Employee Benefit News Canada SupplementMarch/April 2008
LDI ON TAPsays MolsonCoors’ Mike Rumley
SPONSORS DISCUSS LDI THREE WAYS
MANAGERS SAY LDI MARKET CAPACITY EXISTS
HOW LOW CAN BONDS GO?
I2_308_COV.FINAL.qxd 3/13/08 5:59 PM Page 1
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For most of my career I was one of
only a few lawyers in an actuarial con-
sulting firm. I will never forget one of
my co-workers, also a lawyer, who firmly
stated on many occasions that as
lawyers, our forte is words. In contrast, she maintained
numbers are reserved for the actuaries and investment
consultants.
So you can imagine, it was with some trepidation that I
approached the development of this issue, which focuses
on liability-driven investment. But it suddenly got easier
when I took the advice of the I2 Editorial Advisers and
started talking to plan sponsors.
As Nortel’s Director of Global Pensions John Poos says,
it all comes down to writing the cheque:
“Once you understand the volatility of your plan versus
your liabilities, you realize the impact that can have on
contributions. Could you write that cheque? If the answer
is that it would be dreadful, then you are a prime candi-
date for LDI. If you are not concerned about the size of
that cheque, then LDI is not for you.”
In the articles that follow you will hear from both
Canadian and American plan sponsors who are engaged in
asset/liability matching, and investment managers who
help pension funds to execute these strategies.
Our goal in this issue is to help you put LDI in perspec-
tive. Let us know if we succeed.
And stay tuned for future issues dealing with fixed
income and infrastructure, governance, and alternative
investments. All articles, and the pdf of this and past
issues, can be found at ebnc.benefitnews.com.
Putting LDIin perspective
SHERYL SMOLKINEditor-in-Chief
FEATURE
6
Guest COMMENTARY 4Bond yields are flirting with their cyclical lows.Could a trend reversal be around the corner?
Southern EXPOSURE 12Cross-border LDI implementations reveal markedly different investment brews.
Market WATCH 14A snapshot of current investment trends looks atdiversification, portfoliowide strategies and fees.
F E AT U R E SA trio of case studies illustrates that whenit comes to LDI, "one size does not fit all."
Long bonds may be in short supply, butinvestment managers say there is marketcapacity to implement LDI.
610
CO
NT
EN
T
INVESTMENT INSIDER 3
I2308_Ednote.FINAL.qxd 3/13/08 6:02 PM Page 3
Given that the level and
direction of long-term
bond yields significant-
ly impact the value of
pension plan liabilities
and assets, it is not surprising that
plan sponsors are closely monitoring
global bond markets.
Around the world, bond yields
have been trending lower for the past
25 years, dropping from more than
12% in the mid-1980s to less than 3%
in the mid-2000s. This is due to one
crucial development: the world’s cen-
tral bankers’ victory against inflation
in the late 1980s.
Following that victory, and during
the ensuing decade, central banks
remained vigilant and successfully
kept inflation at bay, resulting in a
gradual decline in interest rates. As
inflation stabilized, investors stopped
demanding inflation premiums,
allowing bond yields to move even
lower. Now that bond yields are flirt-
ing with their cyclical lows, one can’t
help wondering if a trend reversal is
around the corner.
INFLATION VS. DEFLATIONThe future direction for bond mar-
kets could depend on which threat
central bankers believe is the greatest
threat for the world economy —
inflation or deflation.
For the past quarter century, infla-
tion has been their top concern.
However, now that inflation in the
industrialized world is well-contained
and relatively low by historical stan-
dards, the answer to this crucial
question is not as clear.
At first glance, there seems to be
very little reason to believe that cen-
tral banks could stop worrying about
inflation anytime soon. The problem
is that central bankers could now
become victims of their own success.
The continued decline in interest
rates has done wonders to con-
sumers’ wallets. Since the early 1980s,
the net worth of North American
households has almost quadrupled.
Unfortunately, declining interest
rates also encouraged consumers to
take on a lot more debt. According to
statistics from the U.S. Federal
Reserve, mortgage debt now repre-
sents an unprecedented nearly 50%
of total real estate equity.
This increase in consumer debt
loads has been more than offset by
the rapid value appreciation of their
tangible and financial assets. Since
1985, home prices climbed by more
than 200% in the United States (U.S.
Census Bureau), and by 120% in
Canada (Statistics Canada.) However,
given current debt levels, the
prospect of Japanese-style deflation is
downright terrifying.
THE WORSE OF TWO EVILSJapan’s experience with mild defla-
tion since the early 1990s is a con-
stant reminder of how painful defla-
tion can be. A decline in consumer
Global bonds: Howlow can they go?BY VINCENT LÉPINE
4 INVESTMENT INSIDER
Bond yields have been trending lower for the past 25 years, dropping from more than12% in the mid-1980s to less than 3% in themid-2000s.
I2308_GC.FINAL.qxd 3/13/08 6:04 PM Page 4
INVESTMENT INSIDER 5
prices of less than 1% per year has
been associated with years of painful-
ly slow growth, rising unemployment,
a multi-year decline in the value of
tangible assets, and a very long bear
market in equities due to intractable
financial problems in the banking
and corporate sectors.
How did Japan get into this
predicament? It all started in the late
1980s with deeply overvalued equity
and real estate markets. Both home
and equity prices started falling,
lethally hitting consumers’ wealth. As
the economy plunged into recession,
the Bank of Japan reacted too slowly,
allowing deflation to set in. The result
was a prolonged period of anemic
economic growth, persistent deflation
and a very long and strong bull mar-
ket in Japanese bonds.
If deflation starts out-
side Japan, the long-term
downtrend in bond yields
will remain in place.
However, central banks
have learned from the
Japanese experience. To
prevent deflation from
occurring, central banks
preserve a buffer zone for
the inflation rate. Up until
now, central bankers have generally
been targeting inflation at around 2%.
However, one can wonder if this real-
ly is sufficient.
When the economy dips into
recession, inflation typically starts
decelerating sharply soon thereafter.
During the last global recession in
2001, the U.S. core inflation rate
dropped from more than 2.5% to
close to 1% in less than two years.
This drop happened in the context
of rising home prices. In the context
of falling home prices, there is a high
probability that inflation would
decelerate much more, flirting with
deflation.
Given the amount of mortgage
debt held by households, and the
overvaluation of home prices in many
regions of the world, central bankers
could be very tempted to
preserve a bigger buffer zone
by letting inflation rates
accelerate. In other words,
from this point on, central
bankers could be spending
more time worrying about
deflation than inflation.
This implies that the
monetary policy stance
could, on average, be kept
more often accommodative than
restrictive, turning the structural back-
drop increasingly bearish for bonds. As
inflation starts grinding higher, long-
term inflation expectations would start
drifting higher, putting upward pres-
sure on long term bond yields.
DARKENING LONG-TERM OUTLOOK FOR BONDS
Holding a very bearish long-term
view on bonds requires a strong con-
viction that the world is heading for a
permanent regime shift from a low-
to a high-inflation environment.
Ultimately, this could only happen
in the context of a shift in central
banks’ priorities from fighting infla-
tion to avoiding deflation.
In the current context of low
inflation, frothy real estate prices and
historically elevated consumer debt
burdens, deflation looks more and
more like the worst of the two evils.
We suspect that in situations of
heightened uncertainty, world
central banks will increasingly err
on the side of inflation rather than
deflation. In short, the long-term
outlook for bond markets appears
to be darkening.
At this juncture, all eyes are now
on the Federal Reserve. With the U.S.
economy flirting with recession, and
home prices falling, the risks of a
deflationary bust have significantly
risen. Judging by its quick reaction,
the Fed is fully aware of the risk repre-
sented by a multi-year decline in
home prices. The result: higher infla-
tion over the next several decades. —I2
Vincent Lépine is VP of research at CIBCGlobal Asset Management Inc. (www.cib-cam.com).The views expressed in this arti-cle are the personal views of the author andshould not be taken as the views of CIBCGlobal Asset Management Inc. or CanadianImperial Bank of Commerce . All opinionsand estimates expressed in this article are asof Jan. 31, 2008, unless otherwise indicated,and are subject to change.
