With the extreme market volatility earlier this year following the global outbreak of the Covid-19 pandemic, and expectations of a continuing low yield and low inflation, potentially deflationary, environment, Canadian pension funds have been taking stock of their liability-driven investing strategy and reviewing what they may need to modify to be better positioned for the future. Pension plans need to first focus on the goal of their LDI strategy which is designed to manage their specific liabilities and funding requirements and that, in turn, will help make tactical implementation decisions including addressing interest rate levels, said François Hélou, Head of Balance Sheet Solutions at BMO Global Asset Management, Institutional Sales, and at BMO Insurance.
WHAT’S THE RAISON D’ETRE OF YOUR LDI STRATEGY?
“LDI is a risk management strategy. It's not a de-risking-at-all-costs strategy. In an LDI strategy, both the defined benefit plan's exposures to fixed income and growth assets adjust to the plan’s specific balance sheet risks,” said Hélou, speaking at Pensions & Investments’ Canadian Pension Risk Strategies virtual series in October. “So, before addressing interest rates or the shape of the yield curve, which are next to impossible to always forecast accurately, it's important to remember that the raison d'être of a DB plan is to meet its liabilities toward pensioners. That's what the plan is for. Everything else are tools that help achieve that raison d'être.”
As pension plans confront a world of aggressive actions by central banks in shaping the yield curve and with interest rates approaching zero, can an LDI strategy offer the same risk control and diversification that it did before? “Market-timing decisions are important, but they're tactical,” said Hélou, speaking at the session on ‘LDI in an ever-changing world: New LDI techniques in a non-solvency world.’ “The strategic decision for a DB plan is to design the risk management that caters primarily to two parameters: the plan's liability profile and its funding requirements,” he noted, adding that since those two parameters differ for DB plans, their LDI strategy cannot, and should not, be the same.
There are many corporate pension plans that are relatively well-funded, closed DB plans whose endgame is a pension risk transfer to an insurer, Hélou said, and they have no strategic reason to stay significantly exposed to growth assets. “It makes sense for such plans to establish an LDI that is mostly fixed income oriented, irrespective of the shape of the yield curve or the level of interest rates because the plan is working toward a risk transfer.” He pointed to pension group annuities, which can be seen as the ultimate fixed income de-risking strategy for a DB plan. The volume of bulk pension group annuities has increased several folds in the past few years, both in Canada and globally, despite years of declining interest rates which shows that plans are still de-risking despite historic low interest rates, he noted.
Conversely, some DB plans are open plans or deeply under-funded plans. “These DB plans need an LDI program that incorporates an ongoing exposure to growth assets, or equities. The amount of equity exposure will depend on the plan itself. And market-related tactical decisions, such as the level of interest rates, implementation strategy, and shape of the yield curve, will be very different than for the well-funded closed plans,” he said.
Pension plans should not base a decision to proceed with an LDI strategy strictly on interest rate levels, he said. They should first establish a risk management strategy based on their balance sheet profile, following an extensive asset-liability review, and then base the LDI implementation on market-related factors. “In some cases, it makes sense for DB plans to implement a fixed income strategy in the current interest rate environment. In other cases, the plan might need to establish a fixed income strategy alongside a market growth strategy to ensure that it meets its future funding levels and payment obligations.”
A recurring question that a lot of indexed pension plans, specifically the para-public pension plans that offer inflation indexing, is whether inflation is still a risk in this environment, Hélou said. “Hedging inflation in a low inflation, or even deflationary, environment, is a bit like buying insurance. You may think that the event has a low probability of occurrence but, if it does happen, it usually is totally unexpected and financially significant. So, the prudent approach for a lot of DB plans is to actively manage that risk,” he recommended, adding that a lot of Canadian DB plans are in fact doing so. “Interestingly, even more so today than, say, five or even 10 years ago, many plans have significantly increased their investments in real assets, such as real estate and infrastructure.”
In both Canada and the U.S., political leaders and central bankers are publicly saying that interest rates will stay low for years to come and inflation is not a threat, Hélou noted, adding that the structural trends in industrialized nations that have caused nominal interest rates to decline over the past 30 years remain in place. Still, he said, inflation remains a mid- to long-term risk.
“First, the money-printing machines are working overtime in industrialized economies,” he noted, with trillions in relief programs in the U.S. and Canada increasing its federal debt to GDP by 50% in a few months. “There’s no question these programs are necessary but they are inflationary. Financial markets don't seem to be pricing inflationary risks so far. Remember that markets didn't price COVID risks before early March.” If and when inflation happens, it will occur outside of governments’ control and planning decisions. There are also unknown factors that might affect inflation such as the impact of climate change on production or the effect of an escalating trade war with China on consumption goods, he added.
In reviewing real assets as an inflation hedge, COVID-related concerns are redirecting some commercial real estate investments depending on the sectors, Hélou said. In addition to benefitting from higher yields when investing in real assets, a number of public, para-public and indexed pension plans appreciate many of the real assets’ lease adjustments as a function of inflation. “The principal value of real assets and, in many cases, their long-term leases typically adjust to inflation, which makes them an attractive fixed income asset class in inflationary environments. We’ve seen a shift away from marketable fixed income into real assets in the past few years, partially fueled by inflation concerns.”
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