DB pension plans carry many types of risk including investment risk, asset-liability mismatch, longevity risk, demographic risk and inflation risk, and this puts smaller plans at a disadvantage. Because of their smaller asset base, it’s difficult to diversify the investment risk among many different asset classes like larger plans can do.

At the same time, liabilities are subject to greater swings from demographic risks such as mortality and retirement. Moreover, many small plan sponsors simply do not have the resources to allocate to a significant de-risking effort.

Risk management is a systematic way to assess, identify and prioritize risks, and in turn, develop strategies to minimize, monitor and control the probability and impact of negative events. The goal is to reduce risk to a manageable level, not eliminate it altogether—that would mean winding up the pension plan.

For small employers that want to continue to offer a DB pension plan, there are manageable strategies for mitigating risk.

Elements of a risk management strategy
Mitigating risk is best accomplished by creating and overseeing three key policies: an investment policy, a benefits policy and a funding policy. The most successfully managed pension plans integrate the assessment and management of most risks through these three policies.

Investment policy
The largest component of risk facing the typical pension plan is investment risk. It includes equity risk, interest rate risk, inflation risk, credit risk and currency risk, among others. Plan sponsors must ensure that their investment policy contemplates the key risks the plan faces and that exposure to these risks is appropriate.

The best way to achieve this is with an investment policy that outlines an effective risk management process to address risk throughout the entire investment decision process.

The first step in analyzing investment strategy is to review the plan’s asset allocation. The primary tool to help identify the investment risk factors facing a plan is with an asset-liability study. It provides projections of assets and liabilities into the future under diverse economic and market scenarios. Through this process, a wide variety of asset mixes and investment strategies can be evaluated to determine which strategies best meet the plan’s objectives. For small plans, asset-liability studies can be scaled back to make them more affordable.

The main benefits of asset-liability studies include the following:

  • evaluating investment strategies and their impact on the pension plan’s key issues and objectives;
  • prioritizing the plan’s key objectives, which are often in conflict with one another; and
  • testing the plan’s sensitivity to a wide variety of risks it faces.

With these objectives and issues in mind, an asset-liability study can help answer a host of questions when considering investment strategy options.

  • Which asset classes make the most sense given the plan’s key objectives?
  • What is an appropriate structure for the bond portfolio to ensure a good match to the liability cash flows?
  • How much should be allocated to equities?
  • What is the appropriate split between domestic and foreign investments?

One approach that can be considered by small plans is immunizing assets against changes in liabilities, also called liability driven investing. Immunization can be achieved by increasing the plan’s exposure to bonds, increasing the duration of the bonds or using fixed income overlay strategies to manage interest rate risk.

Benefits policy
The benefits policy is an important part of an integrated risk management framework. It sets the guiding principles for plan design, negotiations and amendments but also directly affects the cost of the plan. It should codify the pension benefits a plan sponsor wants to offer its plan members, as well as the process for considering benefit improvements or reductions. Doing so ensures thoughtful decisions and protects the interests of all stakeholders. The plan’s benefits policy should include some of the following considerations:

  • purpose of the plan;
  • level of benefits provided to plan members;
  • costs the plan sponsor intends to absorb;
  • nature of the plan; and
  • degree of complexity of the plan.

Funding policy
Many pension plans have informal funding policies to provide funding at the legislated minimum required contribution level. Although a formal funding policy is not a legislative requirement, it is considered “best practice” and an integral part of both the governance structure and the risk management framework.

Developing a funding policy has many advantages. Most importantly, the funding policy allows the plan sponsor to understand and articulate the key risks facing the plan. Communicating the policy improves management’s transparency, and can help plan members understand the funding decisions that are made. It also helps ensure that selected actuarial assumptions are in step with standards of practice, and within the sponsor’s risk tolerance limits.

One funding policy consideration that small plans can explore is annuitizing their pension liabilities.  Annuitizing pension liabilities not only protects plans against changes in interest rates, but also protects plans against longevity risk.

Preparing an integrated framework for managing the risk of a pension plan is a valuable exercise for plan sponsors regardless of plan size. It enables the sponsor to assess the plan as a whole and consider each of its facets, establish procedures and benchmarks for evaluating risk, and implement strategies for mitigating and managing that risk. Most importantly, it ties all decisions back to the key objectives of the plan.

For small plan sponsors, the best approach is one that starts small and builds over time with experience and understanding of risk.

Jasenka Brcic is a principal with Eckler Ltd. in Toronto.

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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shirley robidoux:

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Monday, December 19 at 4:21 am | Reply

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