Vincent Lépine
HOW LOW CAN BOND YIELDS GO?Global 10-year bond yields and secular downtrend
2
3
4
5
6
7
8
9
10
11
12
13
`
SOURCE: Datastream & CIBC Global Asset Management Inc.
Yields have been trending lowerfor the past 25 years…
Per cent
…is a trend reversal aroundthe corner?
1985M01
1987M01
1989M01
1991M01
1993M01
1995M01
1997M01
1999M01
2001M01
2003M01
2005M01
2007M01
2009M01
2011M01
2009M01
I2308_GC.FINAL.qxd 3/13/08 6:04 PM Page 5
does
INVESTMENT INSIDER 7
FEATURE
Pension plans of every stripeembrace customized LDI strategies
SizeLDI: One
OOpen, closed. Small, large. Publicsector, private sector. Multi-employer, single employer.
No two pension funds are thesame, and a liability-driven invest-ment strategy is not the solutionfor every plan. Yet an increasingnumber of sponsors of all types ofpension plans are striving to bettermatch their assets and liabilities.
Speaking at a recent CPBIinvestment seminar, University ofToronto Asset Management’sDirector of Investment StrategyJohn Lyon, and Peter Jarvis, CIO at BIMCOR, explained why their pension plans have decided against LDI.
Lyon said a study was recentlyconducted by the university, andUTAM ultimately ruled out LDI.“This was no surprise because itwas considered too costly, with lowreturns on fixed income,” he said.
not fit allBy Sheryl Smolkin
I2308_F_Size.FINAL.qxd 3/13/08 10:31 PM Page 7
“It’s a very poor use of company
capital, because you are basically
locking in at those lower rates,” says
Jarvis. “The question really becomes,
how do we get more LDI-like in our
asset structure? That’s what I believe
is driving the movement to a much
more diversified portfolio structure
by funds across the board.”
In contrast, the Colleges of
Applied Arts and Technology Pension
Plan, Manulife and Operating
8 INVESTMENT INSIDER
FEATURE
OPERATING ENGINEERS LOCAL 955The Operating
Engineers Local 955
pension plan’s
administrator
Rainer Semler is an
LDI veteran.
This collectively bar-
gained, Alberta-registered,
specified multiemployer plan has
been managing assets ($500 mil-
lion at the end of 2007) against
liabilities for over 10 years. It is
fully funded on both a solvency
and going-concern basis. “I don’t
think it has ever fallen into deficit
while the LDI strategy has been
in use,” says plan actuary Tony
Williams, president of PBI
Actuarial Consultants Ltd.
Semler believes that, “Probably
the most important thing for any
pension plan is to maintain the
pension promise for beneficiaries
(4,800 active; 1,600 retired). LDI
allows us to manage risk into the
future, so we know we have a
series of pension cash flows each
and every month.”
Another advantage of LDI,
says Semler, is that it allows the
plan to consider the amount of
risk they are going to assume, so
they can both invest in bonds or
fixed-income products to match
cash flows and make other
investments that will
result in asset growth.
Nevertheless, the
portfolio is primarily
domestic Canadian
bonds. “If our investment
manager used a strategy like
derivatives it would be OK with
us, providing it is within the risk
parameters,” says Semler. “But I
don’t want you to think deriva-
tives are a big part of this. The
investments are primarily inter-
national bonds, maple bonds and
some mortgages — all relatively
high quality fixed income invest-
ments.”
The benchmark is constructed
based on a projection of cash
flow that is shared with the
money managers, who develop a
benchmark for that year and
then build a portfolio that match-
es the cash flow.
“Without letting the cat out of
the bag, we are certainly looking
for more alpha. We’ve got risk
under control and the benchmark
returns, but we haven’t got a lot
of added value,” says Williams.
“So I’d say we are actually
approaching phase 2 of this LDI
approach.”
Rainer Semler
Manulife’s VPGlobal Pensions& BenefitsSylvie Charestis applying LDIprinciples to themanagement oftwo small company plans.
In one case there was a partial wind-up involving 150 employees and $16million in assets, which were carved outinto a separate fund for the benefit ofthese members only. It is expected thatthe wind-up will be completed withintwo years and all funds will be trans-ferred out.
