employee benefit november/december 2008

Employee Benefit News Canada SupplementMarch/April 2008

LDI ON TAPsays MolsonCoors’ Mike Rumley

SPONSORS DISCUSS LDI THREE WAYS

MANAGERS SAY LDI MARKET CAPACITY EXISTS

HOW LOW CAN BONDS GO?

I2_308_COV.FINAL.qxd 3/13/08 5:59 PM

EDITORIAL HEADQUARTERS1325 G Street, N.W., Suite 900, Washington, D.C. 20005202/504-1122 • Fax: 202/772-1448

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For most of my career I was one of

only a few lawyers in an actuarial con-

sulting firm. I will never forget one of

my co-workers, also a lawyer, who firmly

stated on many occasions that as

lawyers, our forte is words. In contrast, she maintained

numbers are reserved for the actuaries and investment

consultants.

So you can imagine, it was with some trepidation that I

approached the development of this issue, which focuses

on liability-driven investment. But it suddenly got easier

when I took the advice of the I2 Editorial Advisers and

started talking to plan sponsors.

As Nortel’s Director of Global Pensions John Poos says,

it all comes down to writing the cheque:

“Once you understand the volatility of your plan versus

your liabilities, you realize the impact that can have on

contributions. Could you write that cheque? If the answer

is that it would be dreadful, then you are a prime candi-

date for LDI. If you are not concerned about the size of

that cheque, then LDI is not for you.”

In the articles that follow you will hear from both

Canadian and American plan sponsors who are engaged in

asset/liability matching, and investment managers who

help pension funds to execute these strategies.

Our goal in this issue is to help you put LDI in perspec-

tive. Let us know if we succeed.

And stay tuned for future issues dealing with fixed

income and infrastructure, governance, and alternative

investments. All articles, and the pdf of this and past

issues, can be found at ebnc.benefitnews.com.

Putting LDIin perspective

SHERYL SMOLKINEditor-in-Chief

FEATURE

6

Guest COMMENTARY 4Bond yields are flirting with their cyclical lows.Could a trend reversal be around the corner?

Southern EXPOSURE 12Cross-border LDI implementations reveal markedly different investment brews.

Market WATCH 14A snapshot of current investment trends looks atdiversification, portfoliowide strategies and fees.

F E AT U R E SA trio of case studies illustrates that whenit comes to LDI, "one size does not fit all."

Long bonds may be in short supply, butinvestment managers say there is marketcapacity to implement LDI.

610

CO

NT

EN

T

INVESTMENT INSIDER 3

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Given that the level and

direction of long-term

bond yields significant-

ly impact the value of

pension plan liabilities

and assets, it is not surprising that

plan sponsors are closely monitoring

global bond markets.

Around the world, bond yields

have been trending lower for the past

25 years, dropping from more than

12% in the mid-1980s to less than 3%

in the mid-2000s. This is due to one

crucial development: the world’s cen-

tral bankers’ victory against inflation

in the late 1980s.

Following that victory, and during

the ensuing decade, central banks

remained vigilant and successfully

kept inflation at bay, resulting in a

gradual decline in interest rates. As

inflation stabilized, investors stopped

demanding inflation premiums,

allowing bond yields to move even

lower. Now that bond yields are flirt-

ing with their cyclical lows, one can’t

help wondering if a trend reversal is

around the corner.

INFLATION VS. DEFLATIONThe future direction for bond mar-

kets could depend on which threat

central bankers believe is the greatest

threat for the world economy —

inflation or deflation.

For the past quarter century, infla-

tion has been their top concern.

However, now that inflation in the

industrialized world is well-contained

and relatively low by historical stan-

dards, the answer to this crucial

question is not as clear.

At first glance, there seems to be

very little reason to believe that cen-

tral banks could stop worrying about

inflation anytime soon. The problem

is that central bankers could now

become victims of their own success.

The continued decline in interest

rates has done wonders to con-

sumers’ wallets. Since the early 1980s,

the net worth of North American

households has almost quadrupled.

