Canadians turn to new strategies to fight underfunding

TORONTO — Canadian defined benefit pension plans, much like their U.S. brethren, are facing a three-headed monster of low return expectations, a low interest rate environment and climbing liabilities, according to a new report from JPMorgan Investment Management.

In response, pension executives in Canada are considering or already are engaging in asset-liability management, portable alpha strategies and hedge funds, according to the report, "Evolving Trends of Canadian Pension Plans."

Of the 240 largest pension plans in Canada representing some US$240 billion, 104 responded to a JPMorgan survey — 52% were corporate pension plans, 27% public plans, 6% union plans, and 15% were classified as "other." Additionally, 40% of the respondents to the survey said their plans were less then 95% funded.

Meeting assumed rates of return was the biggest worry for 41% of the respondents, according to the survey. For the next year, the average assumed rate of return is 7.7% among the respondents, while the average discount rate is 5.9%.

Additionally, 16% said declining Canadian interest rates is the biggest concern, because liability discount rates are based on current and past interest rates. The average yield on the Canadian yield curve was 4.5% as of Dec. 31. The Central Bank of Canada's benchmark interest rate is currently 3.5%. Fifteen percent said market volatility is the biggest concern, while 12% said the main concern was the funded status of their plans.

In other areas, 78% of the respondents said they plan to revisit their asset allocation within a year; 76% will focus on alpha generation; 56% will look to reduce volatility in their portfolios; 51% will look to manage assets relative to liabilities; and 41% said they will look at portfolios that separate alpha and beta.

Gabriella Barschdorff, vice president of the Strategic Investment Advisory Group at JPMorgan, said the concerns of Canadian pension plans are similar to their U.S. counterparts: "Canadian pension funds are underfunded and they have to have some return on assets that is greater then the growth of liabilities." One roadblock that Canadian pension plans are seeing, she said, is a general lack of liquidity in the derivatives market in Canada. U.S. plans that want to increase the duration of their bond portfolios in order to match assets to liabilities can turn to the interest rate swap market in order to do so synthetically. In Canada, however, that is difficult because the market for swap contracts is small.

"Canada is a smaller country with a smaller economy. The fixed-income market is less liquid and less deep," said Ms. Barschdorff. "Theoretically, a Canadian pension plan could turn to the U.S. swap market and manage the currency, but that would involve several derivatives transactions and probably be available only to the largest plans with the deepest resources."

In general, Ms. Barschdorff noted the strong desire of Canadian pension plans for structured products: "I think in general, pension plans are moving in the direction of separating alpha and beta."

Joseph Doolan, vice president and treasurer overseeing the $5.2 billion defined benefit pension plan of Canada Pacific Railway, Calgary, said his company's biggest concern this year is low interest rates.

"My concerns are not that much different," from what JPMorgan found, he said. "Low interest rates tend to drive liabilities upward and that creates deficits which have to be funded."

Janet Rabovsky, a senior investment consultant focusing on Canadian pension plans for Watson Wyatt Investment Consulting, Atlanta, said most Canadian pension plans are looking at overlay strategies and managing assets relative to liabilities.

"If you go back a few years, plans were meeting their rates of return because of strong performance in the Canadian stock market and the strong Canadian dollar. But because of declining bond yields, they are facing larger deficits. Also, … Canadian pension plans are facing relatively low returns in equities in the next year or two. It's going to be very hard to grow their way out of being underfunded," she said. "So the main concern I've seen is how their assets perform relative to liabilities. Right now, Canadian pension plans are looking at a multitude of things, such as alpha transfer strategies and commodity and currency overlays."

According to the Watson Wyatt Pension Barometer, the average corporate pension in Canada was 90% funded at the end of 2004, up from 85% at the end of the 2003.