And, like the last time, this current downturn will not simply affect defined benefit (DB) plans. Louis Martel, senior vice-president, product development and client service, with Greystone Managed Investments Inc., says if there’s a perfect storm for DB, there’ll also be one for DC (defined contribution). “I think what people aren’t talking about—and they should be—is the poor DC member who got hit last year with the rise in currency,” says Janet Rabovsky, investment practice leader, with Watson Wyatt Worldwide. “Are [members] even aware of what’s happening out there in the equity markets?” Although the responsibilities of a DC plan fall more to the plan member than the plan sponsor, it’s incumbent upon the sponsor to offer a range of options. “It’s just as important that sponsors of DC plans be ready to address what the consequences or issues will be for their members,” says Martel.
But there are some important differences between the earlier storm and the present “cool breeze,” as one consultant called it. Now, the typical pension plan is already underfunded, says Forestell. “They’ve gone from being poorly funded to more poorly funded,” he says. “The last time, a lot of plans were adjusting to coming from surpluses to deficits.” According to Mercer’s Pension Fund Health Index, which measures the funding status of plans, that status peaked in 2000 at 120%. Since 2003, it has dipped and risen between 80% and 90%. As of the end of March 2008, it fell to 77%, down from 82% at the end of 2007.
Jim Leech, president and chief executive officer of the Ontario Teachers’ Pension Plan, says that compared to 2001/02, DB plans are much more mature now. “Last time we faced the elements of low interest rates and low returns, we had more flexibility based on the number of retirees versus the number of actives,” he says. Another difference is inflation. “In 2001/02, we didn’t have this inflation spectre that we have right now,” says Peter Lindley, vice-president and head of investments, with State Street Global Advisors in Canada. “The one thing that has saved our bacon here has been the appreciating Canadian dollar. I think that appreciation now has pretty much run its course.” According to Lindley, this is worrisome for pension funds. “At the same time we’re having this financial crisis, which has required central banks to cut rates to support the financial integrity of our banking systems, we are also starting to see inflation pick up.” This, he says, poses a conflict for the central banks: do they increase interest rates to fight inflation or do they keep interest rates artificially low to help the banks? Leech agrees. “The one thing we’ve all got to be concerned about at this point is the stimulus that the central banks have put in,” he says. “Is that going to stimulate inflation?”
Many consultants and industry experts don’t believe 2007/08 to be a repeat of the beginning of the millennium. Normand Gendron, chief actuary, with Buck Consultants, says although it’s discomforting, it’s not a storm yet in comparison with 2001/02. “It would be the echo wave of the first one,” he says.
2007 was a tough year for pension funds. While the total pension assets for the Top 100 were up slightly ($719 billion in 2007 compared to $693 billion in 2006), 27 funds showed a decrease in assets from last year. And overall growth was significantly less—3.8% from 2006 to 2007 versus 14% from 2005 to 2006. Along with the usual suspects, there were some newcomers to the Top 100 ranking, including the Canada Mortgage and Housing Corporation (No. 99) and the University of British Columbia Faculty Pension Plan (No. 100), both with close to $1.3 billion in pension assets.
Others see what’s happening now as part of the natural cycle of the market. “The market is the market,” says H. Clare Pitcher, principal and consulting actuary, with Buck Consultants. “It does have its ups and downs.” David Schneider, manager of communications for the Local Authorities Pension Plan in Alberta, agrees. “There’s been no panic in the office,” he says. “We recognize that the markets are going to go up and down. So we’ve been patient and not alarmed at all.” Leech isn’t fazed, either. “There will be periods of time where the returns are low, interest rates are low,” he says. “And we’re all getting older, so the key is to have as much flexibility in your funding management policy [as you can].”
