A different world

While the economic turmoil of the past two years has shaken the economies of many countries to their core, Canada has emerged as one of the lesser affected countries. While other countries bailed out their banks, Canada’s financial institutions remained untouched and its companies have remained well capitalised. It is fair to say that this steady approach to financial matters has also flowed through to its pensions. While Canadian pension plans did sustain some damage it was certainly not on the scale of that seen in countries such as the US and UK. 

The overarching theme it would seem to Canada’s approach to pensions is to be prudent and don’t panic. According to Canadian Life and Health Insurance Association’s director of policyholder taxation and pensions, Ron Sanderson rather than panic due to market turmoil “Canadians generally make their investment decisions with the best advice and stay the course.”

One reason behind this steady performance lies in the Canadian tendency to have a smaller overall asset allocation to equities in portfolios than you would see in other countries. 

“In the UK defined benefit plans had higher exposure to equities than we had in Canada and so the impact of the market turmoil is lessened,” said Mercer, director of consulting for Mercer Canada’s investment consulting business Jaqui Parchment. “Depending on the plan, a 50% to 60% allocation to equities is reasonably typical and has been for some time.”

Canadian plan sponsors felt the impact of the recent market turmoil, along with other countries but in Canada, performance over the past few years has been stronger than some other regions, because of the strong domestic equity bias taken in many plan portfolios.  Historically, Canadian pension plans were limited in how much they could invest outside Canada, and while restrictions have been eliminated, plans have retained substantive weightings to domestic equities, which have performed strongly overall over the past four years. However, investors do need to be careful of allocating too much to a market that is concentrated in three sectors with a relatively low number of stocks. 

“Canadian equities tend to be driven by materials, energy and financials – I would say over 70% of the Canadian market is made up of these classifications,” said Parchment. “Our market is strongly driven by commodities, and that helped us over the past several years (except for 2008). We encourage plan sponsors to diversify, and to take advantage of investment opportunities in a broader context”.

Indeed, rather than looking at the events of the last few years as a challenge other plans are seeing them as an opportunity as they take advantage of good quality investments coming on to the market. This is certainly the approach taken by Canada Pension Plan Investment Board’s (CPPIB) senior vice president – head of public market investments, Don Raymond who said the plan’s long term investment view enables it to be less focused on short term volatility.

“I think we’ve done well considering the turbulence in the financial markets but I think this is largely down to the fact we are a large long horizon investor with ample liquidity,” he said. “As a result we are seeing a lot of opportunities in the markets. We have maintained a significant weighting to equities and we have navigated the credit minefield very well. We’ve been able to take advantage of purchasing assets that otherwise wouldn’t be for sale. People seem to have become more short term in their focus and this has enabled us to build on our high quality real estate, infrastructure and private equity exposure.”

Challenges

However, despite this steady performance in the face of great economic turbulence it is fair to say the Canadian pension system still faces challenges. Canada’s pension market is heavily weighted towards defined benefit provision and many plans have sustained damage and continue to nurse liabilities. Earlier this year, the federal government announced temporary funding relief for pension plans effectively giving them longer to meet these liabilities. Despite these measures, Watson Wyatt’s retirement practice leader – Central Canada, Kevin Tighe believes many plans could still be in for something of shock when assessing their liabilities for the coming year. 

“Accounting liabilities are based on corporate bonds and the liquidity crisis last year meant corporate bond yields went up and this softened the blow by reducing the accounting liabilities,” he said. “However, now that credit spreads have returned to more normal levels these spreads have narrowed which I think will result in accounting liabilities that could be 20% higher than last year. It’s also worth remembering that we could be in for more volatility going forward and so we are not out of the woods at all.”

The situation could then be made worse with the adoption of international accounting standards which look set to highlight the costs associated with defined benefit schemes and nursing liabilities even further. 

“The adoption of international accounting standards will aid plan sponsors’ in better understanding the mismatch between their pension assets and liabilities and should help them to review the impact of various risk reduction strategies more effectively,” said Mercer’s national partner, Scott Clausen. “Going forward, one thing that is certain is that the financial position of the pension plan that is disclosed in the company’s financial statements will likely be much more volatile from year to year.”

However, while adoption of these standards will do much to aid understanding of pension plan liabilities, it will also mean turbulent times ahead for many defined benefit plans, according to Tighe.