As a result, the portfolio was fullyimmunized through the purchase ofprovincial and corporate bonds that,as much as possible, match the liability flow.
The second plan is a legacy plan thatis closed to new members, with no fur-ther accrual of defined benefits. Of the$50 million in assets, a large portion issurplus.
“We have approved going to an LDIstrategy for this plan when the time isopportune,” says Charest. “In order tofully match the liabilities, we’ll get moreheavily into bonds when market condi-tions are more favourable.”
For the surplus, a multiasset target-return strategy is planned, comprised offixed income (45%); Canadian equities(23%); alternatives such as commodi-ties, natural resources, real estate inves-ment trusts (15%); foreign equities(11%); and cash (6%).
One reason Charest says they areable to go to a somewhat more exoticapproach with the surplus is becausethe assets are managed internally byMFC Global. “This is our business atManulife. Senior management under-stands the issues, so it was not a long,drawn-out discussion.”
Sylvie Charest
MANULIFE
I2308_F_Size.FINAL.qxd 3/13/08 3:39 PM Page 8
Engineers Local 955 are three of
many very different pension plans
that have concluded a customized
LDI strategy is the best way to man-
age funding volatility and risk.
CAAT CIO Julie Cays says she
brought LDI alive to certain trustees
by showing them, “If we have a cer-
tain asset mix, or take a certain
amount of risk, this is the probability
that you will reach a certain funding
level and have this amount of surplus
or deficit.”
“Be clear on your commitments,
how you price them and what kind of
risk you are ready to take to meet
these commitments,” says Manulife’s
VP Global Pensions and Benefits
Sylvie Charest. “Once you have some
clarity on these three things, and you
are also clear on what rewards you as
a risk-taker get for taking these risks,
I think the fog will start to lift on
the LDI strategy you are about to
embark on.”
And plans of all sizes can success-
fully implement LDI, says Tony
Williams, the Operating Engineers
Local 955 plan actuary and president
of PBI Actuarial Ltd.
“Even at a half-billion dollars, it
was relatively easy to execute LDI for
the Engineers’ plan. I’m working with
an $80 million plan, and I’m also not
having any difficulty,” he says. “It just
gets more complex if you try for
derivatives, swaps, overlays and
those more esoteric things. If you
keep it simple you can have LDI
down to a relatively small plan.”
MolsonCoors Director of Global
Pensions and Risk Management Mike
Rumley agrees. “Any smaller pension
plan is going to pay higher fees, but
we do not see that as an impediment
to implementing LDI.”
It all comes down to writing the
cheque, says Nortel’s Director of
Global Pensions John Poos.
“Once you understand the volatili-
ty of your plan vs. your liabilities,
then you realize the impact that can
have on contributions,” he says.
“Could you write that cheque? If the
answer is that it would be dreadful,
then you are a prime candidate for
LDI. If you are not concerned about
the size of that cheque, then LDI is
not for you.” —I2
INVESTMENT INSIDER 9
FEATURE
The Colleges of Applied Artsand Technology PensionPlan has assets of $5.4billion and, at thebeginning of 2008,shifted their asset mixfrom 60% equi-ties/40% bonds(including 5% in infra-structure) to a 57% return-enhancing/43% liability-hedg-ing portfolio (including 10% infra-structure and 5% real estate).
As of 1/1/07, the plan was 98.8%funded on a solvency basis, and thegoing-concern funding ratio was91.3%.
“I’m not using LDI a lot as aphrase with my trustees because itseems to mean so many differentthings to different people,” saysCAAT CIO Julie Cays. “I’ve alsohammered home the message thatyou can’t really match liabilities orperfectly hedge against liabilities.”
Cays says her goal is to controlsurplus at risk and variability of con-tributions — which, by 2010, arealready slated to increase to 12.1%for both employers and employees.
Nominal bonds are benchmarkedagainst the long-bond index, and oneof the CAAT bond managers is buyingstrip bonds outside the long-bondmandate to extend them even further.
“Also, we have been building aninflation-linked component byopportunistically buying real-returnbonds every now and then. In addi-tion, we are getting into swaps,
other derivatives and overlays,but not necessarily from
an LDI perspective,” she says.
