Reforms of pension funding regulations are sweeping across Canada, changing the way plan sponsors value liabilities and set funding targets. Naturally, many are weighing whether asset allocation shifts should be implemented in light of those changes. This question is especially important given that a plan’s asset allocation directly affects its required funding target under the new regulatory framework. Higher return-seeking allocations, while tempting, may be costly. In our view, plan sponsors should instead consider optimizing their fixed income portfolios. This approach may achieve similar results at far lower cost or risk.

While reforms differ from province to province, many of the contemplated (and in some cases already enacted) changes create an asset allocation tug-of-war. On one hand, reforming the method for discounting liabilities (to a long-term asset return assumption from a market-based yield – i.e., a shift to a going-concern from a solvency approach) rewards higher return-seeking allocations by (artificially) lowering the value of liabilities. On the other hand, shifting to funding requirements that vary based on asset allocation (and potentially asset-liability duration mismatch) penalizes higher return-seeking allocations by increasing funding targets and contribution requirements.

The dilemma is clear: By pulling the liability lever to lower its value (thus improving the plan’s reported funding ratio), the plan sponsor will also invariably push up the funding target lever, potentially cancelling out gains in funding flexibility. Many plan sponsors will seek the optimal balance between the two levers to achieve flexible funding without compromising traditional objectives, such as low funding ratio risk, which continue to be important from both an economic and accounting balance sheet perspective (see Figure 1).

Under this new reward-penalty system, the underlying optimization problem can be expressed as maximizing the long-term expected asset return while minimizing the increase in the funding target and funding ratio risk. In this regard, the current widespread investment strategy for Canadian defined benefit plans – a barbell approach that pairs low-discretion (or sometimes even passive) government-heavy and domestic-focused fixed income with return-seeking equities and alternatives – may lead to suboptimal results. This tactic relies heavily on the most penalizing source of return to achieve its investment return objective.

We believe the new regulations are instead supportive of a more balanced approach in which the plan sponsor seeks to achieve its return target by combining a more efficient/higher-return-potential fixed income portfolio with a reduced allocation to return-seeking assets. This could allow plan sponsors to pursue their return objectives with lower funding target and funding ratio risk (see Figure 2).

Optimizing the reward-penalty trade-off

Traditionally, a plan sponsor seeking to increase its going-concern discount rate would shift assets from fixed income to return-seeking asset classes. However, under the new pension funding framework, this shift may bring a number of undesirable consequences such as a higher funding target and higher funding ratio volatility.

To illustrate this, assume that a plan sponsor is seeking to increase its estimated asset return (and going-concern discount rate) by 50 basis points (bps) to reduce its liability value. Assuming a 14-year liability duration, the potential discount rate increase could reduce the going-concern liability by approximately 7%.

As shown in Figure 3, our hypothetical plan sponsor could increase its return-seeking allocation by 15 percentage points to reach the desired 50 bps increase in expected return. However, this would come at the cost of a significant increase in its funding target (to 118% from 114%) as well as a 27% increase in funding ratio volatility (to 8.1% from 6.4%). For every billion dollar of liabilities, the funding target would increase by $40 million and the funding ratio risk would rise by $17 million.

The increase in the funding target alone would significantly reduce the savings from a lower liability valuation (4% versus 7%). In other words, the plan would end up in a relatively similar position in terms of its funding requirement but with a significantly higher funding ratio risk. Furthermore, this approach would involve a significant overhaul of its investment strategy (e.g., a 15 percentage point increase in its return-seeking allocation).  This is a change that the plan sponsor would need to consider carefully, particularly from a participant-benefit-security perspective.

However, plan sponsors should consider an alternative approach that has the potential to provide the coveted incremental return expectation without the undesirable increases in funding target and funding ratio risk.

An enhanced approach, for example, could boost the fixed income portfolio return potential by expanding its investment universe (think core plus over core, global over domestic, higher credit exposure, etc.) and by allowing sufficient degrees of freedom in active management to improve alpha potential. With this approach, the plan could achieve the same goal (increasing the estimated asset return by 50 bps to reduce liabilities) without materially increasing its funding target and funding ratio volatility, although asset-only volatility may increase.