“If you look at the FRS17 standard in the UK, it got rid of smoothing which made the DB plan volatility hit their balance sheets straight away,” he said. “The UK also introduced mandatory indexing which increased the cost of DB plans. FRS17 combined with mandatory indexing accelerated Britain’s move away from defined benefit plans towards defined contribution plans. In Canada, we have taken much longer to get there, but we will be adopting IFRS in 2011 which will result in a similar increase in balance sheet volatility that the UK experienced when FRS17 was adopted.”

A new understanding of risk

As a result, pension plans are diversifying away from traditional investment strategies in order to meet their liabilities, seeking to de-risk wherever possible. 

“A lot of our clients are looking to do asset liability studies and they are looking to see how they can de-risk,” said Watson Wyatt’s investment practice leader, Central Canada, Janet Rabovsky. “We are seeing them use more bonds of lengthening duration and we are also seeing increasing demand for customised portfolios. We are also increasingly looking at style biases. If you employed a value manager last year, for instance, you got whacked as they tended to buy banks. Basically we are at a point where everything is being re-examined.” 

Russell’s director, investment strategy, Bruce Curwood agreed saying Canadian pension plans are looking to branch out and try new things as a means of gaining return while mitigating risk.

“We are now seeing a sustained move towards more global investments with many plans looking to adopt at least a 50/50 split between their allocations to domestic and global equities,” he said. “In addition, they are starting to diversify more broadly in other asset classes. I think this is an indicator that diversification is important and that risk management is becoming more the order of the day. In the past fiduciaries generally paid lip service to the whole area of risk management, but were concentrating more on return. That outdated approach is starting to change. There is a need for plans to be more prepared and disciplined in their risk management approach.” 

This approach is echoed by the CPPIB’s Raymond who says the challenging markets have led the plan to take a closer look at risk despite having a healthy funding position.

“Our focus since April 2006 has been to build our internal active capabilities to add value over rolling four year periods. We’ve got one more year until the end of the first four year period but we’ve already been able to deliver C$5.3bn over our market based benchmarks,” he said. “However, I think the magnitude and speed of this downturn has made us think about the whole issue of opaque risks and these are being integrated into our risk-monitoring processes.” 

According to Curwood, plan sponsors are increasingly looking to stress test their portfolios after being blindsided by recent events. While some plans are looking to go down the liability driven investment (LDI) route Curwood urged caution saying “LDI can be a very expensive and sometimes complex road to go down, particularly if your plan is significantly underfunded.” Instead he said some plans are adopting liability responsive asset allocations (LRAA). “The market is unpredictable but you may not want to lock in your losses, after such a severe downturn. The fund may need to take a less risky approach over time, but you also can’t take all the risk away either, if you want to achieve your objective. LRAA allows you to maintain your current asset allocation but convert to a less risky asset mix as you get closer to 100% funded.

Investment trends

Areas that are proving particularly popular with pension plans are infrastructure and real estate as plan sponsors look to diversify their assets and gain long term returns.

The move towards real estate and infrastructure is indicative of the fact that there is less pursuit of alpha and more pursuit of balance,” said Hugh Kerr, chairman of the advocacy and government relations committee at the Association of Canadian Pensions Management. “Real estate is a good hedge for the long term liabilities for both public and private schemes. Real estate has always been part of the mix and we are seeing infrastructure coming into the mix now as well as a great generator of long term income which matches well to the payment of a pension.”

Infrastructure and real estate form considerable parts of particularly the larger plan portfolios. The Ontario Teachers’ Pension Plan recently added to its sizeable infrastructure holdings with the acquisition of a further stake in the UK’s Bristol International Airport (see interview on pages 21-22). 

The plan also owns Cadillac Fairview, a large real estate company worth $16.2bn. At December 2008 The Ontario Municipal Employees Retirement System’s (OMERS) infrastructure investments totalled $12,140m with real estate accounting for $4,162m of the portfolio. Canada Pension Plan Investment Board currently has 3.9% in infrastructure and 5.9% to real estate. According to CPPIB’s Raymond these assets are desirable as a hedge to inflation.

“The core attributes of these classes are attractive and we can generate long term secure income from them which forms a good fit to our liabilities,” he said. “You also have to take the issue of inflation into account. We have come through a deflationary period and many central banks have thrown money at the problem. So what happens when inflation kicks in again? More plans are looking at real assets as a way of dealing with this.”

