Potential Impact Of FPR Elimination
By: Peter C. Arnold
The impact of the removal of the foreign property rule would have been different in the late 1990s than it would today. Peter C. Arnold, of Buck Consultants, offers his perspective on what will take place in an investment environment today with no foreign limits.
There are rarely dull days in the world of investing. Just when pension plans are at last beginning to feel like they are recovering from the ‘perfect storm’ – characterized by negative equity returns, historically low interest rates, and aging demographics – between 2000 and 2002 the federal government proposed the elimination of the 30 per cent foreign property rule in its February 2005 budget.
What is the potential impact of this budget measure?
On the surface, the change represents a continuing opportunity to foreign- based investment management firms providing specialized global investment services versus Canadian-based investment managers (more on this later). Most important is the priority this measure has in the queue of other issues facing pension plans today and going forward.
Group RRSPs and Defined Contribution plans deserve a separate article devoted to the asset allocation decision, regardless of the status of the foreign property rule. While the CAPSA Capital Accumulation Plans (CAP) Guidelines are a welcome and needed governance standard, the potential elimination of the foreign property rule unfortunately does not make the asset allocation decision any easier or better for CAP members than under the current 30 per cent foreign property rule.
Defined Benefit pension plans are complicated systems. While some in our industry characterize pension plans as similar to a financial services company, the term ‘system’ may be more appropriate. Pension plans and financial services companies do face similar issues such as return on investment from assets and cash outflows attributable to ‘liabilities,’ human and intellectual capital needs, quality management, and the fundamental need to get value for cost.
However, there is a clear difference. Companies try to minimize costs, pension plans pay pensions.
In addition, each pension plan is unique in terms of its plan design, return needs, demographics, and liabilities. As a result, the need to define plan-wide risks, prioritize them, and clearly communicate the need to mitigate these risks is paramount to the ongoing operation of a successful pension plan.
What if this budget measure had been announced in the late 1990s when plans were enjoying double digit positive returns? Chances are due diligence requirements could have been fast-tracked as plans were in surplus positions and good returns seemed to be available without limitation. Perspective and timing are important.
In 2005, the timing of this announcement coincides with plan sponsors seriously reflecting on industry best practices and reevaluating the direction and strategy for their investment programs. Long-used and once trusted general rules of thumb are being questioned. The concept of an equity risk premium is debatable, benchmarking can lead to funding deficits and closet indexing, and asset management should really be driven by liabilities.
Point Of Inflection
Points of inflection are not new in our industry. They are a by-product of both the realities of the financial status of plans in different eras and the ongoing evolution of thought leadership in our industry. The issues to be tackled in terms of the potential elimination of the foreign property rule are no different really than they were in the past. Plans have always had ample access to foreign strategies through derivatives. The question of the potential impact of unlimited foreign content has been, and still remains, dependent on the goals and objectives of the plan.
Figure 1 outlines an integrated investment process which, once begun, is continuous. This repetitiveness ensures that the activities of the plan are consistent with the current and evolving goals and objectives of the plan. The process includes risk management and compliance as these issues are more difficult to initially define and prioritize than simply monitoring them once they are established. It is also a process that realizes that for most trustees and pension committee members, fiduciary responsibilities pertaining to their pension plans often represent second full-time jobs.
Investment return, return volatility, and currency impact are examples of financial risks which are closely related to foreign content. The important information to infer from this is that the projected return for Canadian equity is not dramatically different versus U.S. and international equities, nor has it really ever been. The historical rationale and the continuing validity for having foreign content is to provide the diversification benefits that result when different asset classes are combined together. That is, the destination may be the same for each asset class, but the ride that each asset class experiences to get there will be different in terms of how big the bumps are and when they happen.
Currency risk becomes more of a consideration as foreign content is increased. Many issues surround currency risk, including the direct financial impact, and the fact that the underlying liabilities of a Canadian plan are denominated in Canadian dollars, which can represent another potential contributor to the risk of a mismatch between assets and liabilities.
Under the current foreign property rule, currency swings have both helped and hurt Canadian investors. Through the 1990s, the decline in the Canadian dollar versus the U.S. greenback gave unhedged Canadian investors in U.S. stocks greater returns, but the boost was curtailed for plans at or below the foreign content limit.
On the other hand, when the Canadian dollar rebounded in the past few years against the greenback and other global currencies, unhedged Canadian investors were hurt by the change in exchange rates, but this was mitigated by the 30 per cent limit.
Difficult To Pinpoint
Going forward, it is difficult to pinpoint the impact of currency in an unconstrained foreign content environment. The concept of diversification is evolving and some plans leave the hedging decision to an investment manager’s discretion, hedge 50/50 to smooth the longer term pattern, or leave it unhedged thereby accepting the risks. Many investment managers do not attempt to hedge against currency risk or even consider it in their investment decisions. Expect this to change in an unconstrained environment.
Another factor to consider is the continuing globalization of companies doing business around the world. These companies are hedging their own currency risks by operating in a global economy and this may lead to reduced currency risks by investing in these companies.
As mentioned earlier, a continuing equity risk premium is considered debatable by some. This may very well be true for some plans and it needs to be considered in this light on a case-by-case basis. For return seekers, if the equity risk premium does not exist, then the entire equity investment management industry is in jeopardy if investors are not going to be properly compensated for taking additional risk!
