Canadian plans prepare to increase risk assets

Canadian pension plan executives are starting 2018 expecting to invest more in alternative investments, specifically infrastructure and real estate, as the easing of funding rules in Ontario gives plans more opportunity to take on risk, sources said.

"This funding rule change is a game-changer," said Manuel Monteiro, partner and head of the financial strategy group at Mercer (Canada), Toronto. "It could change plan design, change investment strategies and should impact funding strategies."

The Ontario Legislature last year approved the law that will eliminate the requirement that defined benefit plans base their funding on the basis of both solvency, or immediate termination basis, and going concern, or ongoing operations. Instead, plans that are more than 85% funded will be allowed to calculate annual funding on a going-concern basis alone.

The Ontario Finance Ministry is expected to implement the new rules sometime this year, once a comment period on regulations closes at the end of January.

Ontario's move comes after Quebec in 2016 dropped the solvency funding requirement for all DB plans based in that province. Other provinces maintain both funding requirements, although some have smoothed contributions over longer time horizons. But Mr. Monteiro said he expects all other Canadian provinces to follow suit eventually. (Most pension plans in Canada are governed by provincial rules.)

The change will make higher-yielding investments like alternatives more popular among Canadian institutional investors as more money will be freed up for riskier investments with the potential for higher return, sources said.

"Any alternatives, infrastructure particularly," said Ian Struthers, partner and practice lead, Aon Hewitt Investment Consulting, Toronto. "We expect growth in those asset classes to continue, particularly among the large pension plans. It's easy for plans the size of Canada Pension Plan to do; they have long time horizons and huge asset inflows. But for small to midsize plans, they can take on more exposure to alternatives through diversified investments with external managers. But there's a lot of money looking for infrastructure and for real estate. There will be more interest in less vanilla kind of investments to add value, like brownfield projects."

Martin Leclair, portfolio manager at Phillips, Hager & North ​ Investment Management, Toronto, said the move to those strategies already is happening. "What we're seeing from the solvency rule changes is a lot of rerisking. That's already happening. It's more about yield than about risk. So fundamentally, yes, there will be a lot of rerisking."

For example, Mr. Leclair said he's seen interest among pension fund investors in strategies that incorporate infrastructure, real estate and private debt, as ways to provide "big yields with a small allocation" despite the three- to five-year lockup. He also said sponsors have shown interest in unconstrained equity, core-plus fixed income and highly concentrated global equity strategies, as well as more long/short and market-neutral investments.

"2018 will not be the year of one strategy, it will be the year of being creative," Mr. Leclair said. "Traditional bond and equity strategies will not get you there. You have to find alpha. These strategies are out there … I think you'll see departures from traditional benchmark-oriented strategies, away from being a 'closet indexer.'" PH&N Investment Management has C$90 billion in institutional assets under management, according to its website.

Canadian money managers are responding by going beyond the country's largest plans like the C$328.2 billion ($257.6 billion) Canada Pension Plan, Ottawa, and the C$286.5 billion Caisse de Depot et Placement du Quebec, Montreal, which manages Quebec's provincial public pension assets.

"More managers are working to develop ways to invest in alternatives for small- and midsize plans through partnerships and co-investments," said Scott McEvoy, Toronto-based partner at the law firm of Borden Ladner Gervais LLP, whose clients include institutional money managers. "One of the things that will come from this is how to provide governance around these co-investments. I think that's an exciting prospect."

Mercer's Mr. Monteiro said that the funding rule changes in Ontario and Quebec provide "a disincentive" to be in liability-driven investment strategies, which has been a growth industry for Canadian insurers and money managers in recent years. "More plan sponsors will decide to hang on to their plans, and that means they'll have incentive to increase investment in things like infrastructure and real estate. I also think they'll increase their equity investments as well to take on more risk. You may see some rerisking among plans, but I think it will be less derisking."

Borden Ladner's Mr. McEvoy also said the Canada Infrastructure Bank, created to invest in a revamp of the country's infrastructure, could provide opportunity for institutions of all sizes to invest in 2018.

"They've now got a governing board in place; that should make it available to institutional investors, and not only the large ones," said Mr. McEvoy. "That's part of the bank's mandate, to seek investments from a variety of institutions."

Aon Hewitt's Mr. Struthers said 2018 should also see the continuation of consolidation of provincial pension asset management under entities such as the Investment Management Corp. of Ontario, which began in 2017 with the goal of managing the assets of smaller public plans in the province.

Alberta, British Columbia and Quebec already consolidate money management under individual provincial entities like the C$95.7 billion Alberta Investment Management Corp., the C$135.5 billion British Columbia Investment Management Corp., and Quebec's Caisse.

"Then there's CAAT (the C$9.4 billion Colleges of Applied Arts and Technology Pension Plan, Toronto), which is actively seeking to merge with other plans," said Mr. Struthers. "I think you'll see management consolidation continue, and multiemployer plans become more acquisitive in 2018." On Jan. 4, CAAT announced it was merging with the C$32 million Youth Services Bureau of Ottawa Pension Plan.

Also looming large over Canadian plan executives is the impending start of the enhancement of both the Canada Pension Plan and the C$62.2 billion Quebec Pension Plan, Quebec City. Scheduled to begin in January 2019, employer and employee contributions to both plans will gradually increase by up to 1 percentage point each by 2025 — to a combined 10.9% for the CPP and 11.9% for the QPP — and benefits will be raised to one-third of pensionable earnings from 25%.

"The legislation for this was in late 2016, and given how far off the start was from then, a lot of employers have left the legwork on how to do this until this year," said Jonathan Marin, senior associate, pensions and benefits, at the law firm of Osler, Hoskin & Harcourt LLP, Toronto. "It kind of was pushed down the road, but this begins next year, so employers will need to get up to speed on it this year."

Mr. Marin said Canadian employers "first will need to evaluate their plan design in relation to what CPP enhancement will provide their workers. They'll also need to consider whether their plan design needs to be changed to take CPP enhancement costs into account. They'll also need to update member education on CPP and employer plan integration and update their payroll and administrative processes. This will take a lot of work and, even though the 2019 date begins the phase-in, many of these will need to be done before it starts."