Unfortunately, declining interest

rates also encouraged consumers to

take on a lot more debt. According to

statistics from the U.S. Federal

Reserve, mortgage debt now repre-

sents an unprecedented nearly 50%

of total real estate equity.

This increase in consumer debt

loads has been more than offset by

the rapid value appreciation of their

tangible and financial assets. Since

1985, home prices climbed by more

than 200% in the United States (U.S.

Census Bureau), and by 120% in

Canada (Statistics Canada.) However,

given current debt levels, the

prospect of Japanese-style deflation is

downright terrifying.

THE WORSE OF TWO EVILSJapan’s experience with mild defla-

tion since the early 1990s is a con-

stant reminder of how painful defla-

tion can be. A decline in consumer

Global bonds: Howlow can they go?BY VINCENT LÉPINE

4 INVESTMENT INSIDER

Bond yields have been trending lower for the past 25 years, dropping from more than12% in the mid-1980s to less than 3% in themid-2000s.

I2308_GC.FINAL.qxd 3/13/08 6:04 PM Page 4


prices of less than 1% per year has

been associated with years of painful-

ly slow growth, rising unemployment,

a multi-year decline in the value of

tangible assets, and a very long bear

market in equities due to intractable

financial problems in the banking

and corporate sectors.

How did Japan get into this

predicament? It all started in the late

1980s with deeply overvalued equity

and real estate markets. Both home

and equity prices started falling,

lethally hitting consumers’ wealth. As

the economy plunged into recession,

the Bank of Japan reacted too slowly,

allowing deflation to set in. The result

was a prolonged period of anemic

economic growth, persistent deflation

and a very long and strong bull mar-

ket in Japanese bonds.

If deflation starts out-

side Japan, the long-term

downtrend in bond yields

will remain in place.

However, central banks

have learned from the

Japanese experience. To

prevent deflation from

occurring, central banks

preserve a buffer zone for

the inflation rate. Up until

now, central bankers have generally

been targeting inflation at around 2%.

However, one can wonder if this real-

ly is sufficient.

When the economy dips into

recession, inflation typically starts

decelerating sharply soon thereafter.

During the last global recession in

2001, the U.S. core inflation rate

dropped from more than 2.5% to

close to 1% in less than two years.

This drop happened in the context

of rising home prices. In the context

of falling home prices, there is a high

probability that inflation would

decelerate much more, flirting with

deflation.

Given the amount of mortgage

debt held by households, and the

overvaluation of home prices in many

regions of the world, central bankers

could be very tempted to

preserve a bigger buffer zone

by letting inflation rates

accelerate. In other words,

from this point on, central

bankers could be spending

more time worrying about

deflation than inflation.

This implies that the

monetary policy stance

could, on average, be kept

more often accommodative than

restrictive, turning the structural back-

drop increasingly bearish for bonds. As

inflation starts grinding higher, long-

term inflation expectations would start

drifting higher, putting upward pres-

sure on long term bond yields.

DARKENING LONG-TERM OUTLOOK FOR BONDS

Holding a very bearish long-term

view on bonds requires a strong con-

viction that the world is heading for a

permanent regime shift from a low-

to a high-inflation environment.

Ultimately, this could only happen

in the context of a shift in central

banks’ priorities from fighting infla-

tion to avoiding deflation.

In the current context of low

inflation, frothy real estate prices and

historically elevated consumer debt

burdens, deflation looks more and

more like the worst of the two evils.

We suspect that in situations of

heightened uncertainty, world

central banks will increasingly err

on the side of inflation rather than

deflation. In short, the long-term

outlook for bond markets appears

to be darkening.

At this juncture, all eyes are now

on the Federal Reserve. With the U.S.

economy flirting with recession, and

home prices falling, the risks of a

deflationary bust have significantly

risen. Judging by its quick reaction,

the Fed is fully aware of the risk repre-

sented by a multi-year decline in

home prices. The result: higher infla-

tion over the next several decades. —I2

Vincent Lépine is VP of research at CIBCGlobal Asset Management Inc. (www.cib-cam.com).The views expressed in this arti-cle are the personal views of the author andshould not be taken as the views of CIBCGlobal Asset Management Inc. or CanadianImperial Bank of Commerce . All opinionsand estimates expressed in this article are asof Jan. 31, 2008, unless otherwise indicated,and are subject to change.

