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Expected investment returns and risk management
in a post solvency-test world?
ACPM Webinar
October 18, 2017
Presented by:
Ben Homsy, CFA
Portfolio Manager
Marc Williams, CFA, F.C.I.A.
Portfolio Manager
Leith Wheeler Investment Counsel Ltd.
2
The Perils of Economic Forecasting
3
History Doesn’t Repeat Itself, But…
Severe Systemic Crises
• 1977 Spain
• 1987 Norway
• 1991 Finland & Sweden
• 1992 Japan
• 1997 Asian Crisis ex-Japan
Extended Recovery
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-2 -1 0 1 2 3 4 5 6 7 8 9 10
Pe
rce
nta
ge
Date since trough in leading indicators (Years)
Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff
Average Post-WWII recoveries
Extended Recovery
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-2 -1 0 1 2 3 4 5 6 7 8 9 10
Pe
rce
nta
ge
Date since trough in leading indicators (Years)
Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff
Current US Recovery…
Average Post-WWII recoveries
Extended Recovery
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-2 -1 0 1 2 3 4 5 6 7 8 9 10
Pe
rce
nta
ge
Date since trough in leading indicators (Years)
Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff
Current US Recovery…
Average Post-WWII recoveries
Severe Crises…
7
History of Interest Rate Policy
0
2
4
6
8
10
12
14
16
18
16
94
17
04
17
13
17
23
17
32
17
41
17
51
17
60
17
70
17
79
17
88
17
98
18
07
18
17
18
26
18
36
18
45
18
54
18
64
18
73
18
83
18
92
19
01
19
11
19
20
19
30
19
39
19
49
19
58
19
67
19
77
19
86
19
96
20
05
Ban
k O
f En
glan
d In
tere
st R
ate
Long-Term Central Bank Interest Rate Source: Bank of England, The Guardian
Interest rate
8
Global Policy Interest Rates
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
2004 2006 2008 2010 2012 2014 2016
Po
licy
Rat
e
Global Policy Rates Source: Bloomberg
United States Canada Europe Australia Sweden Norway New Zealand Japan
How Pervasive Are Negative Yields?
Mar
ket
Val
ue
US$
Tri
llio
n
Source: BofA
Unconventional Easing
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
2005 2007 2009 2011 2013 2015 2017
US$
Bill
ion
Central Bank Balance Sheets Source: Bloomberg
US Federal Reserve ECB BoJ Total
Building Blocks of Growth
Building Blocks of Growth
Working Age Population
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
1976 1986 1996 2006 2016
An
nu
al %
Ch
ange
Working Age Population Source: OECD
United States Canada
Participation Rate
58
59
60
61
62
63
64
65
66
67
68
1950 1960 1970 1980 1990 2000 2010
Par
tici
pat
ion
Rat
e (
%)
Participation Rate Source: Bureau Of Labor Statistics, Statistics Canada
United States Canada
Changes In The Labour Force
-1%
0%
1%
2%
3%
4%
5%
6%
Canada
Labour Force Growth Labour Force Trend growth Labour Force Forecast Growth
-1%
0%
1%
2%
3%
4%
United States
Labour Force Growth Labour Force Trend growth Labour Force Forecast Growth
-2%
-1%
0%
1%
2%
3%
4%
Japan
Labour Force Growth Labour Force Trend Growth Labour Force Forecast Growth
-2%
-1%
0%
1%
2%
3%
4%
Germany
Labour Force Growth Labour Force Trend Growth Labour Force Forecast Growth
Hours Worked
32
33
34
35
36
37
38
39
40
1965 1975 1985 1995 2005 2015
Ave
rage
Wee
kly
Ho
urs
Average Weekly Hours (US Non-Farm) Source: Bureau Of Labor Statistics
United States
Building Blocks of Growth
Capital Investment
-20
-15
-10
-5
0
5
10
15
20
25
1990 1995 2000 2005 2010 2015
Inve
stm
en
t %
Gro
wth
US Gross Private Domestic Investment (Non-Residential) Source: Bureau Of Economic Analysis
Recession United States Long-Term Average
Global Productivity Challenges
-1
0
1
2
3
4
5
Pro
du
ctiv
ity
Gro
wth
(%
) Canada
Annual growth rate Trend growth
-1
0
1
2
3
4
5
Pro
du
ctiv
ity
Gro
wth
(%
) United States
Annual growth rate Trend growth
-1
0
1
2
3
4
5
6
7
8
Pro
du
ctiv
ity
Gro
wth
(%
)
Japan
Annual growth rate Trend growth
-3
-2
-1
0
1
2
3
4
5
6
Pro
du
ctiv
ity
Gro
wth
(%
)
Germany
Annual growth rate Trend growth
Downshift in Trend GDP
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
1981 1986 1991 1996 2001 2006 2011 2016
No
min
al G
DP
%Yo
Y
US Nominal GDP Source: Bloomberg, Bureau of Economic Analysis
US Nominal GDP Growth 5Y Trend GDP Growth
• Introduced to improve security, minimal impact initially (prudent actuarial Going Concern valuations)
• As market yields fell sharply:
– Solvency Liabilities rose, dominating GC
– Interest rate risk became the main
investment risk (along with mark
to market volatility)
– More desire to remove interest rate
risk (and add diversifying return premia)
• CBs keeping rates low for surprisingly long time
• Temporary easing rules were introduced
• Now more permanent changes considered – Quebec, Ontario, BC, Sask, Others?