The industry has long promoted the importance of long-term results over shortterm results. While it is intuitively difficult to argue against this well-advertised and accepted general rule of investing, it does have its pitfalls. What this rule fails to realize is that pension plans do not have the luxury of cherry-picking dates to be valued on. As a result, the effects of short-term results will occasionally overshadow long-term dogma. Actuarial smoothing has assisted with this issue in terms of funding liabilities, but is it in peril as a methodology?
Actuarial smoothing effectively amortizes strong and poor performance years over a period of time, resulting in a less volatile return pattern. This is a reasonable process, but it does not reflect the market value reality of results. If marking plan assets to market becomes mandatory, plan funding positions that are more volatile will be used to make plan decisions and funding calls. If this ensues, fiduciaries of plans may wish to consider more tactical and rotational investment strategies which may include varying the use of foreign investments in an effort to mitigate the impact that marking to market will have on return expectations, pension expense, and contribution volatility.
Asset Liability Modeling
The tool used to model return assumptions versus liabilities, pension expense, and contribution volatility is the asset liability management (ALM) study. This tool can also be modified to assist capital accumulation plans in projecting the potential impact of various asset allocation strategies including the varying use of foreign investments. Whether dealing with a single employer, multi-employer, or public pension plan, an ALM study can be designed to assist in mapping out and measuring clear performance objectives, all of which are quantifiable through performance measurement and attribution analysis. An ALM should include:
- Asset Mix Policy – the plan’s strategic asset mix policy
- Asset Mix Call – value added or detracted versus the asset mix policy attributable to being under- or over-weighted in various asset classes in the asset mix
- Security Selection Call – value added or detracted versus the asset mix policy attributable to the plan’s manager structure.
Once the asset allocation strategy is determined, the plan needs to outline the strategy in the Statement of Investment Policies and Procedures (SIP&P) and implement the strategy through manager structure. Current SIP&Ps outline the asset allocation ranges for each asset class and give some amount above and below the normal allocation as minimums and maximums. This permits investment managers to make decisions to under-weight or over-weight asset classes. Under the current 30 per cent foreign property rule, the foreign allocation ranges are capped, so the elimination of the foreign property rule would provide managers with more ability to act on their convictions.
The elimination of the foreign property rule is an intuitively appealing concept to investors who are skilled at tactically seeking and realizing successful global investment opportunities. Respectfully, this is not how most Canadian-based investment managers invest. If you ask Canadianbased investment managers what will change in their portfolios with the elimination of the foreign property rule, you may be surprised to hear how modest the changes will initially be. In balanced mandates, it will amount to increasing the existing maximum limit of the foreign allocation in the SIP&P and some managers will consider global bonds for inclusion in balanced and fixed income mandates.
Global bonds are well-covered securities with a large global market to facilitate liquid trading. This is consistent with the foreign equity positions that most Canadian-based investment managers hold – larger capitalization, liquid names that most of us have heard of before. We suggest that Canadian managers will largely keep on doing what they have been doing, regardless if it is appropriate for the unique needs of a given pension plan. If a plan would benefit from exposure to small and mid cap U.S. equities or a commitment to private equity, chances are the pickings will be very slim from existing Canadian-based investment managers.
Handful Of Criteria
This clearly does not apply to all Canadian- based managers, but it illustrates that the offerings available from Canadianbased investment managers are largely differentiated by only a handful of criteria:
- growth, value, and GARP/core investment styles in equities
- core, credit analysis, and duration management styles in bonds
Leaving aside other important considerations – such as service quality, fees, and ownership – for choosing one investment manager over another, the ability of investment managers to seek out quality investment opportunities – consistent with a plan’s goals and objectives, regardless of the investment manager’s preferred investment style – is an important consideration in the context of creating a truly diversified manager structure that embraces global investment opportunities and consistently meets evolving plan objectives.
Some considerations in a manager structure in the absence of the foreign property rule include:
- Employ fewer investment managers and give them broader mandates. This should mitigate fees and permit tactical allocations to investment opportunities.
- Avoid ‘de-worse-ifying’ by not having several modestly differentiated investment managers.
- Consider combining established investment firms with younger firms. These younger firms will (ideally) actually be developing a good track record of their own, instead of buying a track record of an established firm that other investors experienced.
- Consider entering into partnerships with investment managers instead of entering into investment management contracts. This should align manager interests with the plan’s goals and objectives. Finally, we offer a forecast of what lies ahead for investment managers based in Canada.
We should see a continuing increase in the number of foreign-based investment management firms offering global capabilities and multiple product offerings. We can expect Canadian firms to be acquired to expand the presence of these global players.
The export of core U.S. equity and EAFE investment management responsibilities abroad (mainly the U.S.) will increase. Canadian- based investment managers charge less in fees than their U.S. counterparts and this will be a big factor for plans seeking lower fees for services of similar results. The potential elimination of the foreign property rule should be treated no differently than other opportunities that present themselves – in the context of the plan’s process to achieve its goals and objectives.
Peter C. Arnold is practice leader, investment consulting, at Buck Consultants, an ACS Company.
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