Vincent Lépine

HOW LOW CAN BOND YIELDS GO?Global 10-year bond yields and secular downtrend

2

3

4

5

6

7

8

9

10

11

12

13

`

SOURCE: Datastream & CIBC Global Asset Management Inc.

Yields have been trending lowerfor the past 25 years…

Per cent

…is a trend reversal aroundthe corner?

1985M01

1987M01

1989M01

1991M01

1993M01

1995M01

1997M01

1999M01

2001M01

2003M01

2005M01

2007M01

2009M01

2011M01

2009M01

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I2308_F_Size.FINAL.qxd 3/14/08 12:13 PM Page 6

does


FEATURE

Pension plans of every stripeembrace customized LDI strategies

SizeLDI: One

OOpen, closed. Small, large. Publicsector, private sector. Multi-employer, single employer.

No two pension funds are thesame, and a liability-driven invest-ment strategy is not the solutionfor every plan. Yet an increasingnumber of sponsors of all types ofpension plans are striving to bettermatch their assets and liabilities.

Speaking at a recent CPBIinvestment seminar, University ofToronto Asset Management’sDirector of Investment StrategyJohn Lyon, and Peter Jarvis, CIO at BIMCOR, explained why their pension plans have decided against LDI.

Lyon said a study was recentlyconducted by the university, andUTAM ultimately ruled out LDI.“This was no surprise because itwas considered too costly, with lowreturns on fixed income,” he said.

not fit allBy Sheryl Smolkin


“It’s a very poor use of company

capital, because you are basically

locking in at those lower rates,” says

Jarvis. “The question really becomes,

how do we get more LDI-like in our

asset structure? That’s what I believe

is driving the movement to a much

more diversified portfolio structure

by funds across the board.”

In contrast, the Colleges of

Applied Arts and Technology Pension

Plan, Manulife and Operating


FEATURE

OPERATING ENGINEERS LOCAL 955The Operating

Engineers Local 955

pension plan’s

administrator

Rainer Semler is an

LDI veteran.

This collectively bar-

gained, Alberta-registered,

specified multiemployer plan has

been managing assets ($500 mil-

lion at the end of 2007) against

liabilities for over 10 years. It is

fully funded on both a solvency

and going-concern basis. “I don’t

think it has ever fallen into deficit

while the LDI strategy has been

in use,” says plan actuary Tony

Williams, president of PBI

Actuarial Consultants Ltd.

Semler believes that, “Probably

the most important thing for any

pension plan is to maintain the

pension promise for beneficiaries

(4,800 active; 1,600 retired). LDI

allows us to manage risk into the

future, so we know we have a

series of pension cash flows each

and every month.”

Another advantage of LDI,

says Semler, is that it allows the

plan to consider the amount of

risk they are going to assume, so

they can both invest in bonds or

fixed-income products to match

cash flows and make other

investments that will

result in asset growth.

Nevertheless, the

portfolio is primarily

domestic Canadian

bonds. “If our investment

manager used a strategy like

derivatives it would be OK with

us, providing it is within the risk

parameters,” says Semler. “But I

don’t want you to think deriva-

tives are a big part of this. The

investments are primarily inter-

national bonds, maple bonds and

some mortgages — all relatively

high quality fixed income invest-

ments.”

The benchmark is constructed

based on a projection of cash

flow that is shared with the

money managers, who develop a

benchmark for that year and

then build a portfolio that match-

es the cash flow.

“Without letting the cat out of

the bag, we are certainly looking

for more alpha. We’ve got risk

under control and the benchmark

returns, but we haven’t got a lot

of added value,” says Williams.

“So I’d say we are actually

approaching phase 2 of this LDI

approach.”

Rainer Semler

Manulife’s VPGlobal Pensions& BenefitsSylvie Charestis applying LDIprinciples to themanagement oftwo small company plans.

