Is it time to re-risk?

Is that light we see at the end of the tunnel? It certainly could be—Canadian DB pension plans ended 2013 in the best shape they’ve been in for over a decade according to the Mercer Pension Health Index. And the median solvency ratio is also on the rise, up to 93.4% at the end of 2013—an impressive 24.8 points higher than it was a year ago according to Aon Hewitt.

It’s all good news for plan sponsors who’ve struggled mightily with a toxic combination of historically low interest rates and extreme equity market volatility.

Given all the positive signs, there’s one question we’re hearing a lot more of these days, especially from plan sponsors who made the decision to de-risk: is now the time to temporarily re-risk to take advantage of better circumstances?

It’s an important question to ask, especially as plan sponsors eye rising rates. Higher interest rates would certainly give DB plans considerable relief on the funding side of the equation.

But should sponsors be re-risking their DB plans?

Let’s first look at the reason why plan sponsors made the decision to de-risk in the first place—to reduce funded status volatility. Opting for a liability-driven investing (LDI) approach has given many DB plans freedom from the ups and downs of market gyrations. They’ve instead focused on selecting assets that match the interest rate risk of all or some of their liabilities (i.e. generally long-duration bonds). To get there, most sponsors have taken a gradual approach: a glide path with triggers that reduce risk as a plan’s funded ratio or discount rate increases over time.

Stepping off that glide path in pursuit of better returns could more quickly move a DB plan closer to that goal of being fully funded. Does that mean it’s a worthwhile move? Unfortunately, we don’t have a simple answer. Much depends on the position of the plan and its risk tolerance. However, for those plan sponsors who are considering re-risking, there are five main factors to address before making the call:

1. Governance—Pension committees didn’t make the de-risking decision easily. It took a lot of education and deliberation. Are you prepared to reopen this discussion and recommend a temporary move in the opposite direction? Sophisticated and active boards might be better able to handle the process. But in some cases securing board approval for such a move could add confusion within the big picture de-risking process.

2. Market timing—The whole purpose of de-risking is to pull DB plans off the return-chasing treadmill and put the focus on what is all-important—delivering on the pension promise. Plan sponsors that re-risk must have a strong conviction about where markets are headed over the next couple of years. For example, if you’re not certain about where interest rates are headed (and who really is?), then re-risking might not be a good move.

3. Risk tolerance—De-risking glide paths tend to be customized to the risk tolerance of a specific pension plan. If re-risking proves unsuccessful, then a plan could end up in worse shape than it was in the first place. Plans with a high funded ratio (above 100%) might be better able to recover than plans that aren’t as well funded; they could face a long and painful climb back.

4. Costs—Making the decision to re-risk will mean liquidating some assets and buying others leading to higher expenses. And since the re-risking decision is a tactical one, plan sponsors should understand there would be additional costs when moving back into the de-risking glide path.

5. Contributions—If there’s a large contribution scheduled that will improve the funded ratio, then plan sponsors might want to take re-risking off the table. Even if that’s not the case, contribution schedules should be closely looked at before making the re-risking move.

Of course, not all plan sponsors have made the move to de-risk—and in those cases, higher interest rates and improved equity returns might pull them in a different path altogether. But for those plans already in the process of de-risking, caution is advised. While it’s human nature to act tactically in response to changing market conditions, plan sponsors must remember why the glide path was put there in the first place: to ensure stable funded status and long-term sustainability.

Patrick De Roy is an institutional portfolio manager with Pyramis Global Advisors, based in the firm’s Montreal office. François Pellerin is an LDI strategist at Pyramis Global Advisors, based in Merrimack, New Hampshire. These are the views of the authors and not necessarily those of Benefits Canada.