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Canadian pension funds: new freedom to address a familiar problem

Strong asset growth over the past year has helped raise the average funding ratio of Canada’s pension plans. However, under-funding remains the most pressing problem facing Canadian pension fund LPs, according to new research from Greenwich Associates.

“If Canadian pension plan sponsors in years past have been slow to address some of the challenges facing their funds, their inability to improve funding ratios has probably now brought them to the point of action,” says Greenwich Associates consultant Lea Hansen. “With that motivation, and the recent elimination of the limitations on foreign holdings, Canadian plan sponsors in 2005 can be seen as having something of a blank slate.”

These comments are based on Greenwich Associates’ 2005 Canadian Investment Management study. In addition to analyzing trends in assets under management and funding levels, the report also presents the following key findings:

• In the wake of the elimination of the Foreign Property Rule, Canadian plan sponsors intend to increase foreign equity allocations by 13%, non-domestic alternatives by 50%, and foreign fixed-income allocations by almost 70%, according to a special study conducted by Greenwich Associates. U.S. and global asset managers stand to benefit from the expected pick-up in Canadian institutions’ investment in foreign securities.
• Canadian funds reduced domestic equity allocations from 2003 to 2004, while increasing allocations to domestic fixed income and alternative asset classes.
• Unlike their counterparts in the United Kingdom, only 20% of Canadian plan sponsors have closed their defined benefit plans to new employees, and just 3% say they intend to do so over the next two to three years.

Canadian Pensions: Beyond Under-funding

Total assets of the largest Canadian institutions — including corporate, public and provincial pensions, endowments and foundations — increased by 20% from 2003 to 2004 due to significant asset growth among some of Canada’s largest funds buoyed by strong market returns. Thanks in large part to this asset growth, the funding positions of Canadian pension funds improved to a point at which the typical Canadian pension fund is now close to being fully funded. The average funding ratio of Canadian plans increased from 95% in 2003 to 97% in 2004.

“It is important to note, however, that several of Canada’s largest pension funds are still seriously under-funded, so as an industry, Canadian funds are not yet out from under this burden,” says Greenwich Associates consultant Rodger Smith. “Indeed, when asked to name the most pressing issue facing their funds, almost 40% of plan sponsors in 2005 cite the under-funding situation.”

Farewell, Foreign Property Rule

Alongside these strategic considerations, the elimination of the Foreign Property Rule stands front and center in the minds of Canadian fund officials in 2005. A special study conducted by Greenwich Associates revealed that a quarter of Canadian plan sponsors plan to increase their allocations to foreign investments and another 30% are considering such a move.

The Canadian institutions that participated in Greenwich Associates’ special study have an average of 30% of their assets in foreign equities, 3% in foreign fixed income and 2% in non-domestic alternative investments. After the rule removal, this group of plan sponsors — which represented a smaller research base than the universe of Greenwich’s annual research programs — intends to increase foreign equity allocations by 13%, non-domestic alternatives by 50%, and foreign fixed-income allocations by almost 70%. “The most significant change to Canadian institutional asset mixes in coming months will almost certainly be a shift out of domestic equities and into foreign investments,” says Lea Hansen.

Domestic equities, which represented 30% of institutional assets as recently as 2000, fell from 27% of assets in 2003 to 24% in 2004. More than 35% of Canadian plan sponsors say they will decrease their allocations to active domestic equities by 2007, while less than 15% expect to increase them. For passive domestic equities, 13% expect a decrease and only 4% an increase.

Dedication to Defined Benefit

Defined contribution structures play a smaller role in the strategic formulations of Canadian plan sponsors than they do in the strategies of funds in other markets. The continued devotion of Canadian plan sponsors to their defined benefit structures can be attributed in part to funding levels that are stronger relative to those of funds in the United States, and to the fact that Canadian regulators have not embraced mark-to-market accounting to the same extent as their counterparts in the United Kingdom.

About 20% of Canadian plan sponsors have closed their defined benefit plans to new employees, and just 3% say they intend to do so over the next two to three years. By way of comparison, almost half of U.K. defined benefit plans are now closed to new employees. “Canadian plan sponsors do not appear to be following in the footsteps of their counterparts in the United Kingdom, where plan sponsors on a wide scale are closing their defined benefit plans to new employees and shifting to defined contribution structures,” says Rodger Smith. “Instead, Canadian funds seem to be rolling up their sleeves and saying, ‘bridging the funding gap is a challenging task, but we are committed to our defined benefit plans and we are ready to do the work necessary to preserve them.’”

Greenwich Associates is the leading international research-based consulting firm in institutional financial services. Greenwich’s studies provide benefits to the buyers and sellers of financial services in the form of benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with additional offices in London, Toronto, and Tokyo, the firm offers over 100 research-based consulting programs to more than 250 global financial-services companies. Please contact us for further information or to arrange an interview with one of our consultants. You can visit our website, www.greenwich.com, for more information.