Friday, November 8, 2013

Further Restructuring at Canadian Pensions?

Janet McFarland of the Globe and Mail reports, Canadian pension plans face further restructuring, survey says:
Canadian pension plans have taken major steps to restructure because of ongoing funding problems – and a new survey suggests more change is coming.

A survey of pension plans in Canada by consulting firm Aon Hewitt shows 71 per cent of pension plans in the public sector are considering requiring more contributions from members, and about one-third say they are considering reducing discretionary benefits or reducing inflation indexation.

In the private sector, change has been even more rapid. The survey found 75 per cent of traditional defined benefit pension plans operated by companies who shares trade publicly have already closed at least one of their pension plans to new members.

Fifteen per cent of those private sector companies say they are looking at going further to freeze their plans in the near future, which means existing plan members would make no further contributions and earn no additional benefits in the plans.

Aon Hewitt senior partner Will da Silva said pension plans in Canada are reviewing many practices and policies to better manage their funding risks after a decade of turmoil that has seen most pension plans confront large funding deficits.

“For most plan sponsors, the pain of the last few years has led to a greater awareness of the risks faced by their DB pension plans. ... To survive, pension plans must be affordable for their sponsors, and appropriate risk management is one way to manage this goal,” Mr. da Silva said.

The survey found 43 per cent of pension plan sponsors also reported they are “curious” about target benefit plans. Such plans are a hybrid where a fixed benefit level is targeted for payout in retirement like a typical pension plan, but the final payouts can be reduced if the plans are facing a deficit, giving companies more flexibility and reducing the need for large cash contributions when plans are underfunded.

Target benefit plans are still relatively rare in Canada, but are becoming more common in other countries as a way of preserving some elements of traditional pension plans while easing the funding burden for plan sponsors.

There are also signs pension plan funding has been improving in 2013 with the rise in long-term interest rates. Aon Hewitt said the median solvency rate for pension plans in Canada as of September was 88 per cent – which means they had assets equal to 88 per cent of their liabilities on a wind-up basis. Six per cent of plans had a funding surplus as of September.

The survey shows pension plans are reducing their exposure to Canadian equities, while more than 30 per cent say they are increasing their investments in alternative categories, such as infrastructure or real estate. Many funds said they are also looking at hedging risks related to interest rate movements and are planning to increase their investments in long-term bonds to match the long-term nature of their liabilities.

Almost half of pension plans reported they have taken advantage of funding relief options provided by governments, which typically have included allowing pension plans extra time to make up funding shortfalls. Thirty per cent said they will seek relief next year.

As well, 19 per cent said they have exercised an option to use letters of credit to make up shortfalls in their plans, which allows pension funds to conserve cash, and 22 per cent said they intend to use letters of credit in the future.

Aon Hewitt said letters of credit remain “underutilized” by pension plans and are useful for managing short-term volatility in contribution levels.
To sum up, the private and public sector are looking to restructure their pension plans. In the public sector, Canadian pension plans are looking to hike the contribution rate and cut the cost of living adjustment (inflation indexation) and discretionary benefits. In the private sector, the changes are more savage. They're just cutting defined-benefit plans to new employees and looking to freeze them for existing plan members.

But one thing that everyone in Pensionland agrees on is to cut exposure to Canadian equities and increase their exposure to alternative investments. I've seen this movie plenty of times and trust me, it doesn't end well. If you don't believe me, just ask the smarter Leo -- AIMCo's Leo de Bever -- who recently sounded the alarm on alternatives, stating they're too rich for him:
Overvalued. Expensive. Competitive. This is how the alternative investment landscape looks to Leo de Bever, chief executive of pension manager Alberta Investment Management Corp.

The non-traditional asset class, which includes infrastructure, real estate, commodities and other unusual derivative investments, has become a focal point among fund managers in recent years as rock bottom interest rates and uneven markets push investors toward the potential for a bigger payoff.
You have to subscribe to read that article but I've been warning my readers about the bubble in private equity, infrastructure, real estate and hedge funds.

Of course, we all know bubbles can last a lot longer than anyone predicts and with so much pension and sovereign wealth fund money chasing higher yield, the alternatives bubble isn't going to pop anytime soon. You would need a massive readjustment of interest rates for this bubble to pop and I just don't see that happening as inflation expectations remain subdued (although there are signs this is changing, especially in the UK, but I doubt higher inflation will persist).

The problem nowadays is that every asset class is expensive. With central banks pumping billions into the financial system, the story in the stock market is all about multiple expansion, which is why stocks keep making record highs. Bond yields remain near record lows and that won't change unless you see clear signs that growth and inflation expectations are picking up on a sustained basis. If that happens, the Fed will be forced to taper sooner rather than later. But I'm not betting on this scenario and agree with those who expect the downward trend in long-term Treasury bond yields to resurface as weaker growth and softer inflationary conditions persist.

With valuations getting out of whack in public and private markets, this is a tough environment for all investors, especially pension funds. They either play the game hoping the music won't stop or risk severely under-performing their benchmarks and peers.

Below, NYU Stern Business School Professor Nouriel Roubini discusses the risk of asset bubbles on Bloomberg Television's "Money Moves." Good interview, agree with him but remember, bubbles can last longer than anyone predicts so don't expect these bubbles to pop anytime soon.