And it’s possible that we haven’t yet reached the point at which a short-term concern becomes a long-term crisis. “If 2008 produces negative rates of return and then 2009, I might start to get a little more concerned,” says Pitcher. “Six months ago, people watching the markets might have been panicking,” says Schneider. “Today, as the TSX hits these all-time records, that brings a whole lot more comfort to the situation.” In mid-May, the TSX topped 15,000 points.
Tutelage and Training
In any case, pension plans have learned some important lessons since 2001/02. “[Plan sponsors] can still remember it, so they’re better prepared for what’s happening [now],” says Forestell. A key lesson for them was risk awareness. “We lived in the ’80s and ’90s, in a world where we had very high returns,” says Martel. “Maybe we forgot what risk is.” As a result, plans are looking at risk much more closely these days. According to a 2007 State Street survey, almost half of the respondents said they now spend 21% to 40% of their time on managing risk rather than maximizing investment return. Another lesson was volatility. Although market volatility is a given, the markets of the ’90s were swollen with what Forestell calls “good volatility.” “Equity markets were doing well [and] interest rates, while they came down over the decade, were still relatively high compared to today. Things were relatively easy. The volatility was there, but it was helping [plans], not hurting them.”
Pension plans have also learned the value of diversification into different asset classes and obtaining the right mix within these asset classes, says Stephen Taylor, president and chief operating officer, with Morguard Investments Limited. “[The turmoil in the markets] sends a message, or reinforces a message, of the importance of not being overly aggressive in the amount of debt or leverage that you’re using.”
Michele Horne, senior vice-president and portfolio manager, with Bissett Investment Management, a division of Franklin Templeton, senses that pension plans are much more resigned to market fluctuations now. “I’ve had client [portfolios] on my desk for 18 years, so they’ve gone through the bear markets,” she says. “There seems to be more patience as they know markets will eventually turn.” And this patience is linked with experience. Horne says members who’ve been on a pension committee for a number of years have a much better understanding and acceptance of market ups and downs.
Armed Against Risk
Plans took the 2001/02 markets seriously. And if the statistics are any indication, they’re taking steps or have already taken steps to reduce risk. In a 2007 study by the Pension Investment Association of Canada, 73.2% of the 79 plan sponsors surveyed have discussed adopting an investment strategy that would de-risk investments (for example, using bonds or other assets to match their liabilities). And 54.9% would seriously consider implementing a de-risking strategy.
What would these strategies look like? One option is to close off DB plans and offer only DC plans to new entrants. But depending on the workforce demographics, this may not be the most suitable strategy. “It’s a little unfortunate, because the companies are, effectively, putting the onus on the individual,” says Lindley. “Frankly, many individuals are not capable of making those long-term retirement decisions for themselves. DB is that safety net for certain individuals who don’t want to have to worry about what they’re going to do in 10, 15, 20 years.” In a 2007 Buck Consultants study of more than 150 employers, 57% of plan sponsors offer more than 10 investment choices, up from 40% in 2003. And 74% of the capital accumulation plan sponsors think their members are confused about their investment options.
Overall, DC plan implementation appears to be waning. According to the Watson Wyatt/Conference Board of Canada’s 2008 Survey on Pension Risk, less than 3% of respondents will implement a form of DB to DC conversion in the next year, down from 9% in the last two years.
Another option is to take a closer look at early retirement provisions. “Often, plans have early retirement subsidies, so it’s actually advantageous to a plan member to leave before the normal retirement age because [he or she] may have an early retirement reduction that is fairly nominal; for example, 3% per year,” says Rob Vandersanden, principal, with Hewitt Associates. If that’s the case, then more employees could be motivated to retire early—an undesirable outcome for companies concerned about retention.
Vandersanden says companies can make their plans “retirement age neutral” by removing the early retirement subsidy altogether. However, this is easier said than done. It’s not as simple as informing employees that they no longer have the option for early retirement—especially in a union setting or collective bargaining situation.