Other inflation-linkedinvestments are infra-structure funds and the
brand new allocation toreal estate. “We are still
researching how to imple-ment the real estate mandate.
Ultimately there may be some directinvestment, but that would not bemanaged in-house.” Direct invest-ment in real estate and infrastructureassets by large Canadian pensionfunds, like the CPPIB and OntarioTeachers is very much the exceptionrather than the rule, both domesti-cally and on a global basis, Cayspoints out.
Assets are managed against amarket benchmark that simulatesthe liabilities. “Our liabilities prettywell look like a 13-year duration mixof 70% real-return bonds and 30%nominal bonds. We use a mix ofbond indices and hypotheticalbonds to get us to this mix, andwe’ve asked one of our managers toprice it each quarter.”
Cays says implementing thestrategy is a multi-year process andacknowledges that finding productat an affordable price can be a chal-lenge. “But we have the frameworklaid out. We’re measuring ouropportunities relative to what theydo for us and our surplus at riskframework,” she says.
CAAT PENSION PLAN
Julie Cays
I2308_F_Size.FINAL.qxd 3/13/08 3:39 PM Page 9
HALFFULL,NOT HALF
EMPTY
Recent research from Greenwich Associates
reveals that portfoliowide strategies are
gaining in popularity. Of plan sponsors
surveyed, 11% say they are currently using
some form of LDI strategy, while a further
18% expect to start using this approach.
“LDI is a framework that allows plans to continue
their focus on their raison d’etre of paying benefits,
rather than compare themselves to a market bench-
mark; many Canadian pension plans take much more
benchmark risk than active risk,” says Claude Turcot,
senior VP of Standard Life Investments in Montreal.
“And as managers, we bring market experience and
can explain to sponsors how realistic it is to have cer-
tain objectives.”
BUILDING A BENCHMARK“Assets should be benchmarked to liabilities,” says
Zainul Ali, a senior consultant at Towers Perrin. “It is
conceptually correct, and it’s also relatively easy to
build that benchmark.”
Yet the devil is in the details. The plan sponsor —
often in consultation with a consultant and/or one or
more investment managers — still must identify the
plan’s larger objectives.
For example, benchmarks derived from solvency vs.
going-concern considerations will differ drastically
because of the way liabilities are valued. “When using a
solvency liability benchmark, it may be necessary to
leverage the fund to buy the long-term products neces-
sary for an optimal solution,” Turcot explains.
One alternative is to move the fund’s benchmark
toward a public index that matches its liabilities more
closely — e.g., a long term bond index — as opposed to
the frequently used DEX Universe Bond Index, with its
short duration of 6.5 years. Other possibilities are cus-
tom benchmarks or a blend of existing benchmarks.
STRUCTURING A SOLUTIONImplementing a portfolio based on the new bench-
mark is the next step in the process. But with the
increasing demand for long bonds,
there is a perception in some quarters
that instruments capable of matching
plan liabilities are in limited supply.
Managers interviewed generally
agree that capacity constraints in
Canadian markets are still hypotheti-
cal and would not derail any LDI
moves by a small plan.
But the size of the Canadian
swaps market remains an issue.
Although swaps are not a necessary
component of an LDI approach, they
are commonly used in an overlay
strategy to reduce interest-rate risk.
“The lack of depth of the
Canadian swaps market is quite sig-
nificant,” says Damon Williams, VP at
Phillips Hager & North. “If large
plans wanted to implement a swap
portfolio, it would create significant
bottlenecks.”
However, Williams is quick to
point out that although potential
capacity issues related to swaps are a
10 INVESTMENT INSIDER
FEATURE
By David Adler
Investment managers say market can meet demand for LDI
I2308_InvManag.FINAL.qxd 3/13/08 3:49 PM Page 10
consideration, it doesn’t imply large plans won’t be
able to pursue LDI strategies. Williams says, “There
are many other implementation solutions, including
use of repos (repurchase agreements) and cash bonds
to reduce interest rate exposure relative to liabilities.”
Turcot agrees that implementation is linked to
marketplace availability.