Lessons learned

So as the markets emerge from the turmoil of recent years what lessons can be learned? More importantly, will the learnings of any lessons be sustained? Investors also went through difficult times with the bursting of the tech bubble in the early part of the century. Plans lost money then just as they have now, so will any long term lessons come through?

Russell’s Curwood is optimistic that investors have finally learned their lesson.

“Investors have seen what’s happened over the past two years and they don’t want to go there again,” he said. “This is the second major crisis in the last decade (the tech collapse in the early 2000s and the recent financial crisis) and people don’t want to be on a rollercoaster anymore. This time I really hope people will learn and we will see a greater focus on risk management and stronger governance as a result. Plans will go beyond their statement of investment policies. You will see more sponsors asking how they got to where they are? What is the rationale behind their current approach? What are the obvious and inherent risks? They will hopefully use more stress-testing and scenario analysis. At least then if they get the downside of risk they will be prepared for it.”

==========

The three tier pension system and the need for auto-enrolment

Another challenge affecting the Canadian pension system is that of coverage and the need to get more people saving into a pension. At the moment the system operates on three tiers. The first tier is the old age social security which is a tax payer funded benefit to aid the poorest pensioners. The second tier is the Canada Pension Plan, a public plan funded by contributions from employers and employees. Current contributions are 9.9% of eligible earnings and the plan aims to cover roughly one quarter of the average wage which is just under C$44,000. The final tier comprises any further pensions savings the individual chooses to make. 

However, while the system is comprehensive on the surface not everyone is getting the most they can from it. Participation in a pension plan requires there to be an employment relationship between the plan sponsor and the member which means that millions of the self employed (and employees of companies that don’t provide pension plans) are essentially excluded from taking part in pension plans. While many make provisions in Registered Retirement Savings Plans (R RSPs ) – a tax efficient savings account it still raises the question of what more can be done to boost people’s access to retirement savings vehicles. 

“Many retirement plans are optional, where employees must make an election to join. Before the credit crunch there was a lot of talk about auto enrolment where employees are enrolled unless they choose to opt out. Now, some companies are wondering whether to allow an opt out at all.  These issues took a back seat as plan sponsors turned their attentions to dealing with deficits,” said Mercer’s Scott Clausen. “However, these are important issues that will need to be revisited.”

The provinces of Alberta and British Columbia recently put forward a proposal to deal with this issue. The ABC plan would be a voluntary plan aimed at creating a national system for those without a workplace plan. It would be a defined contribution structure that would operate alongside the Canada Pension Plan. 

The plan is in its early stages and still needs to be fleshed out but forms an important start to the debate. 

“We are looking to come up with a formal position to the ABC plan by the end of the year as we need to see more details but we support anything that increases coverage,” said Association of Candaian Pension Management’s Hugh Kerr. “We’ve also been looking at the UK’s personal accounts system but cost is a huge issue and decision makers need to be aware that anything like this would need to be subsidised for the next few years. However, the end goal is the same we need to help small employers, self employed etc.” 

While many welcome the proposals put forward, they have also been received with caution by others. Canada Life and Health Insurance Association director Ron Sanderson said a private rather than government solution to the problem should not be ruled out.

“If we look at people’s priorities over the past few years, people want to spend more than save – is that prudent?” he said. “There is still so much education work we need to do. If you look at the plan put forward by Alberta and British Columbia it doesn’t appear to factor in the costs of either consumer education or distribution. Without investment educstion and advice, would such a plan produce the desired results? We believe that a competitive market with lots of players in it will deliver more than a government monopoly will both in terms of consumer participation and predictable retirement incomes. We are in talks with government and other policy makers to explain what we can do to help and I hope we can continue that process.” 

The issue of how to address coverage looks set to remain a hot topic going forward. At a conference in September Canada Pension Plan Investment Board president and CEO David Denison addressed the issue. He pointed to three possible ways of increasing access to retirement savings plans. The first was to make the current system of voluntary employment sponsored pension plans “more cost effective for plan sponsors and more attractive for plan participants”. He argued that more uniform regulation across all provinces would make the system more attractive and that by making individual retirement savings vehicles more tax effective, more people would be encouraged to save. The second approach would entail the creation of regional or national defined contribution plan options. Initial enrolment would be mandatory with the opportunity to opt out later if required. While this approach has merits, he pointed to the risks inherent in all DC structures of inadequate contribution rates and the need for individuals to make suitable investment decisions. The third approach was to add a “pure supplemental pension benefit” on top of that provided by CPP. 

