The case for Infra & Real Estate for Canadian pension funds, in a Zero Yield world
The Canadian pension funds today outperform their global peers (including the US ones), in investment returns, even while better hedging against their liability risks. The sheer size of the capital pool makes them a force in any asset class, but not without an exposure to an adverse change in the fundamentals.
Success Metrics for Pension funds
There exist two buckets within the Canadian pension plans (the table below has an indicative list), broadly segmented by the primary metric by which they track their performance:
- The ones on the left, tend to track an annual rate of return relative to a benchmark
- Those on the right, typically measure their success through tracking their funded status (Fair value of the investment assets relative to Fair value of Plan liabilities)
That said, a minimum threshold funded status (set by their respective boards) tends to be an absolute requirement across all pension funds and is disclosed periodically.
Consequently, all pension plans tend to aggressively manage the relative movements in their assets, and liabilities towards the members of their plans. The assets comprise the investments across public/private markets, asset classes (equity/bonds) and across sectors. Liabilities could either be defined benefit or defined contribution payouts, based on whether these are a definite stream of pension cashflows or solely a function of the contribution made by the plan members. With Canadian pension schemes tilting towards the former, liabilities tend to be computed based on a discounted value of such predictable payout streams.
Funded Status = PV (Assets)/ PV(Liabilities)
Thus, with a change in macroeconomic parameters, managing the funded status becomes imperative, through a rebalancing of the relative profile of the assets (w.r.t. liabilities).
Current Landscape: Zero-Bound policy
Zero-bound is the lowering of short term interest rates to zero, as part of an expansionary monetary policy of the central banks to simulate their economies. This eventually translates to a lower bond yield, creating a downward pressure on a pension fund's fair value of assets, and thus its funded status.
As Leo Kolivakis, a Canadian analyst who specializes in pension plans, highlighted in his discussions from Sep 28 with Peter Lindley, the CEO of OPTrust-
"As the Canadian long bond yield went from 1.75% at the end of 2019 to 1% now, so the liabilities will be disproportionately impacted, as the duration of the liabilities is a lot bigger than the duration of the assets"
It makes sense that a pension fund's liabilities are inherently long term in nature, as against the assets which have a limited life cycle (as that of the underlying investments) and thus are rotated over time. The last point makes way for a compounding effect from the investments made in bonds, in particular. Given that these bond investments form a significant portion of any pension fund asset base, a drop in the bond yield thus could throw the target funded status off balance.
From Fixed Income to Fixed Income Alternatives
Below is an excerpt from an interview of Mark Machin, CEO at CPPIB to CNBC's Squawk Box Asia on Sep 16-
"The fact interest rates are now zero-bound; does that change the diversification benefit of bonds in the long term? I think we, like a lot of long term asset owners, are looking at reviewing that"
The interest to divest away some of the fixed income positions, though in early stages, doesn't seem to be one off. In another instance, Jeff Wendling, CEO at HOOPP, during an event in mid-August opinionated as below-
"Fixed income assets don’t hedge the plan’s liabilities as well as they did when yields were higher nor do they provide the same kind of diversification benefits. We’re really looking right now at what we need to do, or what we can do differently, to generate the returns that we need and manage the risk appropriately.”
Fixed income investments do have a role to play in hedging the long term nature of any pension fund's liabilities, while also introducing an element of diversification through their distinct position on the risk-reward frontier. However, at zero yields, while these fixed income investments may or may not lose such benefits, they certainly introduce a drag on that investment (opportunity cost from earning nothing).
This then gives way to shifting to fixed income alternatives, assets that maintain a similar (though not equal) risk-return & diversification profile in the portfolio. Such assets include yield investments i.e. that guarantee a stable periodic stream of cashflows, while limiting the downside on the investment.
Infrastructure & Real Estate
Mature, stable assets within Infrastructure & Real estate classes, tend to fulfil these criteria quite closely. Secondly and crucially, these asset classes aren't new to any pension fund and already receive a separate mention as a line item in their balance sheets (refer CPPIB's below).
As can be seen, energy and (Natural) resources, power and renewables are each a separate category in CPPIB's balance sheet, but one or more of these might be consolidated under the broader Infrastructure bucket with various other fund (refer OTPP's next).
All said, the bottomline is having such similar a role to play in a pension fund's portfolio, this is a chance to shine for the broader Infrastructure & Real Estate sector, by stepping into the void created by their close cousin on a pension's balance sheet.
As a closing note, early movements of this transition are already underway. In another interview by Leo Kolivakis, Jeff Wendling of HOOPP broached about his firm's outlook as below-
HOOPP has been late to embrace infrastructure because they thought the asset class was overvalued for many years. But with bond yields continuing to go lower, they decided to start investing in infrastructure. "We set up a team, we committed $1 billion in two infrastructure funds and will co-invest alongside them in bigger deals but it's still early, so we haven't deployed a lot of that billion dollars yet."
Thanks for reading, keep safe!