(Bloomberg) -- Canada's public pension funds, among the biggest in the world, are piling on risk with leveraged bets in a chase for higher returns, Moody's Investors Service warns.
The nation's six biggest pension funds have increased their average leverage to 24 percent, from 19 percent in 2009, in an effort to offset the impact of declining pension member contributions and low interest rates on their cash flow and investment returns, Moody's said in an Oct. 3 report written by analyst Jason Mercer. That's leaving the funds exposed to volatility in the returns they're counting on to fund future pension payouts.
“They are definitely taking on more risk, and the question I ask them is, ‘Why take on more risk if you don't need to?'” Mercer said by phone from Toronto. ‘Why not just invest in very low-risk securities and not worry about volatility?”
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Long-term interest rates in developed countries are currently about half the 4 percent real return pension plans need to remain sustainable. Canada's biggest pension funds have been targeting returns in the double-digits with their use of leverage and investments in illiquid assets such as real estate, infrastructure, and private equity, to compensate for a lower ratio of active members to retirees drawing benefits, Mercer said.
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These strategies leave pension funds more exposed to potential macroeconomic shocks such as a weaker Canadian dollar or drops in equity or credit markets, Mercer said.
To be sure, Canadian pension plans have the financial strength and ability to take on risk, and Moody's doesn't see a credit-rating impact from the increased leverage anytime soon, Mercer said. If a pension fund's leverage ratio were to increase above 50 percent, Moody's would no longer rate the fund higher than its government sponsor, he said.
Ontario Teachers' Pension Plan has the highest leverage, 33 percent, due to their large constituency of teachers retiring early and living longer, according to Moody's.
“As a pension plan, we focus by necessity on our asset-liability balance,” OTPP spokeswoman Deborah Allan said in an email. “Leverage is key in our portfolio construction as we manage our asset mix and reduce our liability risk.”
Many Canadian pension funds, which were among the first to establish private equity arms to take active stakes in businesses in 1990s, have set up in-house hedge funds to invest in more complex derivatives like forwards, swaps and options while also employing debt strategies.
The combined assets of Canada's six largest pension funds nearly doubled to almost C$1.4 trillion ($1.1 trillion) between 2011 and 2016, according to Moody's. Investment income was the largest contributor to growth, with combined earnings contributing more than C$400 billion over the past five years.
Allocation to illiquid, non-public assets increased to 34 percent in 2016 from about 31 percent in 2010, according to Moody's. A risk with these assets is that they rely on assumptions about their value, which can only be determined once the asset is sold and adds uncertainty to portfolio performance, Mercer said.
To contact the reporter on this story: Allison McNeely in Toronto at amcneely@bloomberg.net.
To contact the editors responsible for this story: Jacqueline Thorpe at jthorpe23@bloomberg.net, Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Kenneth Pringle
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