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Canadian pension funds may embrace more risk with rules change

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As the trend toward smoothing defined benefit plan funding requirements in Canada grows, so is the opportunity for some plan sponsors to adjust their asset allocations to take on more risk, investment consultants said.

“This is definitely a game-changer, and it was meant to be,” said Ken Choi, director, investment consulting, Willis Towers Watson PLC, Toronto.

Last month, the Ontario Finance Ministry announced a plan to no longer require all DB plans in the province to value their funding based on both a going-concern basis — the assumption that the plan will remain active indefinitely — and on a solvency basis — the value of the plan if it were terminated immediately. Under the Ontario proposal, solvency funding would be required only for those plans that funded at 85% or less. The ministry this fall will introduce legislation in the Ontario Parliament to make the change.

“Now, with solvency under 85% (in Ontario), you can play around with your fixed-income portfolio,” Mr. Labrosse said. “Perhaps more in credit, but also more of it in fixed income with higher returns, like real estate and infrastructure … If you include (return-seeking) assets … some traditional fixed income will be attributed more and more to real assets, because you'll need to stick with your overall fixed-income allocation because of the end goal. But the higher returns will let the plan have a bigger impact on contributions. I certainly expect plan sponsors to go more into real estate and infrastructure debt.”

Most Canadian DB plans are near full funding. As of March 31, separate reports from Aon Hewitt and Mercer (Canada) Ltd. show that Canadian plans have a median funded status of 96.7% and 93%, respectively. “Thirty (percent) to 40% of Canadian plans are fully funded, but there are still some plans below 85%,” said William da Silva, senior partner, retirement and investment, Aon Hewitt in Toronto. “The mountain's not as high, but it's still there.”

“The Ontario government recognized that solvency funding was creating an undue cash flow burden on many employers,” Mr. Choi said. “This burden in some cases likely contributed to past decisions to freeze the DB plan and switch to DC. These changes were meant to provide a meaningful and long-term measure of relief from those funding challenges.”

Ontario's proposal follows a move by Quebec in 2016 to eliminate solvency valuation entirely for corporate DB plans and enhance its going-concern valuation rules to increase pension fund contributions; public pension plans in Quebec are exempt from solvency valuation.

While Quebec's funding rules are in effect, plans in the province haven't yet made changes to their investment strategy in response. Michel St.-Germain, a Montreal-based partner and actuary for Mercer (Canada) Ltd. and vice chairman of the Association of Canadian Pension Management's National Policy Committee, said he expects that it won't be until 2018 before most corporate plans in the province decide how to react to the new rules.

If Ontario's proposal is enacted, Canada's other provinces are expected to follow suit with similar changes to minimize the use of solvency requirements, said Benoit Labrosse, partner, asset and risk management at Morneau Shepell, Montreal. “Other provinces generally set up rules similar to Ontario, so you'd expect them to adopt similar (funding) rules,” Mr. Labrosse said. “I wouldn't be surprised if similar rules to Ontario's were across the country in two to three years.”

Mr. St.-Germain said active DB plans will be “looking at whether the greater stability in contributions under going-concern (valuation) will let them take more risk. Many of those on a derisking path in Quebec could slow down, in part because of the new rule and in part because of the nature of greed: Selling equities with a return of 3% to buy a bond with a return of 2%, that doesn't seem like a smart move.”

While Mr. Labrosse said the Ontario rule would lighten the burden for active DB plans, most corporate plans in the province and elsewhere in Canada are derisking in some way.

“I'm not a believer that these funding rules will resuscitate defined benefit plans,” Mr. Labrosse said. “There are still a lot of employers on track to either derisk or to purchase annuities for their liabilities. But the need to derisk that was there under solvency will be a little easier.”

He said for the 20% of plans that are active, “the new rules most likely will be much better for any organizations that want to preserve their DB plan for the long term.”

Mr. da Silvia said that a move to going-concern valuation will give all plans, including those with liability-driven investment strategies, some wiggle room to try more risky investments.

“Those plans with long time horizons that, say, never looked at alternatives in the past and were maybe not as quick or measured in going into long bonds are possibly looking at (alts) from a return standpoint,” Mr. da Silva said. “Maybe they'll have more tools to moderate contributions. The new rules reduce volatility, which gives these organizations two decisions to make. If they decide to take on more risk, then yes, they'll look for more return opportunities. This frees up their risk budget to dip a toe into more equities or alternatives. Or if they stay with the same risk posture, the government may be giving them a bit of a free ride on funding rules but they'll stick with what they're doing.”

The effect of more going-concern valuation “is going to be different for different plans,” added Mr. Choi. “There are different degrees of LDI. The spectrum runs from fully derisking to lifting something off the table. But with going concern, everyone may decide to turn down (derisking) a notch. And adding riskier investments could be a part of that. But pension funds going down the road of derisking won't be doing an about-face tomorrow.”

For most Canadian pension plans in LDI, said Morneau Shepell's Mr. Labrosse, “you are getting an option (through going concern) to fund the deficit over a longer period. You're not changing the end goal, but why not make investments that can help fund that deficit as much as possible? Maybe you can contribute a little less to the plan and earn your way out of the deficit.”

Mr. Labrosse agreed that for those in an LDI strategy, there's an opportunity to add a little more risk to the fixed-income portfolio without changing the overall asset allocation. Even though solvency rules most likely won't apply once the rules are in effect, the fact that the plans using LDI have an actual end date, funding will have “an element of solvency” in the background, he said.

Mr. Choi of Willis Towers Watson said he wasn't sure if any asset classes would benefit from these changes, “but I would expect the recent trend away from higher-return, higher-risk asset classes such as public equities might slow down in the future, whereas liability hedging at low yields might take a back seat for some plan sponsors, at least until rates normalize somewhat. Still, smart investing isn't going out of style. Equity markets have high valuations and we think there's a lot of instability bubbling beneath the surface. … All the things that investors are looking for — diversification, putting your eggs in different baskets — won't go away with a new funding requirement.”