Derisking strategy needed for Pension plans
TORONTO—Defined benefit plans represent a substantial risk to many organizations – these companies need to devise a comprehensive strategy to lower their risks. That’s the major conclusion of a new research study by the Canadian Financial Executives Research Foundation (CFERF) which shows that almost 60 per cent of financial executives surveyed indicated that their pension plan posed either a moderate or substantial risk to their organization. The research project was sponsored by Mercer.
At the end of 2012, only about one in 20 Canadian DB pension plans were fully funded on a solvency basis. By far, the biggest factor in the decline is the fact that long-term interest rates have plunged to their lowest levels in 60 years. Disappointing asset returns, demographic pressures and the increasing maturity of pension plans have also played their part.
“The results indicate that hope for better days is not enough and that Canadian corporations must stop depending on investment returns or increasing interest rates to cover pension funding deficits. Organizations need to plan ahead to lower risk to their plans, through a combination of strategies,” said Michael Conway, Chief Executive and National President, FEI Canada.
“DB plan sponsors who wish to derisk their pension plans do have options,” noted Manuel Monteiro, a Partner in Mercer’s Financial Strategy Group. For example:
• Risks could be transferred to another party such as an insurance company through an annuity purchase for some or all the plan members;
• The benefit policy could be changed to transfer or share risks with employees (such as moving to a DC plan or a target benefit structure);
• Investment policy could be changed to reduce the mismatch between assets and liabilities, or to protect against extreme events; and,
• Funding policy strategies could be employed in order to manage the amount and plan the timing of contributions.
Monteiro added, “Each of the derisking strategies have their pros and cons – some take effect quickly but are very painful to implement, some will likely only defer the pain, and others are very effective in the long term but do not provide much short-term relief. This suggests that an effective derisking strategy will often involve the use of multiple approaches working in concert.”
Many plan sponsors are looking to modify their plan design as part of their risk reduction strategy. Of survey respondents with DB plans, 58 per cent remain open to all employees, 37 per cent are closed to new entrants with existing employees continuing to accrue DB benefits, and 6 per cent are closed to new entrants, with no further DB accruals for current employees.
Almost one third of participants said they were either somewhat likely or very likely to close existing DB plans to new employees while continuing benefit accruals for current employees. The majority (62 per cent) of organizations which have made or are considering changes to their DB plans cited the level and volatility of funding contributions as a very important driver of that change. While plan design changes such as moving to a DC plan can be effective in reducing risk in the long term, they do not have much effect in the short term. Sponsors looking to reduce risk in the short term need to turn to investment policy and/or risk transfers.
A critical observation is that the current environment – where plans are deeply underfunded and interest rates are at historic lows – is the most difficult time to make a significant derisking move through investment policy or a risk transfer. However, this does not mean that the status quo should be preserved. Plan sponsors should be planning a comprehensive strategy for derisking, in incremental steps, and using many of the tools available to them. Mapping out a strategy in advance is crucial so that decisive actions can be taken when derisking opportunities present themselves. One such approach is a dynamic derisking strategy – under which the asset mix is shifted gradually from equities into bonds, as the funded status improves. 48% of respondents said they were very likely or somewhat likely to introduce dynamic derisking strategies in the next two years.
A clear example of a derisking opportunity occurred in January 2013. Equity markets did well, and long-term interest rates rose in the first month of the year. Mercer’s Pension Health Index rose from 82 per cent at December 31, 2012 to 86 per cent at January 1, 2013. In this single month, this hypothetical plan would move more than 20 per cent of the distance to the goal line (a fully funded position). Many plan sponsors who have established a dynamic derisking plan will have moved quickly to lock-in some of these gains and taken some risk off the table. To the extent that the market reverses over the next few months, that opportunity will have been lost for those who have not mapped out a strategy.