“Large Canadian plans might someday encounter
problems, including year-long delays, if they wanted
to implement relying heavily on swaps. But even for
these plans there are other routes, such using bonds
plus futures,” he says. And looking to the U.S. market
is always an option, although he concedes this could
be expensive because of the necessary hedges.
“Hypothetical lack of product or depth of instru-
ments for large plans is more of a function of lack of
demand than supply,” suggests Jacques Prévost,
CIBC’s VP of global fixed income. “The
market needs grease to get the wheels
running.”
He believes pension funds should
worry about the overall risk of the
strategy — the surplus at risk — and
how everything fits together, while
leaving the practical concerns of prod-
ucts and market considerations to the
manager.
Similarly, Northwater Capital’s VP
Stephen Foote says any hypothetical
thinness in products can be easily
overcome by an experienced manag-
er. “We have been running portable
alpha and LDI programs for over 10
years, and we haven’t run into any
capacity issues to date. If presented
with a two billion trade, we could exe-
cute and implement, but over a rea-
sonable period of time that any plan
sponsor would be comfortable with.”
“There is still a liquid market that is
sizeable enough to build customized
fixed-income portfolios to better
match defined benefit pension liabilities using cash
markets or overlay strategies employing leverage,” says
John Ellis of TD Asset Manageement Inc.
His firm offers a number of solutions including
pooled funds, which can be used by pension funds of
virtually any size to extend the duration of their fixed-
income portfolio. Some of these funds seek to add
value through the use of portable alpha.
SOONER RATHER THAN LATERThe availability of these and other solutions
notwithstanding, Ellis still urges plan sponsors serious-
ly considering LDI to move sooner rather than later.
“Capacity remains a prime motivation, but because
of price rather than availability,” says Ellis. “The bond
can always be bought, the swap can always get done
but it’s a question of price. If you are the last person
in, the solution will be more expensive.” —I2
David Adler is a New York-based freelance business writer whofrequently contributes to Investment Insider and otherSouceMedia publications.
INVESTMENT INSIDER 11
FEATURE
Understanding “swaps”When bonds are purchased through aswap, the plan sponsor enters into a“swap arrangement” with a financial insti-tution. The financial institution pays theplan sponsor the long-bond return, whilethe plan sponsor pays the short-terminterest rate — e.g., the overnight rate.
As a result, the plan sponsor does nothave to advance funds. The arrangementis a contract that, at the end of the quarteror the end of year, the parties will settle up.
The net result, says Towers Perrininvestment consultant Zainul Ali, is thatthe pension fund is using leverage. “Theydon’t have to spend any money to buy the bond. They use an overlay, while stillpreserving their 60% equity/40% bondsasset mix.”
CLAUDE TURCOTSenior VP
Standard LifeInvestments
DAMON WILLIAMSVP
Phillips Hager & North
STEPHEN FOOTEVP
Northwater Capital
I2308_InvManag.FINAL.qxd 3/13/08 3:49 PM Page 11
MolsonCoors and
Nortel say LDI is on
tap in both their
Canadian and U.S.
defined benefit plans,
but their cross-border implementa-
tions reveal markedly different
investment brews.
Development of liability-driven
investment strategies in the two
countries has been influenced by
individual plan designs, availability of
product and regulatory requirements.
Here’s a look at how the strategies
are unfolding.
MOLSONCOORSIn Canada, MolsonCoors has a
fairly mature salaried plan that was
closed to new workers in the 90s and
an ongoing, collectively bargained
plan for hourly workers. The compa-
ny also has a single defined benefit
plan for U.S. employees, with differ-
ent formulas for salaried and non-
union hourly workers. The U.S. plan
was closed to new entrants at the
start of this year, but existing mem-
bers are still accruing benefits.
Director of Global Pensions and
Risk Management Mike Rumley says
that in the early part of the decade,
with an asset allocation of 70% equi-
ties/30% bonds, the funded status in
the Canadian plans deteriorated.
“Like many plans in Canada, we
have to fund under various provincial
rules to a solvency basis. We realized
that as plan sponsors, we don’t want
to have to ‘re-fund’ if there is a fur-
ther deterioration in the equity mar-
kets or if the interest rates fall further.