Solvency Recap
Going
Concern
ratio
Solvency
ratio
Morneau Shepell News & Views Feb 2017
• Firstly, there is uncertainty as to how Regulators will ultimately amend/replace Solvency rules
• However, early signs are of 2 main approaches
1. ‘Weaker’ solvency tests (e.g. lower funding threshold)
2. No solvency test but a stronger GC test; the assumed wind-up test using market bond yields will become more of a long term sustainability test
Longer term, say 10 or more years for funding
Discount rates based on expected returns; asset mix then matters
Inclusion of margins (PfADs – Provision for Adverse Deviations)
Higher margins if there are more equities
Additional margin if the expected return (GC discount rate) is greater than a reference rate
New Regimes?
So Drop Interest Risk Awareness?
Year
Benefit
Cashflows
• No
• LDI is not merely a product or solution, it is a process
• Obligations are still a stream of cash flows to be delivered
• This profile continues to form part of the risk & mix decision
• Ignoring market timing, bonds will still have a strategic part to play
GDP and Bond Yield Correlation
0
2
4
6
8
10
12
1980 1985 1990 1995 2000 2005 2010 2015
Per
cen
tage
(%
)
Nominal US GDP vs 10Y Treasuries – 7Y Moving Avg. Source: Bloomberg
10Y US Treasury Yield Nominal US GDP Growth YoY%
Expected Returns In Fixed Income
0%
5%
10%
15%
20%
25%
1980 1985 1990 1995 2000 2005 2010 2015
Per
cen
tage
%
Barclays US Aggregate Bond Index Source: Bloomberg
Return Starting Yield at time of investment
Expected Returns In Fixed Income
Decade
Average US Nominal GDP %
YoY
Average Starting Yield at Time of
Investment (Corporate Bond Index)
Average Return (Corporate Bond Index)
1980s 8.0% 10.9% 11.9%
1990s 5.5% 8.3% 9.3%
2000s 4.1% 6.0% 6.5%
2010s 3.7% 4.3% 5.2%
Current 2.9% 2.5% 2.5% +/- 1.0%
Diversification Remains Important Plans Should Play To Their Competitive Advantages
0%
20%
40%
60%
80%
100%
0%
20%
40%
60%
80%
100%
Expected Returns In Equities
Earnings Yield:
Dividends & Share
Buybacks
Earnings Growth:
Corporate Margin
Expansion & Sales Growth
Valuation Adjustment:
Mean Reversion of
Price/Earnings Ratio
Expected Returns In Equities
Earnings Growth
Earnings Yield
Valuation Adjustment
Other Unexplained
Total Return
1980s 5.1% 8.9% 5.6% -2.4% 17.2%
1990s 7.6% 4.9% 7.1% -1.5% 18.2%
2000s 1.5% 5.2% -4.2% -3.5% -0.9%
2010s 9.3% 6.1% 1.1% -3.6% 12.8%
Current 2.9% 4.8% -1.2% - 6.5%
Valuation Multiples and Interest Rates
-
2
4
6
8
10
12
14
16
18
0
5
10
15
20
25
30
35
1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017
10
-Yea
r G
ovt
Bo
nd
Yie
ld
P/E
Rat
io
S&P500 Price/Earnings Ratio vs 10-Year Govt Bond Yields Source: Bloomberg
S&P500 P/E Ratio 10-Year US Government Bond Yield
• Bonds remain but need to be reviewed for their fit in a new environment
• Diversification of return seeking assets remains important
• Revisit the trade-off that may have been made; volatility vs return expectation
– Is it now too large? Have you ‘overpaid’ for lower volatility?
– Models may have placed (too) high a value on (perceived?) low volatility?
– Were some asset classes or products excluded that might be of value?
• May lead to the ability to accept more risk if it is expected to be rewarded
– Accepting short term market volatility for additional long term return
– The split between active and passive management may be affected
• Particularly if active returns come with short term volatility
So What Could It Mean For Portfolios
Thank You
Ben Homsy, CFA
Portfolio Manager, Fixed Income
Marc Williams, CFA, F.C.I.A.
Portfolio Manager
