Canadian pension funds are taking steps to address pension under-funding by increasing their investments in foreign stocks and alternative investments.


"Corporate and public pension plan sponsors in Canada are looking to ensure their ability to generate enough asset growth to raise their solvency ratios to more comfortable levels," says Greenwich Associates' Toronto-based consultant Lea Hansen. "To that effect, they are working to generate incremental returns from core asset classes, they are investing in alternatives, and in both cases, they are bringing in new specialty managers to carry out these strategies."


A new report from Greenwich Associates analyzes the actions taken by Canadian pension plan sponsors to improve solvency ratios, including adjustments to asset allocations, increased investments in hedge funds and other alternative asset classes, and the aggressive hiring — and firing — of investment managers. The report examines rate-of-return expectations, actuarial assumptions, and trends in investment management fees, and assesses current usage of investment consultants, transition managers, and defined contribution plans. In addition, the report presents Greenwich Associates' latest research on the compensation levels of Canadian investment professionals.


Solvency woes


Solvency ratios have been falling steadily among Canadian pension funds for the past four years. After hitting 112% in 2000, average pension fund solvency ratios have dipped to 95% in 2004. Some of Canada's largest pension funds are part of the problem: As many as 17% of 70 Canadian funds with assets of more than $1 billion are less than 90% funded, and 9% of these jumbo funds are below 75%.


Low interest rates have helped to keep solvency ratios under water, even in the midst of the recent equity market recovery, by increasing pension fund liabilities. However, Canadian plan sponsors appear determined to limit the need for contributions from taxpayers' pockets or from companies' own capital funds. "Provided that their return expectations are valid," says Lea Hansen, "the great majority of plan sponsors should be generating enough asset growth to restore funding levels."


International and alternative investments


In their effort to bolster overall portfolio returns, Canadian institutions are focusing in large part on international equities and alternative investments — assets classes in which rate of return expectations are relatively strong. Even though the 30% limitation on foreign securities is still in force, Lea Hansen notes that Canadian funds still have some leeway to further increase foreign investment. "The 'global' total in EAFE, U.S. stocks, and international bonds, is still only 26.1% of total assets this year, so they could invest another $30 billion in foreign securities if they believe they can get better returns that way," she says.


Even institutions that are bumping up against the 30% limit are finding avenues for increasing their foreign exposure. "Twenty percent of Canadian funds allow their outside managers to achieve foreign exposure above the regulatory limit by using derivatives," Lea Hansen says, "and the same proportion of funds expect to continue to do this."


Canadian institutions also expect to maintain the current strong growth trend in allocations to alternative asset classes, such as private equity and hedge funds. Canadian plan sponsors now have $20.1 billion invested in private equity, up from just $6 billion in the year 2000, $8 billion in 2001, and $14.6 billion at the end of 2002. While hedge fund allocations round off to just 1% of total institutional assets for both 2002 and 2003, the absolute amount invested jumped to $8.8 billion from $6 billion over the period — an increase of almost 50%. Looking ahead, the number of Canadian institutions expecting to increase their alternative asset allocations outnumber those expecting declines by a wide margin — especially with regard to hedge funds.


Asset mix shifts


The extensive hiring of new investment managers revealed in Greenwich Associates' 2004 research is a reflection of Canadian plan sponsors' attempt to address the solvency issue by increasing portfolio returns. For example, even as these institutional investors reduce their allocations to fixed income, the proportion of plan sponsors hiring active domestic bond managers from 62% in 2003 to 68% this year.


Similar trends can be seen in domestic equities, where allocations were stable year-to-year and twice as many institutions plan to cut their allocations as plan to add domestic stocks in the future. Despite this retreat, demand is intensifying among investors for domestic growth stocks, which were used by 42% of institutions in 2003, up from just 38% in 2002. Mandates for value stocks also increased, with usage jumping to 57% from 41% year-to-year.


Pace quickens in hiring and firing


Last year, Canadian institutions told Greenwich Associates that they were planning large increases in their manager hiring in 2004. In reality, their hiring vastly outstripped even these aggressive expectations over the past 12 months, and Canadian institutional investors are now hiring new managers at a pace seldom seen in Canada.


The increase in hiring has been accompanied by a corresponding growth in manager terminations. "While almost half of Canadian institutions hired a new manager in the last year, more than 40% say they've terminated a manager in the same period," says Greenwich Associates consultant Rodger Smith. "While high manager turnover can sometimes be seen as problematic, in this case it appears that Canadian institutional investors are responding to the solvency problem by raising their standards for investment.


Compensation and Staffing


Average total cash compensation for Canadian plan sponsors in 2003 totaled C$163,900. Average salaries rose by nearly 3%, from C$116,300 in 2002 to nearly C$120,000 in 2003, and bonuses increased slightly at a similar rate to C$44,300. Despite the increase in salary, bonus levels decreased 4% to just over C$15,000 in 2003.


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