In one case there was a partial wind-up involving 150 employees and $16million in assets, which were carved outinto a separate fund for the benefit ofthese members only. It is expected thatthe wind-up will be completed withintwo years and all funds will be trans-ferred out.

As a result, the portfolio was fullyimmunized through the purchase ofprovincial and corporate bonds that,as much as possible, match the liability flow.

The second plan is a legacy plan thatis closed to new members, with no fur-ther accrual of defined benefits. Of the$50 million in assets, a large portion issurplus.

“We have approved going to an LDIstrategy for this plan when the time isopportune,” says Charest. “In order tofully match the liabilities, we’ll get moreheavily into bonds when market condi-tions are more favourable.”

For the surplus, a multiasset target-return strategy is planned, comprised offixed income (45%); Canadian equities(23%); alternatives such as commodi-ties, natural resources, real estate inves-ment trusts (15%); foreign equities(11%); and cash (6%).

One reason Charest says they areable to go to a somewhat more exoticapproach with the surplus is becausethe assets are managed internally byMFC Global. “This is our business atManulife. Senior management under-stands the issues, so it was not a long,drawn-out discussion.”

Sylvie Charest

MANULIFE


Engineers Local 955 are three of

many very different pension plans

that have concluded a customized

LDI strategy is the best way to man-

age funding volatility and risk.

CAAT CIO Julie Cays says she

brought LDI alive to certain trustees

by showing them, “If we have a cer-

tain asset mix, or take a certain

amount of risk, this is the probability

that you will reach a certain funding

level and have this amount of surplus

or deficit.”

“Be clear on your commitments,

how you price them and what kind of

risk you are ready to take to meet

these commitments,” says Manulife’s

VP Global Pensions and Benefits

Sylvie Charest. “Once you have some

clarity on these three things, and you

are also clear on what rewards you as

a risk-taker get for taking these risks,

I think the fog will start to lift on

the LDI strategy you are about to

embark on.”

And plans of all sizes can success-

fully implement LDI, says Tony

Williams, the Operating Engineers

Local 955 plan actuary and president

of PBI Actuarial Ltd.

“Even at a half-billion dollars, it

was relatively easy to execute LDI for

the Engineers’ plan. I’m working with

an $80 million plan, and I’m also not

having any difficulty,” he says. “It just

gets more complex if you try for

derivatives, swaps, overlays and

those more esoteric things. If you

keep it simple you can have LDI

down to a relatively small plan.”

MolsonCoors Director of Global

Pensions and Risk Management Mike

Rumley agrees. “Any smaller pension

plan is going to pay higher fees, but

we do not see that as an impediment

to implementing LDI.”

It all comes down to writing the

cheque, says Nortel’s Director of

Global Pensions John Poos.

“Once you understand the volatili-

ty of your plan vs. your liabilities,

then you realize the impact that can

have on contributions,” he says.

“Could you write that cheque? If the

answer is that it would be dreadful,

then you are a prime candidate for

LDI. If you are not concerned about

the size of that cheque, then LDI is

not for you.” —I2


FEATURE

The Colleges of Applied Artsand Technology PensionPlan has assets of $5.4billion and, at thebeginning of 2008,shifted their asset mixfrom 60% equi-ties/40% bonds(including 5% in infra-structure) to a 57% return-enhancing/43% liability-hedg-ing portfolio (including 10% infra-structure and 5% real estate).

As of 1/1/07, the plan was 98.8%funded on a solvency basis, and thegoing-concern funding ratio was91.3%.

“I’m not using LDI a lot as aphrase with my trustees because itseems to mean so many differentthings to different people,” saysCAAT CIO Julie Cays. “I’ve alsohammered home the message thatyou can’t really match liabilities orperfectly hedge against liabilities.”

Cays says her goal is to controlsurplus at risk and variability of con-tributions — which, by 2010, arealready slated to increase to 12.1%for both employers and employees.

Nominal bonds are benchmarkedagainst the long-bond index, and oneof the CAAT bond managers is buyingstrip bonds outside the long-bondmandate to extend them even further.

“Also, we have been building aninflation-linked component byopportunistically buying real-returnbonds every now and then. In addi-tion, we are getting into swaps,

other derivatives and overlays,but not necessarily from

an LDI perspective,” she says.

