Keith MacIsaac of the Canadian Mortgage and Housing Corp. describes the results of its move to a liability-driven investment strategy.

By Rick Baert

Keith MacIsaac of the Canadian Mortgage and Housing Corp.

Keith MacIsaac

Canadian Mortgage and Housing Corp.’s decision — made over two years ago — to put more of its C$2.8 billion defined benefit plan in liability hedging assets has been a success, according to Keith MacIsaac, pension fund risk specialist at CMHC.

Increasing liability hedging as part of the pension fund’s move to a liability-driven investing, or LDI, strategy “has proven to be successful,” MacIsaac said. “It has helped improve solvency funding, improve liability hedging, reduce surplus volatility and volatility of contributions while keeping funding costs low.”

In addition, “In terms of the overall long-term objective of the pension fund — namely, to achieve a total rate of return that will provide for pension benefit obligations with an acceptable level of volatility of expected contribution requirements — the LDI strategy has fulfilled this objective,” he explained.

CMHC’s Asset Allocation

As of Dec. 31, CMHC’s liability hedging assets were 59% of its overall asset allocation, 34% physical assets and 25% leverage, along with 44% in public equities and 17% in real assets.

Before the new allocation was established in 2017, the pension fund employed a traditional asset allocation of 57% equities, 28% liability hedging, 13% inflation-sensitive and 2% cash.

Proof of the success of the new allocation can be seen in the jump in the CMHC fund’s 10-year real return rate before 2017 and after. The pension fund had a 10-year net return of 4.0% at the end of 2017, but the net 10-year return jumped to 7.7% in 2019. Its one-year return last year was 16.7% vs. a custom benchmark of 14.9%.

Plus, the CMHC pension fund was 112.6% funded on a going concern basis as of year-end 2019 vs. 110.2% at the end of 2016, and 95.8% on a solvency basis vs. 83.6% three years earlier.

LDI Lookback

MacIsaac said the decision to move to LDI and increased liability hedging was easy when looking at recent history. “You don’t have to go back too far in time to see when and how the pension industry changed,” he explained.

About 25 years ago, pension plan management “seemed an easier endeavor: high yields on fixed income and double-digit returns in equity markets were the norm and seemed likely to continue for some time,” according to MacIsaac.

Next, came the dot-com crash of 2000-2002 and the Great Financial Crisis of 2008. “In both cases, the solvency ratios for defined benefit pension plans, CMHC included, fell abruptly,” he said.

“The key determining factor was volatility — not of assets alone, but of assets and liabilities, since both affect plan health,” explained the risk specialist. “This fatigue was further exacerbated by the ensuing period of chronically low interest rates.” CMHC “saw the need for an investment approach that does not depend on rising interest rates, reduces surplus volatility and manages plan cost. An LDI strategy ticked all the boxes,” he said.

‘Modest Leverage’

The key changes made by CMHC to its traditional allocation included adding “modest leverage” through an overlay, reallocating to more long-term bonds to increase duration and reducing its equity allocation, the risk specialist points out.

“The results indicated improved liability hedging and the reduced equity allocation lowered funding risk and surplus volatility, not to mention the volatility of contributions,” according to MacIsaac.

“Equally important in keeping funding costs low was that the long-term expected return was not sacrificed in most circumstances,” he explained.

Its ability to use leverage “was crucial to the success of the LDI strategy, since the existing assets alone were not sufficient to achieve the required economic exposure to long duration bonds in order to improve the asset/liability mismatch,” the risk specialist said.

“Since leverage in this capacity was new to CMHC’s pension fund, it was necessary to convey to governance bodies the experience of the trading team using repurchase transactions and reverse repurchase transactions for investing,” he added.

Hedging Ratio

CMHC set its target liability hedging ratio at 50%, which means that for every dollar change in liabilities, assets change by about 50 cents, MacIsaac said: “The strategy is designed to hedge parallel changes in interest rates to help mitigate surplus volatility.”

Also, CMHC does not include cash in its calculation, “since in our model cash is used for liquidity purposes, not liability hedging,” he explained.

“In addition, its sensitivity to interest rates changes is so benign as to render it ineffective as a hedging tool. The 50% hedge ratio was chosen to balance the corporation’s risk tolerance with long-term pension costs,” said the risk specialist, adding that the hedge ratio is calculated and monitored daily.

Rick Baert is a freelance journalist who specializes in covering institutional money management, trading and asset servicing. He is a retired editor and reporter with 42 years of experience with financial, business and daily news services. Rick has covered the Canadian pension fund industry for the past six years.