In the wake of the financial crisis, few would debate that defined benefit (DB) pension plans have become a major financial management issue for plan sponsors. With long-term interest rates at their lowest levels in more than 50 years and equity markets 25% below their previous highs, sponsors are again facing their “perfect financial storm.” This problem is compounded by the speed with which the pension environment is changing. In response, financial executives are taking an increasingly active role in all facets of the pension decision-making process and managing plans within a total enterprise risk context.
To start the journey, plan sponsors must explicitly consider two different sets of objectives. The fiduciary objective must always be to “adequately” protect the benefits owed to the beneficiaries—how “adequate” is defined and which liability should be used to measure it remain a matter for each plan sponsor to define. The corporate objectives should recognize the key trade-off between the need to maintain average costs at an affordable level in the long term and the need to manage the variability of those costs within tolerable levels.
How the key cost measures are defined should directly relate to how the plan sponsor’s performance is assessed by its external stakeholders. The metrics must recognize the potential consequences of failing to meet those objectives—for example, if additional contributions are required, from which budget will they be drawn and how critical is that budget to the future success of the plan sponsor. This enterprise risk framework should help to better maintain the financial strength of the plan sponsor and, ideally, maintain the DB plan as a viable entity for future employees.
Risk Talk
Most of the talk in risk management circles has been about implementing liability driven investing (LDI) strategies, which attempt to manage volatility of the key funded ratio by hedging or minimizing the interest rate and inflation sensitivities of pension liabilities (i.e., making the bond portfolio behave more like the liabilities). While this is clearly a key financial risk for DB plans, at today’s interest rates it is the smaller part of the risk management puzzle. (The time for LDI strategies was back in the late 1980s, when long-term interest rates were in double-digit territory.)
The main financial risk facing plan sponsors now is “mismatch” risk. In effect, assets can be placed into two categories: matching and return-seeking (or risky) assets. Matching assets are those that behave like the key liability measure—as a rule, the higher the proportion of the fund invested, the lower the return and the less variability in the key financial metric. Return-seeking asset categories generally do not behave like the liabilities but typically have a higher expected return. Many plan sponsors have historically struggled to find the right balance between these two categories.
Journey Plan
To better manage the DB financial risk, plan sponsors should develop a journey plan to get the level and variability of the key cost measures in better balance. This involves defining what cost levels are affordable at different parts of the plan sponsor’s business cycle, and how much those costs can vary from year to year. It is then possible to solve for a funded level and asset mix that jointly will manage the costs to those financial objectives. A series of thresholds can then be defined (based on continued affordability of the plan) at which assets will be transferred from return-seeking to matching. Having this journey plan approved in advance makes it much easier to actually implement the changes as these levels are achieved.
Developing robust financial objectives within the context of your business is a clear first step to better managing the DB pension financial risk. The next is providing a journey plan to get you to the optimal blend of return-seeking and matching assets. Although the road will be long, starting the journey is the necessary first step to ensuring success in the new financial era. BC
David Service is a pension consultant with Towers Watson in Toronto. david.service@towerswatson.com
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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the November 2010 edition of BENEFITS CANADA magazine.