Other inflation-linkedinvestments are infra-structure funds and the

brand new allocation toreal estate. “We are still

researching how to imple-ment the real estate mandate.

Ultimately there may be some directinvestment, but that would not bemanaged in-house.” Direct invest-ment in real estate and infrastructureassets by large Canadian pensionfunds, like the CPPIB and OntarioTeachers is very much the exceptionrather than the rule, both domesti-cally and on a global basis, Cayspoints out.

Assets are managed against amarket benchmark that simulatesthe liabilities. “Our liabilities prettywell look like a 13-year duration mixof 70% real-return bonds and 30%nominal bonds. We use a mix ofbond indices and hypotheticalbonds to get us to this mix, andwe’ve asked one of our managers toprice it each quarter.”

Cays says implementing thestrategy is a multi-year process andacknowledges that finding productat an affordable price can be a chal-lenge. “But we have the frameworklaid out. We’re measuring ouropportunities relative to what theydo for us and our surplus at riskframework,” she says.

CAAT PENSION PLAN

Julie Cays


HALFFULL,NOT HALF

EMPTY

Recent research from Greenwich Associates

reveals that portfoliowide strategies are

gaining in popularity. Of plan sponsors

surveyed, 11% say they are currently using

some form of LDI strategy, while a further

18% expect to start using this approach.

“LDI is a framework that allows plans to continue

their focus on their raison d’etre of paying benefits,

rather than compare themselves to a market bench-

mark; many Canadian pension plans take much more

benchmark risk than active risk,” says Claude Turcot,

senior VP of Standard Life Investments in Montreal.

“And as managers, we bring market experience and

can explain to sponsors how realistic it is to have cer-

tain objectives.”

BUILDING A BENCHMARK“Assets should be benchmarked to liabilities,” says

Zainul Ali, a senior consultant at Towers Perrin. “It is

conceptually correct, and it’s also relatively easy to

build that benchmark.”

Yet the devil is in the details. The plan sponsor —

often in consultation with a consultant and/or one or

more investment managers — still must identify the

plan’s larger objectives.

For example, benchmarks derived from solvency vs.

going-concern considerations will differ drastically

because of the way liabilities are valued. “When using a

solvency liability benchmark, it may be necessary to

leverage the fund to buy the long-term products neces-

sary for an optimal solution,” Turcot explains.

One alternative is to move the fund’s benchmark

toward a public index that matches its liabilities more

closely — e.g., a long term bond index — as opposed to

the frequently used DEX Universe Bond Index, with its

short duration of 6.5 years. Other possibilities are cus-

tom benchmarks or a blend of existing benchmarks.

STRUCTURING A SOLUTIONImplementing a portfolio based on the new bench-

mark is the next step in the process. But with the

increasing demand for long bonds,

there is a perception in some quarters

that instruments capable of matching

plan liabilities are in limited supply.

Managers interviewed generally

agree that capacity constraints in

Canadian markets are still hypotheti-

cal and would not derail any LDI

moves by a small plan.

But the size of the Canadian

swaps market remains an issue.

Although swaps are not a necessary

component of an LDI approach, they

are commonly used in an overlay

strategy to reduce interest-rate risk.

“The lack of depth of the

Canadian swaps market is quite sig-

nificant,” says Damon Williams, VP at

Phillips Hager & North. “If large

plans wanted to implement a swap

portfolio, it would create significant

bottlenecks.”

However, Williams is quick to

point out that although potential

capacity issues related to swaps are a


FEATURE

By David Adler

Investment managers say market can meet demand for LDI

I2308_InvManag.FINAL.qxd 3/13/08 3:49 PM Page 10

consideration, it doesn’t imply large plans won’t be

able to pursue LDI strategies. Williams says, “There

are many other implementation solutions, including

use of repos (repurchase agreements) and cash bonds

to reduce interest rate exposure relative to liabilities.”

Turcot agrees that implementation is linked to

marketplace availability.

