Skip to main content
opinion

Dr. Alex LaPlante, Managing Director of Research, and Dr. Serguei Zernov, Special Adviser, Global Risk Institute

According to Statistics Canada, almost 5,000 baby boomers are retiring every week. Providing pensions for this cohort has many pension managers using leverage to improve investment performance. As the bull market enters its 10th year, people are starting to worry about leverage.

The Bank of Canada recently noted that the “explosion of global debt is creating vulnerabilities in the world’s financial system.” Joining the chorus is Moody’s, which recently raised questions regarding the potential impact of the current economic environment and the use of leverage on the creditworthiness of Canadian public pension plans. For many pension plan managers, however, leverage is essential to delivering the pension promise.

Investors have been operating in a chronic low-interest rate environment since the financial crisis and have had to look for opportunities to generate higher yield, and pension funds are no exception. While using leverage requires advanced knowledge of the theory and practice of investments, pension plans with investment management sophistication can benefit from leverage in strategic asset allocation.

Pension funds are designed to closely follow liability obligations; however, there are varying levels of governance complexity depending on whether the pension is private or public.

Private defined benefit pension plans must value their liabilities in compliance with International Financial Reporting Standards (IFRS). Public pension plans in Canada have much more freedom in determining the rate at which they discount their obligations. They can therefore benefit more from leveraged strategies, and they are more likely to use them.

The potential to create value thanks to leverage depends on particular circumstances of a pension plan – for example, plans with higher return targets and more appetite for risk reap greater benefits from using leverage. But will diversification be sacrificed with leverage?

Harry Markowitz popularized the expression that diversification is the only free lunch in investing, which became an accepted “truth” in academia and industry. In practice, however, diversification is not free.

A diversified portfolio (maximum Sharpe ratio portfolio) is a low risk and also a low expected return portfolio. A diversified portfolio, when leverage is not allowed, is a portfolio with a low expected return. Leverage allows pension funds to achieve higher return targets and to hold a well-diversified portfolio. Leverage also gives pension fund managers the ability to expand the set of possible portfolios to meet the objectives with a better risk/return trade-off. It is not a free lunch, but rather an expanded menu of lunch choices.

As pension funds have targets expressed as return expectations, rather than in risk-adjusted return expectations, the best diversified portfolio that doesn’t use leverage may not be be able to meet the goals. As the asset owner faces fixed costs, their impact on performance is also higher at lower levels of expected returns. The leveraged portfolio of a pension plan with a return target of 6.5 per cent may outperform the portfolio without leverage at the same risk level by more than 1 per cent under realistic assumptions. This is a large margin for a long-term investor (and pension funds can have liabilities stretching out 30 years). Even if only half of the value is realized, it is still economically significant.

Use of leverage requires skillful management of liquidity – it amplifies liquidity risk, and at the same time maintaining excessive liquidity provisions is costly. The manager must have skills and diligence to walk the fine line.

Finally, leverage can emphasize the impact of geometric compounding and the dependency between returns and volatility. For that reason, it is important to model and back-test a leveraged strategy using a framework that accounts for compounding and timing of cash flows.

Leverage in the context of public pension funds is not a dirty word. Leverage is a powerful tool for pension investment managers and the use of it can be an important source of value creation for plan members. To shy away from the use of leverage is counterproductive and could undermine the ability of pensions funds to fulfill their promise.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe