Do your clients’ portfolios look like their pensions?

You hear it time and again: Look to pension managers because they’re the “smart money.” But investors may not be aware of what their pension plans hold. A new survey of defined benefit (DB) plans by the Canadian Pension Fund Investment Directory remedies this by giving a glimpse into how the smart money is being invested.

Sponsored by Pyramis Global Advisors, CPF’s survey of 157 corporate and public plans found that the average Canadian DB plan allocates 56% of its money in equities, 34% in bonds, 5% in cash investments, 3% in alternative investments and 2% in real estate.

Ismo Heikkila, national director of financial education services for fee-only advisory firm T.E. Wealth, says a client’s pension can be of some value in providing a rough illustration of the value of diversification in a portfolio.

“Where we do use DB plans is in [educating clients] about asset allocation. It is sometimes used as a bit of a benchmark that shows diversification makes sense for long-term investing. It shows asset allocation is absolutely an important part of structuring an employee’s portfolio,” says Heikkila, who works with corporate clients to implement financial planning solutions for their employees. “So we can use DB plan info as a kind of a notional benchmark to see what the real big money is doing.”

Currently, the average Canadian DB plan is grossly overweight in Canadian equity, according to Peter Chiappinelli, senior vice-president of investment strategy and asset allocation at Boston-based Pyramis, the institutional arm of Fidelity Investments.

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On average, the 56% allocation to stocks is broken down as follows: Canadian equity, 25% of the total portfolio; U.S. equity, 12%; international equity, 12%; and global equity, 7%. That’s nearly 45% of the equity allocation in Canadian equity.

There is always a home bias, but Canada’s is considerably large, Chiappinelli notes. In U.S. plans, for example, 73% of equity holdings are in U.S. equities, and U.S. equities represent 48% of the MCSI World Index. Canada’s 45% equity allocation is in proportion to 4% of the MCSI World Index.

DB plan managers are aware of the risk of being overweight in Canadian equities, which have too much exposure to the resource and financial sectors. Part of the domestic bias is because past restrictions on foreign property made acquiring large foreign holdings difficult. Since the foreign property rule (FPR) was removed in 2005, there has still been some hesitance to move away from domestic equity — fortunately, Canadian equity has served Canada’s plans well.

The Canadian market has had five-year annualized returns of 13.1% versus the 6.2% realized on the U.S. market. The performance of Canadian bond holdings has also been considerably stronger. This has helped Canadian DB plans achieve an average funding level of 101% versus 90.5% in the U.S., Chiappinelli says.

Now plans are selling off their Canadian holdings. Eighty-one per cent of public plans are considering reducing domestic exposure, or are already in the process of doing so. On average, Canada’s large plans intend to move 47% of their Canadian equity holdings into other asset classes.

What are they moving them into? Sixty-five per cent of corporate plans and 46% of public plans intend to move some of them into international equity. Forty-eight per cent of corporate plans and 31% of public plans are opting to increase U.S. equity exposure. Only 10% of public plans and 28% of corporate plans intend to trade Canadian equity for fixed income.

Heikkila cautions advisors not to read too much into this. A pension is created using enormous amounts of wealth and uses complex formulas to construct investment horizons anywhere between six months and 50 years. These formulas must ensure the payout for retired employees as well as ensure there is enough money for future retirees.

“We can’t just model your portfolio after a defined benefit plan,” he says. “Even if the DB plan is moving away from Canadian equity, we don’t know exactly why. The pension plan may be looking at investment horizons 20 to 25 years out.”

One of the biggest benefactors of the Canadian equity sell-off may be alternative investments. This could provide a good talking point for advisors to broach the subject of how alternative asset classes can be used in a portfolio. Sixty-two per cent of public plans intend to trade some of their domestic equity holdings for alternative investments, which include private equity, hedge funds, venture capital and infrastructure.

“In total, three-quarters of Canadian plans are reconsidering alternative investments,” Chiappinelli says. “For those that have alternatives, the average plan has allocated about 4% of their total assets to them.”

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He adds that 90% of large plans are likely to increase their alternative holdings, and a little less than a third of all plans (31%) are loosening their trading constraints to approve more shorting, which will allow them to implement long–short strategies like 130/30.

Heikkila says if advisors are going to use pension asset allocation as an educational tool to explain how asset classes work in a portfolio construction, they need to keep in mind the sophistication and the risk tolerance of the employee.

“Even though there may be something that’s more appropriate for their portfolio from a generic objective point of view, the client may not feel comfortable from a risk point of view, in terms of loss of capital risk and in terms of volatility,” he says.

Heikkila says T.E. Wealth’s advisors ignore the asset allocation of the DB plan when it comes to creating an independent portfolio for their clients. Their concern with the pension plan is with what benefits it will provide their clients in retirement.

“The employee’s pension is based on a formula that is guaranteed by the plan sponsors,” he says. “Whether the plan sponsor is invested in treasury bills or growth equity securities, it really doesn’t matter; the money has to be there.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(11/13/07)