Options for pension fund investing

Sliding stock markets have fund sponsors considering alternative investment strategies

Economic downturn. Terrorism. Enron. War in Iraq. The rupture of the tech bubble. All of these factors have contributed to dismal financial market performance, particularly in equities. Consider the following grim statistics, gathered as of March 31, 2003:

•Canadian equities (S&P/TSX Composite Index) off 41.1 per cent since the August 2000 peak;

•U.S. equities (S&P 500 Index) off 42.1 per cent since the August 2000 peak; and

•offshore equities (MSCI EAFE Index) off 47.4 per cent since the December 1999 peak.

While the current outlook is somewhat more optimistic, there’s no guarantee that the bumpy ride is over. What can fund managers of both defined benefit (DB) and defined contribution (DC) plans do to chart a smoother course for the future?

Given the low returns on equities, the immediate reaction might be to switch from equities to bonds — the approach adopted by the Boots pharmacy chain in the United Kingdom to immunize its pension fund from volatility. However, Boots made this change prior to the worst of the market declines and, in actuality, few fund managers are making dramatic changes to their asset mix. In fact, some are making no changes at all, preferring to maintain the status quo and ride out this rough patch.

One of these tactics may well be the correct course of action. However, when making any change to the pension fund asset mix, fiduciaries should be guided by the objectives of the plan. It’s important to remember that pension plans are long-term propositions, especially DB plans and especially those in the public sector. Fiduciaries must guard against short-term decision-making.

Let’s presume, though, that the pension fund objectives support making some changes to try to cover DB liabilities or meet DC expectations. Market fluctuations will always affect returns but nothing can be done about that. The key is to focus on what’s possible to control, namely the risks in the portfolio. With that goal in mind, what investment alternatives are available?

There are some basic risk management avenues to pursue: asset class diversification and manager style diversification. Of course, fiduciaries could utilize both strategies.

Alternative strategies for DB plans #1: Asset class diversification

In an ideal world, a pension plan asset mix would change in lock step with pension liabilities and produce cash flows identical to pension payments. While that’s a tall order, there are courses of action that may take a plan closer to this goal.

Before launching into the world of alternate investments, it’s important to note that there are options available within the more standard bond and equity asset classes. For instance, fiduciaries may want to consider investments that closely match the expected payments out of the pension fund, like long bonds or real-return (inflation-indexed) bonds.

With respect to equities, fund managers may want to look at diversifying into interest-sensitive, higher yielding equities that behave a little more like bonds and therefore better track liabilities.

Added diversification possibilities may exist in alternative investment strategies. But these alternatives are more complex, and they must be funded from contributions to existing, easier to understand investments.

Alternative investments include:

Real estate: At times an effective inflation hedge. Generally produces steady cash flow, but suffers from less liquidity.

Hedge funds: Some funds allow a manager to sell shares short (or bet that the price will fall). An “absolute return” focus product, but with less regulation and some spectacular fund meltdowns.

Private equities: Non-listed shareholdings, with high-return potential, but limited liquidity and high volatility, costs and maintenance requirements.

Venture capital: Also non-listed investments, generally made at an earlier stage of a company’s life cycle. Returns can be high, but liquidity is lacking, while costs and maintenance are high.

Commodities: A potential inflation hedge with few investment vehicles for most Canadian pension plans. Generally less liquidity and an even greater commodity bet on top of Canada’s already commodity-biased domestic market.

It’s important to realize that some of these alternative strategies are less mainstream and are not “tried and true” in the institutional world. Because they haven’t proven themselves in the long term, venturing into this territory can be a little like strolling through a minefield. An old investing axiom should always be applied: if you can’t fully understand it, don’t invest in it. Simply put, education is required.

Another key message is that what works for one fund may not work for another. It depends on the needs of the stakeholders and their tolerance for risk.

There is also no quick fix and no right “off the shelf” answer.

Alternative strategies for DB plans #2: Manager style diversification

Another alternative strategy is to take a closer look at the plan’s investment manager(s) and their investment philosophy.

Asking these questions helps to zero in on whether you have the right manager or combination of managers:

•Does the plan have the right exposure to the markets?

There should be an appropriate mix of large cap, mid cap and small cap.

•Has the manager made decisions to reduce volatility?

For managers with equal returns, lower volatility wins the day.

•Has the manager protected the fund’s value as well as could be expected?

Certain manager styles and processes soften the blow of weak markets.

Alternative strategies for DC plans

There are those who advocate adopting the same alternative strategies for DC plans as those available to DB plans. The greatest stumbling block to doing so is that, in the case of DC plans, it’s the plan members who make and bear the risks of the investment decisions. Some of these alternate investment vehicles are just too complex for plan members to understand easily. Hedge funds are a case in point.

Moreover, providing too many investment choices may not be a good thing.

Many plan members make investment choices that would never be made in the institutional world, indicating a lack of understanding of their options. For example, a typical breakdown of a DC plan’s assets looks something like 20 per cent to 40 per cent in balanced funds, 20 per cent to 40 per cent in Canadian equity funds and 20 per cent to 40 per cent in GICs or T-bills.

The best strategy in the DC world is one of education.

Plan members know that economic uncertainties are having an impact on their retirement savings. They see their pension statements and many are keen to learn more. This may mean providing plan members with financial planning. Studies have shown that face time with a financial planner provides the most impact.

Alternatively or additionally, plan sponsors can provide information over the organization’s intranet (including modelling exercises), direct employees to information on the Internet, and distribute an easy-to-understand investment newsletter.

Until plan members are educated so that they are able to make wiser investment choices, it’s hard to justify providing them with more options.

However, assuming this education process takes place, one new strategy that is gaining momentum is life-cycle funds. These funds, also called lifestyle funds, provide an easy way to ensure a proper, diversified mix of assets through a single investment. As plan members move closer to retirement, the fixed income-equity ratio changes, reflecting a more conservative approach to risk.

Life-cycle funds are not very prevalent in Canada and only slightly more common in the U.S. However, their popularity is on the rise. According to research conducted by Hewitt Associates in the U.S., the percentage of 401(k) plans that offer life-cycle funds grew to 35 per cent in 2001 from 19 per cent in 1997. While these funds account for less than 10 per cent of the total assets of plans that offer life-cycle funds as a choice, they only accounted for two per cent of assets in 1997. This trend is expected to appear in Canada.

If there is any good news on the pension plan investment front, it’s that the situation is not quite as dire in Canada as it is in the U.S. American pension funds, generally speaking, are in more trouble. There, DB plans were more heavily invested in equities and DC plan members invested more aggressively, particularly in their own employer’s equity.

So while Canada is in stronger shape than the U.S., the time is right for fund managers to take a closer look at investment strategies and determine whether steps might be taken to improve returns.

Even if the ultimate decision is to make no changes, fiduciaries owe it to plan members to check out alternatives.

John Myrah and Perry Teperson are both investment consultants with James P. Marshall, a Hewitt company. John works out of Regina (306) 525-3761, [email protected]. Perry is in Vancouver (604) 683-7311, [email protected].

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