Nos perspectives

Preparing to weather a stormy future

Canadian pension plans seek long-term security in the face of changing conditions

Defined benefit plans in Canada have participated in the decade-long bull market, but can they protect themselves from future market downturns?

Key insights

  • Economic observers are suggesting a recession may be on the horizon in the coming year, meaning Canadian defined-benefit pension plans will need to prepare for the end of the long-term bull market conditions that have prevailed since the global financial crisis
  • The use of alternative assets to add diversification and smooth plan returns may include a variety of investment types
  • The use of “big data” to reveal patterns and trends may provide a source of competitive advantage for defined-benefit plans, as it can be used to enhance traditional research models

Over the past 10 years, Canadian pension plans profited from the prolonged rise in share prices that followed the 2008-2009 global financial crisis. In the 10-year period ending December 31, 2018, the median portfolio in the RBC Investor & Treasury Services’ (RBC I&TS) All Plan Universe, a benchmark that tracks the performance and asset allocation of Canadian defined benefit pension plans, showed a cumulative return of 123 percent.1

Looking forward, however, these positive results may not be repeated. Today, markets are characterized by increasing uncertainty resulting from factors such as low interest rates, heightened volatility stemming from slower economic growth, the gradual removal of monetary stimulus by the Bank of Canada and the US Federal Reserve, and increasing protectionist and populist sentiment. Some observers are suggesting an economic recession may be on the horizon.

In light of this changing environment, Ryan Silva, Director, Head of Pension and Insurance, Global Client Coverage at RBC I&TS, says, “New approaches may now be required to better position defined benefit plans for success, including strategies to leverage private capital and data solutions.” 

Traditional asset allocation strategies may no longer be sufficient to guard against a recession

“In recent months,” comments Silva, “the prospect of an economic recession has surfaced, meaning Canadian pension plans are now ‘on notice’ about the need to respond.” For example, in January 2019 economic models showed a 50 percent chance of a recession before 2020, based on two market measures: the slope of the yield curve and credit spreads.2 In February 2019, the National Association for Business Economics, an international association focused on applied economics, reported that 42 percent of their members expect a recession by 2020.3

“Typically, defined benefit pension plans maintain a balanced portfolio designed to smooth out performance over the long term,” notes Silva. “Pension plans might normally respond to the threat of a coming recession by shifting their portfolios to more defensive allocations, which are designed to provide constant earnings regardless of the state of the overall market.” 

New approaches may now be required to better position defined benefit plans for success, including strategies to leverage data solutions

“In the current bull market environment,” Silva adds, “this strategy may fall short because in recent years both equities and fixed income have generally been performing well, despite several periods of exceptional volatility.” If plans are faced with a downturn while the positive correlation across both equities and fixed income remains, both asset classes may fall at the same time. “In other words, the conventional approaches to portfolio allocation may not be sufficient to protect portfolios from recession in the current environment, and managers may need to seek out alternative sources of diversification,” Silva says.

Private capital. A good fit?

One source of additional diversification continues to be found in the private capital sector. Since the financial crisis, institutional investors with long time horizons, including pension plans, have steadily increased their allocations to private capital assets. According to RBC I&TS’ ‘Plans over CAD 1 billion Universe’, the median allocation to alternatives increased from 7.1 percent to 13 percent over the last decade. These assets include real estate, private equity (PE), infrastructure, hedge funds and private debt. Over the past decade, this strategy has been successful, as private assets helped push 2018 Canadian pension plan returns into positive territory despite negative returns in equity markets.4

“As we look towards the future, some may have concerns about whether all private capital strategies will retain their lustre,” says Silva. For example, a January 2019 white paper from global investment management firm AQR Capital Management takes the view that in recent years, private equities have underperformed public equities while incurring higher risk, based on an assessment of benchmarking practices.5 AQR does acknowledge, however, that there continues to be institutional demand for private equity, likely given the “return-smoothing properties of illiquid assets in general.” Moreover, they note that, “for many investors, the bottom line is that PE firms have delivered clearly higher net-of-fee return than the S&P 500 over the past 20 years.” 