“Large Canadian plans might someday encounter

problems, including year-long delays, if they wanted

to implement relying heavily on swaps. But even for

these plans there are other routes, such using bonds

plus futures,” he says. And looking to the U.S. market

is always an option, although he concedes this could

be expensive because of the necessary hedges.

“Hypothetical lack of product or depth of instru-

ments for large plans is more of a function of lack of

demand than supply,” suggests Jacques Prévost,

CIBC’s VP of global fixed income. “The

market needs grease to get the wheels

running.”

He believes pension funds should

worry about the overall risk of the

strategy — the surplus at risk — and

how everything fits together, while

leaving the practical concerns of prod-

ucts and market considerations to the

manager.

Similarly, Northwater Capital’s VP

Stephen Foote says any hypothetical

thinness in products can be easily

overcome by an experienced manag-

er. “We have been running portable

alpha and LDI programs for over 10

years, and we haven’t run into any

capacity issues to date. If presented

with a two billion trade, we could exe-

cute and implement, but over a rea-

sonable period of time that any plan

sponsor would be comfortable with.”

“There is still a liquid market that is

sizeable enough to build customized

fixed-income portfolios to better

match defined benefit pension liabilities using cash

markets or overlay strategies employing leverage,” says

John Ellis of TD Asset Manageement Inc.

His firm offers a number of solutions including

pooled funds, which can be used by pension funds of

virtually any size to extend the duration of their fixed-

income portfolio. Some of these funds seek to add

value through the use of portable alpha.

SOONER RATHER THAN LATERThe availability of these and other solutions

notwithstanding, Ellis still urges plan sponsors serious-

ly considering LDI to move sooner rather than later.

“Capacity remains a prime motivation, but because

of price rather than availability,” says Ellis. “The bond

can always be bought, the swap can always get done

but it’s a question of price. If you are the last person

in, the solution will be more expensive.” —I2

David Adler is a New York-based freelance business writer whofrequently contributes to Investment Insider and otherSouceMedia publications.


FEATURE

Understanding “swaps”When bonds are purchased through aswap, the plan sponsor enters into a“swap arrangement” with a financial insti-tution. The financial institution pays theplan sponsor the long-bond return, whilethe plan sponsor pays the short-terminterest rate — e.g., the overnight rate.

As a result, the plan sponsor does nothave to advance funds. The arrangementis a contract that, at the end of the quarteror the end of year, the parties will settle up.

The net result, says Towers Perrininvestment consultant Zainul Ali, is thatthe pension fund is using leverage. “Theydon’t have to spend any money to buy the bond. They use an overlay, while stillpreserving their 60% equity/40% bondsasset mix.”

CLAUDE TURCOTSenior VP

Standard LifeInvestments

DAMON WILLIAMSVP

Phillips Hager & North

STEPHEN FOOTEVP

Northwater Capital

I2308_InvManag.FINAL.qxd 3/13/08 3:49 PM Page 11

MolsonCoors and

Nortel say LDI is on

tap in both their

Canadian and U.S.

defined benefit plans,

but their cross-border implementa-

tions reveal markedly different

investment brews.

Development of liability-driven

investment strategies in the two

countries has been influenced by

individual plan designs, availability of

product and regulatory requirements.

Here’s a look at how the strategies

are unfolding.

MOLSONCOORSIn Canada, MolsonCoors has a

fairly mature salaried plan that was

closed to new workers in the 90s and

an ongoing, collectively bargained

plan for hourly workers. The compa-

ny also has a single defined benefit

plan for U.S. employees, with differ-

ent formulas for salaried and non-

union hourly workers. The U.S. plan

was closed to new entrants at the

start of this year, but existing mem-

bers are still accruing benefits.

Director of Global Pensions and

Risk Management Mike Rumley says

that in the early part of the decade,

with an asset allocation of 70% equi-

ties/30% bonds, the funded status in

the Canadian plans deteriorated.

“Like many plans in Canada, we

have to fund under various provincial

rules to a solvency basis. We realized

that as plan sponsors, we don’t want

to have to ‘re-fund’ if there is a fur-

ther deterioration in the equity mar-

kets or if the interest rates fall further.

