Avoid complacency in pension risk management

• strong global equity market returns, which increased pension plan assets;
• increases in long-term interest rates, which reduced pension liabilities; and
• cash contributions made during the year by employers to fund plan deficits.

These factors caused a typical pension plan’s solvency funded ratio (the ratio of plan assets to solvency liabilities) to increase by approximately 25% during 2013. For most plans, this improvement in the funded position eliminated much and, in some cases, the entire deficit in the plan. Similarly, the funded ratio of plans on an accounting basis increased dramatically during this period. (The effect of the events of 2013 on a plan’s funded status will vary significantly from plan to plan.)

In 2014, employers have begun reaping the following rewards from the positive developments in 2013:

• a reduction in required cash contributions to their plans;
• the ability, in certain situations, to defer the deadline for filing the next funding valuation with the pension regulator from one year to three years. This serves to stabilize the level of required contributions for a three-year period. (The rules regarding the required frequency of valuation filings depend on the jurisdiction in which a pension plan is registered.);
• a reduction in the level of Pension Benefits Guarantee Fund premiums for plans with Ontario members and former members;
• a reduction in the annual pension cost reflected in the employer’s profit and loss statement; and
• a significant reduction and, in some cases, the elimination of the pension liability recognized on the employer’s corporate balance sheet.

The risk remains
This pension financial relief is welcome news for employers that sponsor DB pension plans. However, these employers should recognize that, if no action has been taken to alter the risk profile of their plans, the financial markets could reverse much or all of the gains of 2013. Consider the following.

• There is a one in 20 chance that the solvency funded ratio of a fully funded plan with an asset mix consisting of 60% equities and 40% universe bonds will decrease from 100% to 80% or lower in just a 12-month period.
• Twice within the last seven years (2008 and 2011), the solvency funded ratio of a typical pension plan actually decreased by more than 15% within a period of 12 months or less.
• During the first six months of 2014, decreases in long-term interest rates increased the solvency liabilities of a typical pension plan by 9%. In most cases, employers have been fortunate that this increase in liabilities has been at least partially offset by positive investment returns on both the equities and bonds in their pension funds. However, if equities had not generated positive returns during the first six months of the year, many plans would have experienced a significant deterioration in their financial health during this period.

Opportunities for de-risking
The events of 2013 have created opportunities for employers to take de-risking action, since the improvement in pension financial health has made certain de-risking strategies more affordable. Depending on the circumstances, there is a range of available actions, including the following:

• changing the plan’s investment strategy;
• changing the plan’s funding strategy, such as contributing more than the minimum required now that the minimums have decreased;
• offering deferred vested members the lump sum value of their pension entitlement;
• transferring the obligation to pay retiree and deferred vested member pensions to an insurance company through the purchase of a group annuity;
• for employers that sponsor more than one pension plan, merging the plans into one plan;
• changing the plan design to reduce pension risk; and
• terminating the pension plan.

Avoid complacency
An employer that decides to take action will need to formulate and execute a plan. An employer that is not ready to move immediately should still consider taking initial steps in the short term, such as developing a longer-term journey plan needed to achieve the ultimate desired risk level. These employers should confirm their pension risk objectives and clarify the conditions under which they will take action.

With the improvement in the financial health of pension plans, it is tempting for employers to reduce the attention paid to their pension financials. However, it would be unwise to become complacent regarding pension risk. For many employers, the risk that caused significant financial pain over the past decade has not disappeared and, if not addressed, will come back to bite in the future. The opportunities provided by the current environment may be short-lived. Now is the time for focus and action.