At the same time, our beneficiaries
are interested in having the benefit
promises locked down.”
As a result, the Canadian salaried
plan has been almost completely
invested in bonds that — to the
extent possible — mirror liabilities.
“Where bonds are not available, we
will definitely do a futures overlay or
swap strategy to close the gap, but we
are not really interested in an overlay
strategy or portable alpha,” he
explains.
Because the funded status of the
active hourly plan is not yet as good
as in the salaried plan, Rumley says
the 70/30 mix was retained. But the
company took the 30% in normal
bonds and extended the duration to
also make them look more like the
liabilities.
The equity allocation in the U.S.
plan has been reduced in the last few
months as well, so the asset mix is
now 45% equities, 10% core real
estate and 45% long-duration bonds.
However, with a greater universe of
bonds and other credit products
available south of the border, the
company wants to retain the ability
to generate alpha by looking at rela-
tive returns among a fairly broad
asset class.
LDI on tap in Canadaand the U.S.BY SHERYL SMOLKIN
12 INVESTMENT INSIDER
Phot
ogra
ph o
f Mik
e Ru
mle
y &
Mol
sonC
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INVESTMENT INSIDER 13
“The decision was made not to
extend duration so far out in the cash
market that it will eliminate these
opportunities or significantly lower
them,” he says. “In the U.S. space,
there is much more opportunity for
managers to demonstrate alpha while
still doing a pretty good job manag-
ing liabilities.”
NORTELJohn Poos, director of global pen-
sions at Nortel, says the company
moved approximately $3.5 billion in
defined benefit assets in Canada and
about $1 billion in the U.S. into a
long-duration portfolio three years
ago. Both plans had “hard” closes
effective Jan. 1, 2008, and no further
service is accruing. The asset mix in
both countries has been shifted from
60% equities/40% bonds to a 50/50
split.
“What we’re doing now, in terms of
our specific LDI position, is just
enhancing it further in terms of some
leverage in order to even further
match our liabilities.”
However, he acknowledges there
are more challenges in completing the
Canadian implementation because of
both the size of the plan and the fact
that liabilities are indexed to inflation.
“The answer is real-return bonds, but
30% of a $3.5 billion plan would
monopolize the market, so we need to
look at other options.”
Not only are there a larger number
of bond issues in the U.S., says Poos,
“but even if you do find the bonds
you need in Canada, there are not as
many counterparties that will take
the ‘swap’ risk.”
Investing Nortel’s Canadian pen-
sion funds in the U.S. market and
hedging the risks is certainly some-
thing to consider but, he says, “All our
liabilities are measured against the
Canadian long index, and if we move
to something else, there is going to be
some mismatch. The question is
whether, in today’s world, we are pre-
pared to accept that, as opposed to
no match.”
A TOTAL MINDSHIFTBoth Rumley and Poors agree that,
at the onset, one of the biggest chal-
lenges in both countries was getting
stakeholders to think about pensions
differently.
“A total mindshift was required
from how well our assets are doing vs.
the external world to how well our
assets are doing vs. our liabilities.
Once people got their head around
that, the process of getting from
where we were to where we are today
got much easier,” says Rumley.
“One of the things that will hap-
pen when you embark on any kind of
LDI strategy is the volatility of assets
will increase materially because
interest rate volatility also affects lia-
bilities,” comments Poos. “If your
committee continues to be pro-
grammed to measure performance as
against peer groups, at the first diver-
gence from the peer group they could
have a knee-jerk reaction, and you
could be out of a job!”
Poos also does not believe that low
interest rates necessarily make it a
bad time to embark on LDI.
“The question really is, are you
concerned today for the liabilities in
your plan if interest rates drop anoth-
er 25 or 50 basis points? You won’t get
the upside of the market with LDI,
but you will be protected from the
downside,” he says. —I2
At the onset, one of the biggest problems inboth countries was getting stakeholders tothink about pensions differently.
JOHN POOS
There are not as many counterparties that will takethe “swap” risk in Canadawhen it comes to bonds.
MIKE RUMLEY
The Canadian salaried planhas been almost completelyinvested in bonds that mirror liabilities.
