Canadian funds adapting strategies to fight underfunding

By David Clarke

As many as 17% of 70 Canadian pension funds with assets of more than C$1 billion are less than 90% funded, and 9% of these large funds are less than 75% funded, according to a new report by Greenwich Associates, Greenwich, Conn.

Solvency ratios have been falling steadily among Canadian funds for the past four years. After hitting 112% in 2000, average pension fund solvency ratios have dipped to 95% by the end of 2003.

To combat the underfunding, Canadian pension funds are increasing their investments in foreign stocks and alternative investments, and hiring new investment managers at an unprecedented pace, according to the Greenwich survey.

"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," said Lea Hansen, Greenwich Associates' Toronto-based consultant. "Provided that their return expectations are valid, the great majority of plan sponsors should be generating enough asset growth to restore funding levels."

The actions taken by Canadian pension plan sponsors to improve solvency ratios, include adjustments to asset allocations, increased investments in hedge funds and other alternative asset classes, and the aggressive hiring — and firing — of investment managers, Greenwich's research showed.

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 2003, the typical Canadian fund in the Greenwich universe had 27% in domestic equities, 30% in fixed income, 13% in EAFE equities 13% in U.S. equities, 5% in real estate, 3% in private equity, 1% in hedge funds and the remainder in other investments. In 1999, the typical Canadian fund had 31% in domestic equities, 33% in fixed income, 12% in EAFE equities, 11% in U.S. equities, 4% in real estate, 1% in private equity, nothing in hedge funds and the remainder in other investments.

Canadian plan sponsors now have C$20.1 billion (US$15.7 billion) invested in private equity, up from just C$6 billion in 2000, C$8 billion in 2001, and C$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 C$8.8 billion from C$6 billion over the period — an increase of almost 50%. Looking ahead, the Greenwich report said 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.

Still, "while the recent negative performance in the markets has certainly led many pension funds to examine the performance of their managers, I do not see a movement generally to investments with a higher risk component," said Kathryn Bush, partner in the Toronto office of law firm Blake Cassels & Graydon LLP, in an interview. Ms. Bush has served as vice chair of the Financial Services Commission of Ontario and the Pension Commission of Ontario.

In their effort to bolster overall portfolio returns, Canadian institutions are focusing in large part on international equities as well — where the rate of return expectations are relatively strong. Even though Canada limits foreign securities to 30% of a pension fund's assets, Ms. Hansen noted in a news release that "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 C$30 billion in foreign securities if they believe they can get better returns that way."

Individual funds that are bumping up against the ceiling 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," Ms. Hansen noted, "and the same proportion of funds expect to continue to do this."

"From a legal perspective we have seen pension funds looking toward derivatives for some time, i.e. long before the recent deficits emerged in pension plans," Ms. Bush added. "The movement toward derivatives has been a response, most would argue, to the fact that the Canadian market is ssmall and concentrated."

Last year, Canadian sponsors told Greenwich researchers that they were planning large increases in their manager hirings in 2004. They have followed through with those plans; Canadian institutional investors are hiring new managers at a pace seldom seen in Canada.

The increase in hiring has been accompanied a boom in firing. "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," Greenwich Associates consultant Rodger Smith said in the report.