At the same time, our beneficiaries

are interested in having the benefit

promises locked down.”

As a result, the Canadian salaried

plan has been almost completely

invested in bonds that — to the

extent possible — mirror liabilities.

“Where bonds are not available, we

will definitely do a futures overlay or

swap strategy to close the gap, but we

are not really interested in an overlay

strategy or portable alpha,” he

explains.

Because the funded status of the

active hourly plan is not yet as good

as in the salaried plan, Rumley says

the 70/30 mix was retained. But the

company took the 30% in normal

bonds and extended the duration to

also make them look more like the

liabilities.

The equity allocation in the U.S.

plan has been reduced in the last few

months as well, so the asset mix is

now 45% equities, 10% core real

estate and 45% long-duration bonds.

However, with a greater universe of

bonds and other credit products

available south of the border, the

company wants to retain the ability

to generate alpha by looking at rela-

tive returns among a fairly broad

asset class.

LDI on tap in Canadaand the U.S.BY SHERYL SMOLKIN


Phot

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I2308_SE.FINAL.qxd 3/13/08 6:25 PM Page 12


“The decision was made not to

extend duration so far out in the cash

market that it will eliminate these

opportunities or significantly lower

them,” he says. “In the U.S. space,

there is much more opportunity for

managers to demonstrate alpha while

still doing a pretty good job manag-

ing liabilities.”

NORTELJohn Poos, director of global pen-

sions at Nortel, says the company

moved approximately $3.5 billion in

defined benefit assets in Canada and

about $1 billion in the U.S. into a

long-duration portfolio three years

ago. Both plans had “hard” closes

effective Jan. 1, 2008, and no further

service is accruing. The asset mix in

both countries has been shifted from

60% equities/40% bonds to a 50/50

split.

“What we’re doing now, in terms of

our specific LDI position, is just

enhancing it further in terms of some

leverage in order to even further

match our liabilities.”

However, he acknowledges there

are more challenges in completing the

Canadian implementation because of

both the size of the plan and the fact

that liabilities are indexed to inflation.

“The answer is real-return bonds, but

30% of a $3.5 billion plan would

monopolize the market, so we need to

look at other options.”

Not only are there a larger number

of bond issues in the U.S., says Poos,

“but even if you do find the bonds

you need in Canada, there are not as

many counterparties that will take

the ‘swap’ risk.”

Investing Nortel’s Canadian pen-

sion funds in the U.S. market and

hedging the risks is certainly some-

thing to consider but, he says, “All our

liabilities are measured against the

Canadian long index, and if we move

to something else, there is going to be

some mismatch. The question is

whether, in today’s world, we are pre-

pared to accept that, as opposed to

no match.”

A TOTAL MINDSHIFTBoth Rumley and Poors agree that,

at the onset, one of the biggest chal-

lenges in both countries was getting

stakeholders to think about pensions

differently.

“A total mindshift was required

from how well our assets are doing vs.

the external world to how well our

assets are doing vs. our liabilities.

Once people got their head around

that, the process of getting from

where we were to where we are today

got much easier,” says Rumley.

“One of the things that will hap-

pen when you embark on any kind of

LDI strategy is the volatility of assets

will increase materially because

interest rate volatility also affects lia-

bilities,” comments Poos. “If your

committee continues to be pro-

grammed to measure performance as

against peer groups, at the first diver-

gence from the peer group they could

have a knee-jerk reaction, and you

could be out of a job!”

Poos also does not believe that low

interest rates necessarily make it a

bad time to embark on LDI.

“The question really is, are you

concerned today for the liabilities in

your plan if interest rates drop anoth-

er 25 or 50 basis points? You won’t get

the upside of the market with LDI,

but you will be protected from the

downside,” he says. —I2

At the onset, one of the biggest problems inboth countries was getting stakeholders tothink about pensions differently.

JOHN POOS

There are not as many counterparties that will takethe “swap” risk in Canadawhen it comes to bonds.

MIKE RUMLEY

The Canadian salaried planhas been almost completelyinvested in bonds that mirror liabilities.

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Canadian institutions are in the

early stages of a strategic shift that

could ultimately transform the way

pension assets are managed.