In short, by expanding the fixed income portfolio to make it work harder as outlined above and using active management to seek increased returns, the enhanced approach needs a reduced amount of return-seeking assets to achieve the same return target as the traditional approach. And with a reduced reliance on the dominant drivers of portfolio risk (such as equities or other higher-risk asset classes), our hypothetical plan sponsor could lower its funding target and funding ratio risk relative to the traditional approach (see Figure 4).

In sum, sourcing coveted excess returns by getting more from the fixed income portfolio may be less costly than sourcing it from a higher allocation to return-seeking assets. Therefore, we believe that plan sponsors should first consider adjusting the structure of their fixed income allocation and increasing its active management potential before increasing allocations to return-seeking assets (see Figure 5).

Status quo?

Our analysis assumes that, in response to the new funding framework, our hypothetical plan sponsor would seek to increase its going-concern discount rate to reduce liabilities. However, not all plans should alter their asset allocation to pursue that objective. Consider a plan that is well-funded and far down its de-risking path. This plan is in a relatively ideal position with a low risk of incurring a significant deficit and a low contribution requirement and volatility. In this case, the benefits of increasing asset returns (and lowering the value of liabilities) may be marginal. Indeed, contribution requirements are already subdued and restrictions may exist on surplus usage. Instead, this can be an opportunity to seek to further de-risk through the enhanced approach.

We illustrate this in Figure 6, where our hypothetical plan sponsor maintains the same expected return under both the current and enhanced approaches. Under the enhanced approach, the incremental return potential derived from the broader opportunity set and higher degree of active management of the fixed income portfolio allows the plan to reduce its reliance on return-seeking assets while maintaining the same expected return. The net result is that both approaches may lead to the same liability valuation (as they achieve the same expected return), but the enhanced approach may achieve significantly more funding flexibility by lowering the funding target (to 111% from 114%). In addition, the enhanced approach also leads to a 36% reduction in funding ratio risk (to 4.1% from 6.4%).

Yes, but …

Some would argue that in order to realize the benefits of the enhanced approach, plan sponsors would need their actuary’s expected return calculation to recognize the excess return potential (i.e., alpha) from active management of the broader fixed income portfolio. This is a valid concern as a significant number of actuarial firms have historically not factored potential fixed income alpha in to the determination of expected returns.

In response, we would first point out that only a portion of the incremental fixed income return under the enhanced approach is attributable to alpha from active management. In fact, a meaningful share of that incremental return is attributable to exposure to the broader investment universe (global over domestic, emphasis on credit, etc.). It should be straightforward to recognize that portion of the incremental return in the expected return calculation because it arises more from market and sector beta exposure than from pure active management alpha.

That said, it is true that in order to get the maximum value from the enhanced approach, plan sponsors would need their actuary to recognize, at least partially, the excess return potential of active fixed income management. We think that the changing pension regulation landscape across Canada offers an opportunity to revisit the treatment of active management. More specifically, we would point out that when measured relative to liabilities, the volatility of excess returns derived from equity exposure is drastically higher than the volatility of excess returns derived from active management of fixed income (see Figure 7).

In this context, we find it hard to reconcile why the potential excess return from equity beta is so easily incorporated into the expected return calculation while the potential excess return from fixed income active management is not. We believe a change is in order.

The time has come to get more from your fixed income portfolio

In principle, regulatory changes should not drive investment decisions. Prudent investment decisions should not be abandoned just to gain a regulatory edge.

However, regulatory changes provide an opportunity to review allocations to ensure optimality within the changing landscape. We believe that pension regulation changes currently being implemented across Canada (as well as traditional goals) are supportive of a more balanced approach to return generation – one that combines wider-ranging and actively managed fixed income portfolios with lower return-seeking allocations. By seeking to extract more value from fixed income portfolios, plan sponsors could enhance funding flexibility and may lower risk while preserving expected return targets.