How to manage the long-term obligations of a DB pension promise

Defined benefit pension risk is as much in the spotlight today as ever and remains a significant issue for plan sponsors, even when the sponsor’s DB plan has been closed to new hires for years. This is because the obligations associated with a DB plan remain for many years into the future.

Changes to the regulatory framework for DB funding in Ontario and Quebec may, in the near future, help to alleviate some of the pressures experienced by employers with plans in those provinces. But it will still be important to manage the risks associated with closed DB plans for many years to come.

Pension risk in the spotlight

Some of the main reasons DB pension risk is in the spotlight today as much as ever are:

  • Pension plan sponsors are concerned about the potential effect on the funded status of their pension plans of recent financial market volatility caused by the Brexit vote in Britain.

Read: Canadian pension solvency survives Brexit, for now: survey

  • There is a greater realization that continued weak growth in the global economy may mean historically low long-term interest rates will not be increasing any time soon. Low long-term interest rates increase DB pension liabilities and typically reduce the funded status of pension plans.
  • Quebec has overhauled its funding rules for private sector DB pension plans in order to reduce employer contribution volatility. Minimum funding requirements are now based on an “enhanced” going-concern valuation and solvency deficit funding is no longer required. Regulations released in July to confirm the calculation of the stabilization provision clear the way for employer contributions to be calculated under this new approach.

Read: Quebec shakes up pension landscape with shift to going-concern funding

  • In June 2016, Ontario enacted temporary solvency funding relief measures for private sector DB pension plans. This is the third round of temporary funding relief implemented by Ontario within the past decade.

Read: Ontario introduces draft rules for DB pension solvency funding relief

  • Ontario has also started a review of its pension funding rules with a focus on plan sustainability, affordability and benefit security. Many sponsors of Ontario-registered pension plans are hopeful that this review will lead to less stringent and less volatile funding requirements.

Read: Eliminating solvency funding on the table as Ontario reviews DB rules

Risk still an issue for closed plans

More than a few times over the past years I’ve been asked the following type of question by a pension plan sponsor: “We closed our DB pension plan to new hires 10 years ago. All new hires participate in a new defined contribution plan. Why is DB pension risk still such an issue for our company? We thought with the move to DC, the issue of DB pension risk was behind us.”

Given the movement from DB to DC plan designs that has occurred since the early 1990s, this question is relevant for many pension plan sponsors.

The evolution of DB pension liabilities

So, why is DB pension risk still such an issue given the movement from DB to DC? Simply put, it’s because the obligations associated with the legacy DB promise remain for many years into the future, specifically for the lifespan of current and future retirees and their beneficiaries.

The chart below shows an illustration of the projected DB accounting liabilities for a plan sponsor that has just closed its DB plan to new hires.

Projection of DB Accounting Liabilities

The following are a few observations regarding the projected liabilities:

  1. The chart shows the evolution of the liabilities separately for plan members who were active (in red) and retired, including the beneficiaries of retired plan members (in blue) on the date the DB plan was closed to new hires.
  1. The liabilities for retirees/beneficiaries decline during the projection period, as they are paid their monthly pensions and are expected to die over the course of the next 50 years.
  1. The liabilities for active plan members are expected to more than double over the next 20 years, and then begin to decline. The significant increase in active liabilities may seem surprising given the plan is closed to new hires. However, active members will continue to accrue additional pension benefits while they continue to work with their employer. Also, as active members get closer to retirement, their future monthly pension stream is not discounted as much when calculating the liabilities in future years. These factors serve to increase the active liabilities during the next 20 years.
  1. The total plan liabilities are expected to increase by almost 50 per cent over the next 13 years, and then begin to decline. In 2048 (i.e., after 32 years), the liabilities are back to the same size as they were at the time the DB plan was closed.
  1. The illustrated liabilities are based on a particular set of assumptions which are assumed to remain unchanged during the projection period. The liabilities could increase by even larger amounts, in the short and medium terms, should long-term interest rates decrease from the levels at the beginning of the projection.
  1. Although very small, a liability is still expected to exist in the plan in 2096. This is because a young active plan member today (or his/her beneficiary) could be alive and receiving a monthly pension 80 years into the future.

Read: Employers urged to beware litigation risk in converting pension plans

Although the actual evolution of liabilities over time will differ from plan to plan depending on the demographic characteristics of the plan membership and the plan design, this example illustrates that a DB pension promise will last a long time before it’s expected to be extinguished.

Managing the pension risk

Considering the manner in which DB pension liabilities evolve and the long tail of a pension promise, it’s no wonder DB pension risk remains a significant issue today and will likely continue to be an issue for many years to come – even when a DB plan has been closed to new hires for some time.

The positive news is that there are strategies available to manage DB pension risk, including investment strategies, plan design changes and risk transfer strategies. There are also hopeful signals that policymakers in Ontario are taking a serious look at long-term solutions for DB plan funding. Plan sponsors should assess and apply these strategies with the aim of, to the extent possible, delivering the pension promise for a closed DB plan in a manner that is affordable and within the risk tolerance of the plan sponsor.

Read: Clear objectives, transparency key to ensuring pension plan sustainability