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14 INVESTMENT INSIDER
Canadian institutions are in the
early stages of a strategic shift that
could ultimately transform the way
pension assets are managed.
Greenwich Associates reports
that 25% of 2007 study partici-
pants say they have adopted some
form of asset-liability matching
strategy in their portfolio, and
another 19% say they have plans
to do so.
Slightly more than 10% have
taken the next step and implement-
ed liability-driven investing strate-
gies — more complicated
approaches that use derivatives to
more accurately match assets to
liabilities in their portfolios. Another
18% of funds say they expect to
incorporate LDI strategies into their
portfolios.
At the same time, 20% of
Canadian funds say they are using
absolute-return strategies, and
another 13% say they have plans
to adopt absolute returns.
Funds that have adopted
asset-liability matching devote an
average of 77% of total assets to
the strategy. Users of LDI include
55% of total assets in that
approach, and among users of
absolute returns, the strategy
amounts to 59% of assets.
“The growing use of these
strategies has major implications
for the Canadian investment man-
agement business,” points out
Greenwich Associates consultant
William Wechsler. “The typical
Canadian fund currently uses
about seven asset managers. But
under this new model, a single
manager controls 55% or more.
The rest get squeezed.”
Greenwich Associates’ recently released “2007Canadian Investment Management ResearchStudy” presents a fascinating snapshot of howCanadian institutional investors are investing,and what they are planning going forward.
It also takes a look at trends in investmentmanagement fees, the growing demand forportfoliowide strategies, plus the current and
expected share of assets in defined benefit anddefined contribution plans.
In this issue of Market Watch, we are pleasedto share with you excerpts from the Greenwichstudy, which is based on data collected in inter-views with 257 corporate and provincial gov-ernment pension funds, endowments andfoundations.
A snapshot of current pension investment trends
Freed from past regulatory con-
straints on foreign investments
and driven by a desire for diversi-
fication and higher returns, the
Greenwich study shows that
Canadian pension plans, endow-
ments and foundations are adding
international assets to their
investment portfolio at a rapid
rate.
Key findings include:
• International investments
now make up 30% of all institu-
tional assets in Canada, including
nearly 60% of institutional equity
portfolios.
• More than one quarter of
large Canadian firms have started
using currency overlay strategies
to hedge risks associated with
their exposure to nondomestic
investments.
• When seeking out alterna-
tive investments, Canadian insti-
tutions prefer real estate and pri-
vate equity to hedge funds.
• Strong funding ratios have
enabled Canadian pension plan
sponsors to avoid closing defined
benefit plans and slowed the
growth of the defined contribution
market.
Nevertheless, Greenwich
Associates consultant Chris
McNickle says: “In other markets,
we have seen that the implemen-
tation of mark-to-market account-
ing rules has prompted a sudden
and decisive shift by corporate
plan sponsors out of DB into DC.
When and if Canadian regulators
move the market in that direction,
we could expect the same.”
Portfoliowide strategies could revolutionize plan management
Canadian pension plans rapidly diversify
Investment management fees increased in most asset classes for
Canadian plan sponsors from 2006 to 2007, after dipping the previous
year, according to data collected by Greenwich Associates.
Overall, Canadian funds paid an average 35.1 basis points (bps)
to all outside managers. By asset class, fees paid to active man-
agers of:
• Domestic equities increased modestly to 30.8 bps in 2007 from
29.5 in 2006.
• Fixed income rose to 20.7 bps in 2007 from 18.1 bps in 2006.
• EAFE equities jumped to 56.6 bps in 2007 from 53.7 bps
in 2006.
• U.S. equities declined slightly from 2006 to 2007.
The Greenwich report also notes that only 11% of Canadian funds
use performance-based fees to compensate investment managers.
Among those that do, performance fees are used most commonly for
active U.S. equities and active income. Usage is much higher among
funds with more than $1 billion in assets, about 20% of which pay
managers performance fees.
Canadian funds also saw an increase in fees paid for regular con-
sulting services, which increased to an average of $105,000 in 2007
from $95,000 in 2006, and for fees for traditional actuarial services,
which rose to about $158,000 from $140,000.
Fees on the rise for Canadian Funds
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