Greenwich Associates reports

that 25% of 2007 study partici-

pants say they have adopted some

form of asset-liability matching

strategy in their portfolio, and

another 19% say they have plans

to do so.

Slightly more than 10% have

taken the next step and implement-

ed liability-driven investing strate-

gies — more complicated

approaches that use derivatives to

more accurately match assets to

liabilities in their portfolios. Another

18% of funds say they expect to

incorporate LDI strategies into their

portfolios.

At the same time, 20% of

Canadian funds say they are using

absolute-return strategies, and

another 13% say they have plans

to adopt absolute returns.

Funds that have adopted

asset-liability matching devote an

average of 77% of total assets to

the strategy. Users of LDI include

55% of total assets in that

approach, and among users of

absolute returns, the strategy

amounts to 59% of assets.

“The growing use of these

strategies has major implications

for the Canadian investment man-

agement business,” points out

Greenwich Associates consultant

William Wechsler. “The typical

Canadian fund currently uses

about seven asset managers. But

under this new model, a single

manager controls 55% or more.

The rest get squeezed.”

Greenwich Associates’ recently released “2007Canadian Investment Management ResearchStudy” presents a fascinating snapshot of howCanadian institutional investors are investing,and what they are planning going forward.

It also takes a look at trends in investmentmanagement fees, the growing demand forportfoliowide strategies, plus the current and

expected share of assets in defined benefit anddefined contribution plans.

In this issue of Market Watch, we are pleasedto share with you excerpts from the Greenwichstudy, which is based on data collected in inter-views with 257 corporate and provincial gov-ernment pension funds, endowments andfoundations.

A snapshot of current pension investment trends

Freed from past regulatory con-

straints on foreign investments

and driven by a desire for diversi-

fication and higher returns, the

Greenwich study shows that

Canadian pension plans, endow-

ments and foundations are adding

international assets to their

investment portfolio at a rapid

rate.

Key findings include:

• International investments

now make up 30% of all institu-

tional assets in Canada, including

nearly 60% of institutional equity

portfolios.

• More than one quarter of

large Canadian firms have started

using currency overlay strategies

to hedge risks associated with

their exposure to nondomestic

investments.

• When seeking out alterna-

tive investments, Canadian insti-

tutions prefer real estate and pri-

vate equity to hedge funds.

• Strong funding ratios have

enabled Canadian pension plan

sponsors to avoid closing defined

benefit plans and slowed the

growth of the defined contribution

market.

Nevertheless, Greenwich

Associates consultant Chris

McNickle says: “In other markets,

we have seen that the implemen-

tation of mark-to-market account-

ing rules has prompted a sudden

and decisive shift by corporate

plan sponsors out of DB into DC.

When and if Canadian regulators

move the market in that direction,

we could expect the same.”

Portfoliowide strategies could revolutionize plan management

Canadian pension plans rapidly diversify

Investment management fees increased in most asset classes for

Canadian plan sponsors from 2006 to 2007, after dipping the previous

year, according to data collected by Greenwich Associates.

Overall, Canadian funds paid an average 35.1 basis points (bps)

to all outside managers. By asset class, fees paid to active man-

agers of:

• Domestic equities increased modestly to 30.8 bps in 2007 from

29.5 in 2006.

• Fixed income rose to 20.7 bps in 2007 from 18.1 bps in 2006.

• EAFE equities jumped to 56.6 bps in 2007 from 53.7 bps

in 2006.

• U.S. equities declined slightly from 2006 to 2007.

The Greenwich report also notes that only 11% of Canadian funds

use performance-based fees to compensate investment managers.

Among those that do, performance fees are used most commonly for

active U.S. equities and active income. Usage is much higher among

funds with more than $1 billion in assets, about 20% of which pay

managers performance fees.

Canadian funds also saw an increase in fees paid for regular con-

sulting services, which increased to an average of $105,000 in 2007

from $95,000 in 2006, and for fees for traditional actuarial services,

which rose to about $158,000 from $140,000.

Fees on the rise for Canadian Funds

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employee benefit november/december 2008

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