Pension plans are protecting themselves from market ups and downs by matching assets to liabilities
A year ago, the idea of having a fully funded DB pension plan was a lot like the idea of winning the lottery: a warm, fuzzy feeling that was not, for the most part, likely to occur.
Today, however, many pension plans are closer to being fully funded than they may realize. As of August 30, bond yields were up 0.9% since the beginning of 2013, Canadian equity markets were up 1.8% and U.S. equity markets were up 14.5%.
All of this is good news for pension plans. The June 30, 2013, Mercer Pension Health Index shows that a typical pension plan’s funded ratio improved by 12% (from 82% to 94%) over the first six months of 2013.
The Mercer Pension Health Index (see below) also shows that there have been other times over the last decade when plans were almost fully funded—most recently, in early 2011. In retrospect, these times seem like missed opportunities to reduce pension plan risk, given the challenges that underfunded pension plans have brought their employers over the last several years.
As DB plans once again approach full funding, will employers now take this opportunity to reduce their pension risk?
The Roller Coaster
Most pension plans—whether they realize it or not—are making high-stakes calls on the direction of equity markets and interest rates. Accounting standards as well as funding rules require pension plan liabilities to be determined with reference to prevailing bond yields. (This is because pension promises are bond-like in nature.) If a plan is interested in matching its assets with its liabilities—and minimizing its cash or accounting volatility—then holding a portfolio made up entirely of bonds is the right solution.
However, many plans hold a portfolio with a high proportion of equities (typically, 60% equities and 40% bonds). This portfolio is mismatched to the plan’s liabilities, so the hope for the plan is that the returns from its equities will offset the mismatch from its bonds. In effect, these plans have made a decision to take a 60% long position in equities and fund it using a 60% short position in bonds, leaving the plan with two large bets: one on equities and the other on interest rates.
Equity investments can generate excess returns, which the plan can use to improve its funded position or reduce costs (e.g., take contribution holidays or provide benefit improvements). And there have been many periods where an employer’s bet on equities has more than compensated for its bet on interest rates.
Unfortunately, equity markets don’t provide consistent returns each year and instead can be quite volatile. So a pension plan with a large proportion of its portfolio in equities has to be ready for bad news, in terms of poor equity returns.
For certain employers (e.g., those with small pension plan contributions compared to their revenue or those that are cash rich), the volatility associated with equity investing is manageable. However, most employers aren’t fortunate enough to be in this position, so bad news in their pension plans creates material challenges. As a result, they may have to forgo core business activities in order to divert cash to their plans.
Also, bad news in the pension plan often leads to bad news in the employer’s core business. In other words, bad pension plan news often comes when the employer is least able to handle it.
From an enterprise risk management perspective, it doesn’t always make sense to take risk in the pension plan when the employer is able to take risk in its core business. In the core business, shareholders are responsible for the losses but also enjoy the gains. In the pension plan, shareholders are responsible for the losses but don’t always get to enjoy the gains, as surplus is usually shared with plan members. Taking risk in the pension plan has limited upside for most employers.
Excess returns from equities are helpful in improving the pension plan’s funding level. But if the plan is fully funded, how can it use these excess returns?
- Build a surplus. Surpluses provide a buffer to protect against future pension plan bad news. But a large surplus is not always desirable, given that it must usually be shared with members on plan windup and there are limits on how much surplus can be recognized for accounting purposes.
- Reduce pension plan costs. An employer can do this by using the excess returns to take contribution holidays or to provide benefit improvements. Each employer must ask whether this potential cost savings is worth the volatility associated with equity investing and if it would be better to take this risk outside or inside the plan. Given the volatility of the last few years, members may rank benefit security over potential benefit increases.
Canadian employers are coming to the conclusion that the level of volatility associated with a 60% allocation to equities brings more risk than they’re willing to endure. More employers are shifting out of equities and into bonds as they become better funded, giving them more certainty around the impact of their pension plan on their core business.
The U.K. is further ahead in this area than Canada. The level of equities in U.K. pension plans has fallen to 38% in 2012 from 61% in 2006, according to The Purple Book (2012). This reduction in equities has led to a commensurate increase in bonds, and £446 billion of U.K. pension assets are now managed with reference to their liabilities, according to KPMG’s 2013 LDI Survey.
The U.K. pension industry is realizing that it’s unfair to ask employers to estimate interest rate and equity market movements when most financial institutions do not. Most banks and insurance companies usually match their assets and liabilities at inception and aren’t trying to generate excess returns, because their priority is benefit security for their customers. The U.K. pension industry, with its trustee structure, is also embracing this objective.
Recent changes to pension plan accounting standards will require many Canadian employers to disclose material pension plan risks in their financial statements and provide a description of any asset/liability-matching strategies used by the plan. This will highlight to shareholders which plans have mismatched their assets and their liabilities and are taking equity risk.
A 2011 study by Grant Thornton found that U.K. employers that chose to de-risk enjoyed a 10% increase, on average, in their share prices. This shows that shareholders appreciate the risks associated with pension plans and are willing to reward employers that reduce risk.
So maybe employers should consider taking risk off the table by reducing the amount of equity in their plans as they become better funded. Here are four questions that employers should ask.
- Once my plan is fully funded, do I still need to generate excess returns?
- Are my shareholders better off if I generate these excess returns in the pension plan or in my core business?
- What appetite do my shareholders have for the cash and accounting volatility associated with trying to generate these excess returns?
- How much time and attention does my management team have to spend dealing with bad news if the events of the last several years were to repeat?
A Softer Landing
If an employer is interested in matching its plan’s assets with its liabilities (and, therefore, minimizing its cash or accounting volatility), then holding a portfolio entirely made up of bonds is the right solution. But each employer has a different tolerance for bad news and should decide how much equity (or other risky asset) exposure is appropriate.
The portion of the portfolio dedicated to bonds can be constructed to achieve a number of different objectives. For example, the portfolio of bonds may be constructed to minimize cash contribution volatility, to minimize accounting volatility or to prepare the pension plan for risk transfer (such as an eventual annuity purchase).
Under these different objectives, matching a pension plan’s assets to its liabilities becomes key. The strategy is not to outperform an asset benchmark but to have the plan’s assets move the same way as the plan’s liabilities.
For example, if the objective is to minimize solvency volatility, then a portfolio of bonds can be constructed whose value moves in the same way as the plan’s solvency liabilities. If solvency liabilities increase by 10%, then the bond portfolio will also increase by 10%, leaving the solvency position unchanged. If solvency liabilities decrease by 10%, then the bond portfolio will also decrease by 10%, leaving the solvency position unchanged. This minimizes solvency volatility and enhances benefit security.
The point of the pension plan assets is no longer to take equity risk and try to achieve excess returns. Instead, it is to match liabilities, not to exceed or fall short of them. As pension plans become fully funded, forward-thinking employers that embrace this new perspective will come out on top.
Brent Simmons is senior managing director, defined benefit solutions, with Sun Life Financial.
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