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2012-10-Path

The ancient Romans are widely considered to have been master engineers and builders. One of their many innovations was the design and construction of a massive network of roads spanning across what would encompass much of continental Europe. Since Rome was the centre of the Roman Empire, the system of roads was created to facilitate the flow of people, goods and weaponry to and from the Roman capital—hence the idiom “all roads lead to Rome.”

Modern-day DB pension plan sponsors struggling against the combined forces of low interest rates and volatile investment markets would be wise to study their maps carefully. They, too, have different roads to choose from for the journey to their proverbial Rome: a healthy, sustainable pension plan that benefits employers, plan members and society as a whole. But sponsors must tread carefully, as some roads will no doubt offer a smoother and quicker path than others.

For many plans, the path starts with a steep uphill climb. Financial conditions today are considerably less favourable, even when compared to conditions just four years ago. As noted in the table below, it has been a period of low and volatile stock market returns and an era of historically low interest rates, and the cost to transfer DB risk via an annuity purchase is materially greater, as evidenced by the significantly lower proxy discount rate published by the Canadian Institute of Actuaries (CIA).

Roads to de-risking

Plan consolidation- Complex plan structures with multiple benefits structures, different strategies and multiple providers are fraught with risk and carry significant oversight and maintenance costs. Plan sponsors can achieve operational efficiencies and improve fiduciary oversight simply through plan and provider harmonization and consolidation.

Benefits redesign - Enabling legislation is being introduced by Canadian regulators that now understand that a new hybrid approach will be necessary to ensure the long-term sustainability of workplace pensions. These new plan structures will allow plan sponsors to explicitly share some risk with members.

Funding strategies - Cash flow can be better managed through the use of solvency relief provisions, letters of credit, pre-funding strategies to build credit balances and valuation timing. It is imperative for plan sponsors to stay abreast of the constantly evolving legislation—for example, the proposed solvency reserve accounts in B.C. and Alberta will create new opportunities for plan sponsors to manage cash.

Dynamic investment de-risking - To stay nimble in the face of market volatility and capture market opportunities when they arise, many pension plans are using dynamic strategies, which trigger automatic changes in asset allocations when predefined financial or market thresholds are met.

New investment tools- Leverage and derivatives are effective tools for better managing pension plan asset portfolios relative to their liabilities, but Canadian plans have been slow to adopt these strategies due to their reputation for creating rather than mitigating risk. As well, real estate, infrastructure, high-yield bonds and low-volatility equities are blurring the traditional lines between return-seeking and liability-hedging assets.

Risk transfers and buyouts- Some anecdotal evidence indicates that Canadian pension plans are beginning to explore non-traditional ways to transfer risk to a third party. Early indications suggest that buy-in annuities may offer corporate plans an opportunity to off-load risk without the financial impact on the plan sponsor that would otherwise come with a traditional annuity purchase. There have also been financial transactions designed to protect against longevity risk. Lastly, two recent high-profile U.S. examples involving the purchase of billions of dollars of annuities and the payment of lump sums would suggest that what previously seemed impossible may soon become possible, as capital markets, insurers and legislators all adapt to meet the demands of an evolving pension market.

Unfortunately, plan sponsors’ desire to de-risk and their ability to do so have never really intersected. The best opportunities to de-risk arrived when there appeared to be little reason to consider de-risking, since plans were healthy and markets were soaring, as was the case in the early 2000s and again just prior to the start of the financial and credit crisis in 2008. Now, when few can afford to lock in the losses of the recent past, more plan sponsors are interested in de-risking than ever before. According to Towers Watson’s 2012 Pension Risk Survey, for 53% of Canadian DB plan sponsors, reducing risk over the next year is a top priority, up from 36% in 2011.

But plan sponsors need to look forward, not backwards. And although markets may not be particularly conducive to investment de-risking right now, plan sponsors should not limit themselves to investment solutions, as there are many roads to de-risking a pension plan, including restructuring the liabilities by changing the plan design, managing cash by altering the plan’s funding strategy or settling a portion of the obligations to reduce the size of the plan. And plan sponsors should not overlook ways to improve governance processes and reduce operational costs and risks (another way of reducing risk).

