Pension plans are investing with far too much risk and must adapt to achieving lower levels of returns, Mercer pension consultant Malcolm Hamilton said on Tuesday.

Speaking at a Toronto CFA Society conference on pension plans, Hamilton said pensions have become reckless in the investment risks they take. He pointed to a recent trend among pension funds to increase exposure to equities and alternative investments such as real estate, commodities and private equity, and to pursue alpha-chasing investment strategies.

“Pension plans are voluntarily taking more risk than they should,” Hamilton said. While he admitted that there is a place for these investment strategies, he said pension funds need to recognize the significant risks that are involved.

He pointed to pension fund solvency funded ratios, which have fallen from 104% to 72% in the past 14 months. Furthermore, the typical 2008 loss for pension funds was 25%, he noted.

“That’s a huge loss,” Hamilton said. “That doesn’t speak to good risk management, that speaks to recklessness.”

Pension funds became accustomed to unusually high rates of return during the 1980s and 1990s, according to Hamilton. In the current environment, the same rates of return demand that investors take on much more risk.

“The plan designs and the corporate expectations, the sponsor expectations, the member expectations all got set during two decades of unusually good experience,” he said. “It’s the reluctance to say that period is, for the foreseeable future, over. We need to ratchet down our expectations.”

The extremely volatile market environment in 2008 was a major stress test for pension plans, and should be a wake-up call for funds to reduce their exposure to risk, Hamilton said.

“There’s probably never been a less opportune time to de-risk than today.”

But Hamilton admitted that many plans are unlikely to learn from their recent mistakes and instead, will simply wait for markets to recover, maintaining their existing investment strategies.

If pensions don’t voluntarily reduce their exposure to risk, regulators could step in, according to David Gordon, deputy superintendent of pensions at the Financial Services Commission of Ontario, who also spoke at Tuesday’s conference. He said the events of the past year have prompted the regulatory organization to increase monitoring of pensions’ risk.

“Although this is a time of great challenges for the industry, it’s also a time of great opportunity to fix some of the problems we’ve had,” Gordon said.

He noted that the Canadian Association of Pension Supervisory Authorities has recently established a working group to examine the industry and publish a new set of guidelines on investment and funding policies. The group is set to release guidelines for public consultation at some point in 2010, Gordon said.

He added that the federal government’s national consultations on private pensions, which are currently underway, could lead to important industry changes.

“We’re closely monitoring what the federal government is going to do with those rules,” he said.

On the topic of pension fund industry consolidation to create larger ‘super funds’ — a proposal recently floated by Michael Nobrega, president and CEO of the Ontario Municipal Employees Retirement System — Hamilton said potential advantages for small private sector funds are clear. Nobrega called for government-mandated consolidation as a way to improve the competitiveness of Canadian pensions in the global investment realm.

“There are advantages to scale,” Hamilton said. “It does give you access to investments that you otherwise wouldn’t have access to and it does probably bring costs down.”

IE