Risk aversion weighs on pension funding

Plummeting bond yields and weak equity markets in May, combined with low long-term interest rates, contributed to poor performance. And while stock markets started 2012 with a bang, negative returns in Q2 erased gains and brought most plans right back to square one.

“Pension plans were making a slow but steady recovery in the first four months of 2012,” says Manuel Monteiro, partner in Mercer’s financial strategy group.

He adds, “But despite June being a mildly positive month, most plans are now roughly back to where they started at the beginning of the year [due to weak markets].”

Read: Volatility and the individual investor for more on the three challenges currently impacting investors and the pension world.

The decline in returns in Q2 marks a continuation of disappointing stock performance over the past five years. The S&P/TSX Index is down by 0.7% per annum over the last five years.

This period of poor results has dragged down pension funded ratios, and is causing plan sponsors to consider alternative investment approaches such as greater use of unconventional investments, de-risking strategies and the use of derivatives.

Monteiro says plan sponsors find mitigating risk in the short term too expensive; they’re instead turning to longer-term strategies that will allow them to act in their best interests and take advantage of available de-risking opportunities, with some changing plan designs and investment policies to manage volatility.

“Recent developments like General Motors’ plan to purchase $26 billion of annuities in the U.S. could change the insurance market landscape in Canada over the next few years, making risk transfer strategies possible even for some of the largest corporate plans in Canada,” he adds.

The extreme surge in investor risk aversion is one of the main stumbling for plan sponsors. With stock prices unstable, the safe money is shifting to bonds and inflating pension liabilities and costs. This move also keeps interest rates low.

Read: The difference between volatility and risk

“With interest rates seemingly stuck at such low levels, defined benefit plan sponsors are assessing the investment tools they’ve historically used to boost returns and reduce risk more critically,” says David Service, director of investment consulting with Towers Watson.

He adds, “Led by some of the larger, more sophisticated plans, Canadian pension funds are accelerating a trend toward alternative assets such as real estate, private equity and infrastructure.”

Read: Private equity activity soars in 2011

This post originally appeared on BenefitsCanada.com