Define the destination
The first step in mapping out the de-risking journey is to better define the destination by understanding how that ideal end-state differs from the current situation. Do you wish to improve the funded status, shrink the size of the plan, reduce future uncertainty and volatility, or perhaps remove the DB pension obligations completely? Of course, the financial objectives that are established are unique to each plan sponsor organization and need to be viewed in the context of that organization’s financial objectives. For corporate plan sponsors, the impact of the pension financials on the corporate financials is critical in assessing what the ideal end-state should look like. For many public sector pension plans, long-term sustainability and cost stability are the key financial goals. And for all plan sponsors, it is also important to consider non-financial goals. Interestingly, as DB pensions become less prevalent, their perceived value has increased. For instance, according to Towers Watson’s 2011/12 Retirement Attitudes Survey, 68% of Canadian DB plan members age 50-plus would accept a smaller pay increase in exchange for a guaranteed retirement benefit.

As a result, those employers that can better manage their plans—and thus maintain them—may enjoy a competitive advantage in their future campaigns to attract, retain and engage talent. Even today, some industries in Alberta, where the demand for certain skill sets significantly outpaces supply, are using pension plans as a drawing card.

Some plan sponsors have begun to push the boundaries of traditional design, creating new DB/DC hybrids not seen previously. For example, a plan that provides defined benefits up to given earnings or service thresholds and is topped up with DC benefits above those thresholds doesn’t fit neatly into the traditional DB and DC labels. Instead, it offers a means for sharing risk while still providing a base level of benefit security to plan members. As well, provincial governments are now amending legislation to allow for plan designs that explicitly share the risk between plan sponsors and the plan members.

For example, Ontario, Nova Scotia, New Brunswick and B.C. are all at various stages of creating legislation to accommodate new pension plan structures, such as target benefit and shared risk pension plans. These new designs will allow for benefits to be decreased if assets plus expected contributions prove to be insufficient.

The ideal road to take depends not only on the plan sponsor’s vision for the future but also on the opportunities that are available in the marketplace today and the opportunities that may be emerging tomorrow. The list of de-risking tools is long and they range from plain vanilla to exotic and leading-edge strategies. Each plan sponsor, therefore, should investigate and understand what opportunities can realistically be executed today and those that may not be implementable today but are nevertheless worth waiting for. It is difficult to make informed decisions without first seeing the full spectrum of possibilities.

Prepare for the pilgrimage
With map in hand and a carefully planned route, the next step is to adequately prepare for the journey. It is critical at this stage to think about operational readiness. Because opportunities to de-risk can be fleeting, priorities should be set, and plan sponsors should ensure that they’re ready to act when the window of opportunity opens. For example, if you intend to purchase annuities in the future if certain conditions are met, then you should ensure that your retiree data is complete, up to date and error-free, as this step will be critical in speeding up the annuity purchase process down the road. Communications with members should also be planned out well before the day arrives, so adequate attention can be given to this important task.

A key requirement in the de-risking journey that is often overlooked is the need to monitor. The plan sponsor will need frequent updates of the plan’s funded status—how will this be accomplished, and by whom? What data will be needed, and will that data be available quickly enough? Traditionally, actuarial valuations take months to complete, but you’ll need
to work with your actuary to produce reasonable estimates more quickly, especially if a dynamic investment de-risking strategy is part of the plan.

And to ensure that there are no snags in executing the de-risking journey plan, all those involved should clearly understand their roles and responsibilities. Thus, it is important to ensure that the plan sponsor’s HR, finance and treasury staff, the consultants, investment managers, custodian and any insurance companies involved all know what they are responsible for and
the timelines they need to adhere to.

It’s been four years since pension plans felt the shock waves of the 2008 financial and credit crisis. Yet the recovery at best has been tepid, and many plans are no better funded today than they were at the end of 2008. If there is a lesson to be learned from these past four years, it’s that markets can move quickly and unpredictably. And it’s well documented that behavioural biases can often stand in the way of making “appropriate” investment decisions, especially at times of crisis and uncertainty. Plan sponsors that have done their homework and achieved a state of readiness will be able to overcome those biases and act more nimbly and decisively when opportunities emerge.

There are indeed many roads to Rome. Which road will you take?

Kevin Tighe and Ken Choi are senior consultants with Towers Watson. kevin.tighe@towerswatson.com; ken.choi@towerswatson.com

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© Copyright 2014 Rogers Publishing Ltd. This article first appeared in Benefits Canada.

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