Introduction to asset allocation

There is no formula to developing an investment portfolio in a defined contribution (DC) pension plan that precisely suits each member’s individual goals and needs. However, it is the case that a very well-diversified balanced or multi-asset investment fund can and should form the foundation of most members’ investments carried in the DC pension plan.  

Asset allocation refers to how an investment portfolio is divided or “split up” amongst different asset classes.

Asset classes include stocks or equities, bonds and fixed-income investments, real estate investments, infrastructure investments, etc. Asset allocation is one of the most important decisions that investors make as the lion’s share of long-term risk-adjusted investment returns is driven by the asset allocation decision.  

It is for these reasons that CSS spends significant time and effort every four or five years, with the support of its professional advisors, ensuring that our Balanced Fund continues to be designed to meet its long-term risk and return objectives looking forward.  

CSS’ asset allocation (or portfolio construction) process 

CSS is currently undertaking a portfolio study to assess the current asset allocation of our Balanced Fund to determine whether the expected long-term risk-adjusted investment performance of the Balanced Fund could be improved for our members through changes to asset allocation in the Fund. We thought this would be an ideal time to share with our members how CSS approaches the asset allocation (or portfolio construction) process. 

Steps:

1. Analysis and comparison to relevant market reference points: CSS compares our Balanced Fund to peer/competitor product asset allocations. Are others using asset classes we are not and benefitting from those? Are our peers/competitors using similar asset classes to CSS but investing in those classes in different proportions than CSS? Are those differences leading to benefits in those peer/competitor portfolios? 

2. Model identified differences from #1 above: With the assistance of its professional investment advisors, CSS models peer/competitor products and our Balanced Fund to directly compare all products against CSS’ risk and return objectives. Risk and return objectives include: 

   1. The risk of not meeting our long-term return objective (inflation + 4%) over rolling 5-year periods 

   2. The average expected loss in the worst 5% of possible outcomes 

   3. The number of expected negative returns in a 20-year period 

   4. The minimum return expected in stressed market environment scenarios 

   5. The absolute risk (volatility of returns) of the portfolio 

   6. The maximum exposure to any one risk factor 

   7. The liquidity risk (ability for CSS to enter/exit investment positions to support member financial needs) of the portfolio 

   8. The investment fees associated with the portfolio (i.e., is CSS generating value for money for our members through our asset allocation choices) 

3. Assessment: Analyze the modeling results to determine if exposure to, or differing levels of exposure to, an asset class(es) could offer improved long-term risk and return outcomes for CSS and our members. 

4. Based on the learnings from step 3, create alternative CSS Balanced Fund asset allocations to model against the latest long-term investment return, risk and correlation expectations. 

5. Each of the possible alternative portfolios is modeled and compared to the existing Balanced Fund and its current long-term expected return and risk outcomes. To provide further insight each of the alternative portfolios (and the current Balanced Fund) are stress-tested against a number of possible economic scenarios that might occur in the future (i.e., Global Liquidity Crisis, Goldilocks, Hard Landing, Return to Stimulus, Overheated Economy, Stagflation, Major Conflict, Return to Stable, Secular Stagnation – see below for descriptions of these scenarios). 

6. Based on the learnings and information obtained through step 5, additional iterations of modeling of revised alternative asset allocations within the Balanced Fund are conducted in an attempt to optimize the expected long-term return and risk outcomes. 

7. Management and the Board objectively assess the potential pros and cons of the revised portfolios. There are often trade-offs to consider such as:

   1. higher returns generally mean more risk is being undertaken; accordingly, we focus on improvements in long-term risk-adjusted returns or returns per unit of risk being undertaken 

   2. accessing certain asset classes can improve risk-adjusted returns but correspondingly decrease the liquidity of the portfolio 

   3. accessing certain asset classes may result in higher expected risk-adjusted returns but with the certainty of higher expected fees or higher internal administration costs 

   4. additional asset classes can increase the level of governance and oversight required to administer and manage the portfolio 

   5. to provide daily pricing and liquidity to our members, there are limitations on the amount of illiquid assets and assets which are not marked to market daily that can be considered for our investment portfolio 

Next step:

Once the CSS Board determines that changes to asset allocation are desired, CSS Management is tasked with transitioning the portfolio to the new allocation. Depending on the complexity of the changes, it can take several months or even years to fully implement. 

If new asset classes or mandates are to be added then CSS Management, with the assistance of an external investment consultant, undertakes a search for an appropriate asset manager and product. The search process typically includes a series of phases to narrow the field of potential asset managers down to a small group that is deemed best suited to address the Plan’s needs. This due diligence process can take several months or more to complete.   

Upon selection of an asset manager, contracting, documentation and other steps to partner with the new asset manager occurs. This process can also take up to a few months to finalize.  

Finally, the time comes to fund the new asset mandate. Depending on what existing assets the Plan has to exit to fund the new investment, the availability and accessibility of investable assets in the marketplace, and other factors (for example, mitigating “point in time risk” in selling and buying investment assets), the funding process can vary significantly in the time it takes to fully invest in the new asset mandate. The funding process by itself can take years to complete.  

Conclusion: 

We hope this article has given you a bit of an inside look at the care and diligence that the CSS Board and Management undertake on your behalf to build and evolve the custom-tailored investment products that are exclusively available to members of the CSS Pension Plan. 

While there are no crystal balls when it comes to investing, our regular review and modeling of forward-looking capital market assumptions for a wide and diverse set of potential investment assets, and our very mature and earnest approach to assessing whether asset allocation changes are expected to improve long-term risk-adjusted investment returns for our members, is a hallmark of CSS’ investment philosophy and continues to position our members for financial security in retirement. 

Scenario descriptions: