© Copyright 2002 Rogers Media. The following article first appeared in the April 2002 edition of BENEFITS CANADA magazine.

The battles for the surplus on canadian defined benefit (DB) plan balance sheets are over. It's not that somebody won the surplus struggle and another party has lost it. It's just that there are no surpluses left to fight over.

How did this happen with such shocking speed? While pension plan stakeholders were divvying up the surpluses they thought they had, the financial markets were busy marking pension assets down, and pension liabilities up.

Whether they like it or not, fund fiduciaries now face a new and far less pleasant question: how much more money might have to be put into the pension plan tomorrow to meet the plan's promises to members, and where will that money come from?

They also need to address a related question: does underwriting the risk exposure associated with the standard 60 fixed income/40 equity asset mix make as much sense today as it has historically?

NEED TO REDUCE EXPOSURE
The answer to the latter question is likely 'no' on three counts. First, the surplus battles of the 1990s have taught us that surpluses are shared--no matter who might be underwriting the downside risk on the pension plan balance sheet. In this regard, there is a notable asymmetry between reward sharing and risk bearing inherent in the typical DB plan.

A second reason for reducing risk exposure on DB balance sheets in the years ahead is that the ratio of retirees to active employees is rising. Future asset shortfalls will have to be made up by a relatively smaller group over shorter periods of time.

Finally, the historically fat 4% equity risk premium provided a material reward for bearing long-term investment risk. Today, even after two years of disappointing equity returns, there is still no material risk premium embedded in stock prices. (If you doubt this, just add 2% for the current dividend yield to 2.5% for future real dividend growth, and then subtract 4% for the yield on real return bonds. That gets you a tiny 0.5% current equity risk premium, which is a far cry from the historical 4%.)

All this leaves the fiduciaries of DB plans with some tough choices. The most fundamental question is whether it makes sense in the circumstances set out here to undertake any investment-related balance sheet risk at all. This question is especially relevant for 'old economy' plan sponsors that have pension assets and liabilities of the same magnitude as the assets and the liabilities of the corporation itself.

From a shareholder perspective, are these kinds of organizations best positioned to take on and manage risk from their corporate or pension balance sheet? From a plan member perspective, if things go wrong on the pension balance sheet, is the company financially strong enough to deliver on its pension promises?

If the decision is made to generate excess returns on the pension plan balance sheet, it is going to have to be done differently than before. The old 60-40 formula with a little active management thrown in for good measure simply won't do the job today. As we have already noted, today's prospective equity risk premium is too small to carry this burden. New investment policies will have to be built around some investment mix of selective holding and trading strategies expected to generate an adequate reward-to-risk ratio.

All this raises some challenging issues for pension plan fiduciaries. How much risk exposure is there on the pension plan balance sheet today? Is it too much? What is the right amount? How much extra return should the right amount of risk exposure produce in order to justify the risks undertaken? Are we organized to manage risk and return in this manner? If not, what should we do?

The era of return management is over. The era of risk management has begun. Are you ready?BC

The Romanow Commission has released its final report on the future of healthcare in Canada.

For Commissioner Romanow's recommendations, click here.

Click here for Senator Michael Kirby's report, "The Health of Canadians – The Federal Role: Recommendations for Reform."