He argued that a supplement “would also be a very cost effective way to provide a relatively predictable stream of retirement income. We have estimated that private sector insurers in a voluntary annuity market would have to charge a contribution rate of at least 11% to deliver income benefits comparable to those delivered by the CPP. This amounts to 1.1 percentage points more than the current contribution rate of 9.9% for all benefits provided by the CPP – the cost advantage for a pure supplementary layer would be even greater.”

Finally, he argued for the case of delivering a hybrid solution based on all three options. For instance, only providing the CPP supplemental benefit as an expanded mandatory pension programme and then providing regional or national DC plans as a further voluntary option. 

He said this approach would deliver flexibility for companies to make pension arrangements tailored to their objectives while individuals did likewise. 

However, he said “we recognise that proposing solutions is the easy part. The hard work belongs to policy makers who must bring to bear all of their wisdom and expertise to make the specific decisions required to fashion an effective and practical response to one of the most significant demographic, political and policy challenges of our time.” So the debate continues.

Personal responsibility

Coupled with the challenge of coverage is that of personal responsibility and the need to get people to save more for retirement. According to Sanderson many people don’t understand the nature of their state benefits which can lead them to make inadequate provision elsewhere. 

“People have no idea of what the CPP will actually give them and they just assume they will be fine with what they get and don’t make any further provision,” he said. “We need to get people to realise the government will not look after them and they need to take responsibility for building up supplementary savings.” 

This move towards personal responsibility is also evident in the move by many corporates towards offering defined contribution plans rather than DB. 

“We are seeing a trend to DC particularly in the private sector and if you think of how many of our companies have strong links to the US and the UK then this is bound to make a difference,” said the ACPM’s Kerr. “This, in addition to the adoption of international accounting standards, mortality improvements and low interest rates means sponsors will need to look hard at their DB plans.”

However, it’s fair to say that while the shift to DC is happening it is no where near at the extent that it is in markets like the UK or the US and there is serious discussion within the industry as to whether the shift towards DC is the right way forward. 

“I don’t think a wholesale shift to DC is a solution as it is merely shifting the problem from the employer to the employee,” said Northern Trust Canada president and chief executive officer Robert Baillie. “Until we do something about this then we will have the enduring crisis of people just not saving enough. It’s early days and there needs to be action taken to safeguard people’s retirement income to ensure they have adequate funds. We need more education along with more decision making support and professional management of the appropriate asset mix for the client. I’m not convinced pensioners have the time, expertise or even the inclination to take on this role so is it appropriate that plan sponsors wash their hands of it and assume pensioners can make these decisions?”

According to Kerr the way forward is to adopt a hybrid position of offering a defined contribution that also integrates defined benefit options. 

“I don’t think there will be a straight move to DC, rather we will see the emergence of a more hybrid structure which takes elements of both,” he said. “As a result we could see sponsors looking to add more guarantees to their DC plan. I think we will also see more of a move towards annuitisation as plan members look to guarantee income one bit at a time. At the moment people are very much in the “I can manage my own money” mindset. They don’t want to pass it all on to an insurance company. However, they can just look to guarantee 40% if they wish.”

Mercer’s Clausen agrees saying that plan sponsors will look to take a more risk sharing approach going forward. 

“The biggest challenge tends to centre on how risk should be shared in a pension plan. In DB plans, the employer takes on most of the risk and in DC plans the employee takes on the risk.” he said. “I don’t think it is right that one party should have to take all the risk. DB plans may want to look at increasing contribution requirements from employees to help employers meet the costs of providing this benefit.  This is one area where we do need regulatory discussion as there are no real provisions  for risk-shared DB pension plans right now, especially for plans that already exist.  DC plans need to have high enough contributions so that employees don’t have to take large amounts of risk in order to accumulate enough to provide a reasonable pension.  It is important for pension regulations to be updated to reflect that it’s no longer just a DC or just a DB world anymore.”