The Nova Scotia Asso-ciation of Health Organi-zations spent a year reviewing its pension plan — and has made important changes as a result. Among those changes: adjusting how, and how much, money is invested in hedge funds. The NSAHO also has decided to stop using the firm that had managed its plan for the past four years.

Local media reports have linked the two, but that is not the case, according to Calvin Jordan, CEO of the NSAHO pension plan in Halifax. Both moves, he says, “…reflect a change in the philosophy on the part of our trustees.”

Part of that philosophy is a new approach to risk management and a decrease in the amount invested in bond alternatives, Jordan says. As well, the fund’s trustees have put a cap on any single category of investing alternatives, while at the same time broadening the overall number of alternatives that the fund may invest in.

Hedge fund investment by pension plans has always been controversial. In a global economic downturn, it is even more so. “What’s appropriate depends on the individual fund,” says Frank Belvedere, national partner with Mercer Investment Consulting in Montreal. “It depends on the comfort level.”

That comfort level, or risk tolerance, will vary from pension plan to pension plan. “Depending on a fund’s investment strategy and long-term objective, a pension fund will tailor its risk tolerance profile and invest accordingly,” notes Leon Chin, partner, financial services, and leader of the Canadian hedge fund practice with accounting firm Ernst & Young LLP in Toronto. “As evident in the current market environment, there is always an element of risk when investing. But one of the key responsibilities of pension fund managers is to balance those risks and obtain an acceptable level of return in keeping with the overall philosophy.”

Part of that philosophy, of course, is the need to generate sufficient revenue to meet future demands on the fund by its members. “Pension plan funding is somewhat different, in that it is liability-driven,” notes Tony Lennie, director of finance for Victoria College at the University of Toronto. “As a result, you must be prepared to accept a certain amount of risk if you are to meet your liability target.”

The NSAHO’s pension fund, the largest provincially regulated plan in Nova Scotia, with roughly $2.5 billion in assets under management, has had 15% of its net AUM in bond alternatives. Indeed, says Jordan: “We had a significant allocation in hedge funds before and will continue to have a significant amount in hedge funds.”

The right level is an individual decision, but the NSAHO may have been atypical in its use of hedge funds. “There would be very few funds in Canada that have more than 7% [invested in hedge funds],” says Belvedere. “In the U.S. — endowments, in particular — will go to 10% or 15%. Hedge funds are still a relatively new asset class, and they are the most complicated class. The newness and complexity of the hedge fund industry has led to periodic problems with funds blowing up and fraud. There is the potential for catastrophic loss. With a pension fund, you want to be very prudent.”

It’s also important to understand how hedge funds and pension plans operate: they are not synonymous in their goals. “Hedge fund management is taking both a long and short position,” notes Belvedere. “Pension funds traditionally have taken the long [position] only.”

Concerns over high levels of hedge fund investment — often exceeding 30% — last year led Standard & Poor’s Corp. to issue a report warning health-care organizations that such investments could cost them their credit rating.

“Many not-for-profit hospitals and health systems have changed their investment policies over the past few years to allow for investment in alternative investments, and specifically hedge funds,” says Kenneth Rodgers, a credit analyst with S&P in New York. “Since these types of investments are lightly, if at all, regulated; often employ leverage; may have liquidity restrictions [so-called ‘lock-up periods’]; and generally have been somewhat opaque as far as their strategies, we feel health systems need to have frequent reviews of their exposure to these financial instruments and should have clearly defined and followed investment policies.”

On the plus side, notes Lennie, hedge funds “help over the long run, because they are not as highly correlated with other asset classes, so they help to reduce the volatility and provide capital preservation in bad times.”

@page_break@Indeed, says Belvedere, hedge funds will draw down much less than equities markets, especially in a falling market. He notes that overall, equity funds this year are down by roughly 25%; hedge funds are down by only about 8%.

Canada’s pension plans are clearly feeling the effects of that volatility. After two years of “significant net improvement,” there has been little net change — but significant unpredictability — in the funded positions [as measured using generally accepted accounting principles] of Canadian pension plans over the first half of 2008, according to recent analysis conducted by Watson Wyatt Worldwide, the global consulting firm.

Reflecting the sharp decline in equities markets early this year, typical pension-funded ratios have dropped by three percentage points, from 106% to 103% in the first two months of 2008. This was followed by an eight percentage point gain from March to May and then another four percentage point drop to 107% in the month of June.

“While pension funding levels were slightly better at the end of June than at the end of 2007, they remain highly volatile,” says David Burke, retirement practice director of Watson Wyatt’s Canadian offices.

The analysis also found that over the first six months of 2008, conservatively invested funds had positive returns that tracked close to long-term expectations. Aggressively invested funds (those with 50% or more invested in equities) did not. Such results may send more pension fund trustees into review mode. More shifts in philosophy — as well as investment allocations — could well follow, but it is unlikely that pension funds will turn a cold shoulder to hedge funds.

Says Chin: “We believe hedge funds will continue to play an important role in the asset-allocation strategies of pension plans, as they offer pension funds a way to expand their options.” IE