. At that time, it wasn’t a common subject at all. We were one of the early adopters.”
“Education was critical,” agrees plan secretary/treasurer Duncan Burrill, “because we were changing the dynamic of how you evaluate your pension fund, how you define a successful outcome, how you define risk. Traditionally, pension funds had looked at it on an asset basis, optimizing [the risk/return trade-off] only within the assets, not looking at the liabilities as well.”
Dealing with derivatives
Another key aspect of the plan’s LDI strategy is the use of a bond overlay—a derivative-based exposure—as a hedge. With the fixed income assets matched to the liabilities, the addition of the bond overlay provides 100% hedging against interest rate and inflation risks. (The plan also hedges against currency risk when opportunities present themselves but not consistently, as it does against interest rate and inflation risks.)
But while the new strategy neutralized these risks, plan managers then had to address other concerns. “When you mention the word derivatives to people, and you’re using leverage, it causes a lot of nervousness,” says Burrill. “We put a lot of emphasis on explaining the underlying exposure. We were trying to understand the new risks.”
“One of the considerations is always the risk tolerance of the plan sponsor” – Debra Alves, managing director and CEO, CBC/Radio-Canada Pension Plan
Challenges arose on the operational side, too. Rebuilding the fixed income portfolio involved $4 billion worth of transactions, plus another $2 billion for the bond overlay. The plan has substantial in-house portfolio management capability, while the bond overlay has an external manager—which, Alves says, has been very helpful with implementation and market trading around the derivatives.
It was also necessary to create a liability benchmark, in the form of a bond index. Says Alves: “Because our focus has shifted to our funded status and how our assets and liabilities are matched against each other, we have created a liability benchmark that would simulate the interest rate and inflation rate sensitivities of the liabilities stream. It’s a combination of long-term bond and real return bond indexes.”
In addition, Alves, Burrill and their in-house team created a tool to improve the monthly financial reporting to the trustees. “They can look at performance relative to the liability benchmark,” says Burrill. “And, on an accounting or value basis, they can look at the value of the assets relative to the value of the liabilities. This is all to help them get feedback on how well the strategy is working.”
While the plan reports on both a going-concern and a solvency basis, Burrill says “the more accurate reflection of the health of the plan is the going-concern basis. That reflects how we manage the fund over the long term.” Adds Alves: “Looking at a vibrant, long-dated future outlook is more insightful than assessing what would be the value of the fund if it were closed on a certain date.”
In today’s uncertain economy, the LDI strategy faces more issues. “We are looking at how much lower interest rates can go, and how much interest rate risk we still need to hedge in that portfolio,” says Alves. “One of the main questions we’re weighing right now is, How should the policy look going forward, with interest rates as low as they can be and disappointing stock market performance?”
As the E.U. faces the possible disintegration of the euro, the U.S. economy remains sluggish, and the juggernauts of China and India lose momentum, institutional investors such as the CBC/Radio-Canada Pension Plan will be looking to managers such as Alves and Burrill to help them weather the storm and keep their “long-dated future” a vibrant one.
Sheldon Gordon is a freelance writer based in Toronto. netmon@rogers.com
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