Our Insights

How pension funds are tackling the low-rate conundrum

Diversification across asset classes and geographies may bring a better risk-return ratio

A further decline in interest rates to record low levels has institutional investors going back to the drawing board with their investment policies.

Key insights

  • Interest rates are expected to be "lower for longer," forcing many pension plans to seek out broader portfolio diversification, including alternative investments
  • Alternative investments such as real estate, infrastructure and private equity provide access to different return drivers and may help portfolios achieve a better overall return for risk in a low-rate environment
  • Pension fund investors should remain focused on the strategic challenge of balancing risk and reward for their plan members

The need for change is compounded by the growing gap between aging pensioners—often referred to as the “silver tsunami"— drawing from the plans and the smaller number of working-age employees contributing to them.

"The demographic realities coupled with expectations that rates will be 'lower for longer' has prompted many pension fund investors to adjust their investment mandates to sustain and improve the funded status of their plans for the long term," says Paul Purcell, Institutional Portfolio Manager at Phillips, Hager & North Institutional.

Alternative investments—such as private equity and private debt, infrastructure and real estate— are becoming increasingly popular ways to help meet mounting pension obligations.

Low rates a top concern among pension fund investors

Interest rates are at historic lows and not expected to rise for the foreseeable future given the economic upheaval brought on by the COVID-19 pandemic. "There will be some noise, there will be some volatility, but we don't see rates increasing substantially over the short term, or even the medium term," Purcell says.

Today's low-rate reality is the most pressing challenge for pension fund investors, according to RBC Investor & Treasury Services'(RBC I&TS) third annual Canadian Defined Benefit Pension Survey, followed by market volatility and economic and geopolitical uncertainty.1

Low rates are especially challenging for defined benefit pension plans that were designed decades ago when rates were higher and life expectancies were shorter. The cost of these plans has risen dramatically. Further, Purcell says many plans are now cash flow negative given the growing number of pensioners and shrinking number of active plan members.

The decline in rates has boosted bond returns for many years. Likewise, this period of falling rates has boosted the returns of equities and alternatives. “While more obvious with bonds, it is reasonable to expect that return expectations in all asset classes should be moderated by this very low rate environment," Purcell says.

The expanding fixed income opportunity set

Paul Purcell
Institutional Portfolio Manager
Phillips, Hager & North Institutional

Even within fixed income, more pension fund investors are also looking for opportunities and diversification through different sectors and across global markets. Examples include commercial mortgages, high-yield bonds, emerging market bonds and global bonds, which can produce higher returns than Canadian government or corporate bonds. "This trend is driven by a combination of better diversification and better overall return for risk for portfolios, while maintaining a stable ballast for the portfolio," Purcell says. "That continues to be important even as rates stay down."

The alternative investment opportunity

Alternatives are gaining traction as pension fund investors seek ways to meet ongoing liabilities. Nearly three-quarters of Canadian pension plans, big and small, hold alternative investments within their portfolios or are expected to add them by year-end, the survey shows.2 Over the past decade, Canadian pension plan allocations to alternative investments increased to 30 per cent of assets to 21 percent, exceeding the global pension allocation of 26 percent, according to Thinking Ahead Institute's Global Pension Assets Study.3

It is an opportunity
set to be explored
and exploited to
the right degree

The RBC I&TS survey identifies the popularity of alternatives to be highest among larger, multi-employer and public plans, due partly to the easing of pension funding rules in Quebec and Ontario.4 The change enables plans to supplement their portfolios with potentially riskier and higher-return investments to help meet increasing obligations from an aging membership.

Real estate and infrastructure are among the most popular holdings in pension plans, the survey shows. Purcell says these less liquid assets often provide higher returns, rewarding investors for their long-term commitment. He notes pension funds need to be careful about their capacity to invest in illiquid assets because they are required to make regular payouts. "The more liquidity you need, the less one should allocate to these illiquid asset classes," he says. "At the same time, it is an opportunity set to be explored and exploited to the right degree."

Tactics for sustainable long-term growth

Ryan Silva
Director, Head of Pension and Insurance
RBC Investor & Treasury Services

A growing number of pension funds are relying on outside managers to help them invest in specialized asset classes such as derivatives or foreign assets, according to Ryan Silva, Director, Head of Pension and Insurance, Client Experience, at RBC I&TS. "Each plan has a different strategy as far as what asset classes they want to control in-house versus outsourcing," he says. "The key is to surround yourself with the right experts to meet your fiduciary obligations and to support you through the rapid changes and swings that are happening more often today."

Some pension plans are also looking at consolidation to sustain themselves for the future. Silva says plans with a high number of pensioners may consider combining with plans that have younger working-age contributors to even out their distributions today and in the long run. "They're diversifying their liabilities, and looking to manage cash flows and investment strategies based on their employee population, and against today's economic backdrop," he says.

They're diversifying their liabilities, and looking to manage cash flows and investment strategies

The shifting tide of pension fund management

Regardless of which assets they select, Purcell says pension fund investors need to remain focused about their investment policies in the face of changing tides brought on by low rates, demographics and economic uncertainty. "One of the hallmarks of the Canadian pension fund investing environment is that investors are typically quite sophisticated," he says. "There's a high level of awareness and understanding around these issues. Investors are aware of the need to evolve their portfolios."

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  1. RBC Investor & Treasury Services (February 2020) Preparing for the Silver Tsunami: Canadian Defined Benefit Pension Survey
  2. Ibid.
  3. Willis Towers Watson, (February 2020) Global Pension Assets Study 2019, based on the top seven pension markets by assets globally
  4. Ibid. RBC Investor & Treasury Services