RBC I&TS’ Canadian Defined Benefit Pension Survey Results

Among those looking to include alternatives in their portfolios during the next 12 months, infrastructure, real estate and private debt are the top choices:

  • Infrastructure: 24 percent
  • Real estate: 24 percent
  • Private debt: 20 percent
  • Private equity: 17 percent
  • Hedge funds: 8 percent
  • Other: 7 percent

The results of RBC I&TS’ Canadian defined benefit pension survey, released in January 2019, revealed that nearly 70 percent of respondents are planning to include alternatives in their portfolios over the next 12 months, across a range of investment types.6

Private debt is increasingly attractive to investors as it offers downside protection during periods of volatility. Given current market dynamics, this asset class may see an uptick. A recent Preqin survey of 400 investors revealed that 95 percent of existing private debt investors expect to increase or maintain their allocations over the long term.7

“Taken together,” says Silva, “these findings suggest that defined benefit plans will need to carefully consider the appropriate asset mix as they look to generate superior returns, enhance diversification and strengthen long-term sustainability over the next decade.” 

Using data as a competitive advantage in longer-term investment decisions 

Another factor shaping the future of defined benefit plan returns is the influence of new technologies and approaches, which can help resolve the challenge of analyzing data sets that are too large or complex for traditional data-processing applications. Increasing interest in private capital has also placed alternative data sources at the centre of decision-making for many firms.

“Traditionally, an investment analyst carries out research using information sources like corporate reports and  economic data.” comments Silva. “But in today’s investment landscape that may not be enough, as we live in a world with a variety of additional data sources available to help give savvy managers an edge over their competitors.” For example, the Canada Pension Plan Investment Board, which invests the funds of the Canada Pension Plan, has assembled a “data-driven edge” team that is experimenting with how different kinds of information can be used in making longer-term investment decisions.8 Hedge funds around the world are also investing in web-scraping technology to mine the internet for competitive information, as well as increasingly pursuing alternative data sources such as satellite images to determine factory inventory levels, geolocation data to track foot traffic into stores, and social media data to gauge customer sentiment.9

Managers who are able to incorporate alternative data into their traditional research models, may have a competitive advantage

As these kinds of data sources may be refreshed more frequently than traditional sources of data like corporate financial statements, managers who are able to incorporate alternative data into their traditional research models, may have a competitive advantage.

As Canadian defined benefit plans look to the future, they will need to ensure they prepare for a range of potential scenarios, including the end of the bull market conditions that have prevailed since the global financial crisis. Going forward, some of the longstanding mechanisms plans have used to add diversification and smooth out volatility may require rethinking, as new views on the long-term value of alternative assets emerge. At the same time, the rise of new sources of data, and new ways to manipulate and derive insights from big data, may give plans a comparative advantage to help maintain plan success over the long term.

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Sources

  1. RBC Investor & Treasury Services (February 5, 2019) Q4 All Plan Universe  
  2. Axios (January 11, 2019) The market is pricing in a 50% chance of recession
  3. National Association for Business Economics (February 2019) Economic Policy Survey
  4. The MSCI ACWI Index, which tracks equity returns in 23 developed and 24 emerging markets, returned -0.73% CAD in 2018. MSCI ACWI Index
  5. AQR Capital Management (January 2019) Demystifying Illiquid Assets: Expected Returns for Private Equity
  6. RBC Investor & Treasury Services (January 2019) Embracing Change: Canadian Defined Benefit Pension Survey
  7. Preqin (April 2019) Preqin Investor Outlook: Alternative Assets H1 2019 
  8. The London Free Press (March 18, 2019) How CPPIB is tapping 'alternative data' to refine its investment processes
  9. Greenwich Associates (June 28, 2018) Seismic Shifts: The Future of Investment Research