Looking at investment strategies, plan sponsors can focus on asset/liability matching through liability driven investing (LDI). Rabovsky says that in the ’90s, a lot of plans were not even thinking about assets in relation to liabilities. “It didn’t matter what their liabilities were doing—even though interest rates were declining— because assets were growing at a faster pace than liabilities,” she says. But that was then. According to a 2007 State Street survey of institutional investors, North American plan executives and sponsors see liability mismatch as their No. 1 risk. In the same survey, 58% of plans in North America and Europe intend to use LDI to manage longevity risk. “Instead of focusing on pure asset returns, organizations are focusing on how their investment strategies impact their overall corporate risk exposure and how their asset returns vary from their liability returns,” says Vandersanden.
Diversifying into alternative asset classes such as real estate, hedge funds, private equity or infrastructure is another way to mitigate risk. “You don’t need to be a $5-billion fund anymore to be investing in those things,” says Vandersanden. Taylor says that in the past, a typical pension plan may have had 3% to 5% allocated to real estate, but in his experience at Morguard, this has increased. “We have certainly seen some of our more aggressive pension funds moving that up to 8% to 10%.” According to data from the 2007 Canadian Pension Fund Directory, Canada’s largest pension funds (those with more than $5.0 billion in assets) allocated an average of 5.86% to real estate. They also made smaller allocations to private equity, infrastructure and hedge funds.
No matter which option, or options, a plan sponsor chooses, it’s important to consider the impact these decisions will have on employees. “There is potential risk that you spend a lot of time and money managing your risk exposure internally and you don’t think about the reputational risk associated with the HR programs,” says Vandersanden. “You want to make sure that employees understand and appreciate the value of the programs. Even in a DC environment, you want to help employees take a longer-term view and not overreact to what’s happening in the markets today.”
If pension plans didn’t look carefully at their investment strategies after 2001/02, they should start now. Industry experts say plans need to look to the future and think long term. “You’ve got to have a good solid long-term investment policy that you should stick to and that you don’t change and react to the market fluctuations or the current new trends,” says Horne.
Although pension plans should be thinking longer term, it’s not always easy to do, according to Rabovsky. “The way the accounting standards and the regulation works, you’re forced to think [in] shorter periods,” she says. “You’re being forced into a less than optimal strategy.”
The reports from the Ontario Expert Commission on Pensions and other provincial panels on pensions may offer some relief to plan sponsors when it comes to thorny issues such as funding and accounting requirements. “I think companies are looking to see what these various commissions are going to say and how they’re going to provide reform to the pension environment that will be conducive to DB plans, that will offer more flexibility, and not more regulation, complexity and cost,” says Pitcher. Both commissions are expected to report by the end of this year.
Proper planning is equally important. For example, Teachers’ surveyed its members in June 2007, asking how much they were prepared to pay for their current benefits package. According to the survey, members would be willing to contribute a maximum of 12.3% in order to preserve their current level of benefits. This is actually 1.3 percentage points above the scheduled increase (11%) that will occur in 2009. And more than 75% of members say they understand that their contributions will increase over the next two years. “When the day of reckoning came, at least we have an informed view as to what the members want,” says Leech.
Because the pension environment is much more complex now than ever before, this complexity should give rise to good governance. “Your plan’s governance and the skills [that sponsors] have available to them either internally or externally are critical to success,” says Rabovsky. “It’s not just what you’ve invested in the fund; it’s how you’re making the decisions.” And it’s this kind of tactical thinking that will help shield plans from market fluctuations and combat volatility. Once more unto the breach.
Is DB’s Reputation at Risk?
The declining interest rates and falling markets were two components of 2001/02’s “perfect storm.” The storm also produced two trends, according to H. Clare Pitcher, principal and consulting actuary, with Buck Consultants.
First is a shift in responsibility for pension plan management. “Traditionally, HR departments and finance departments have both been involved, and they both are still. But I think you see a trend in more and more of the control shifting from HR to finance,” says Pitcher. “Certainly, finance has taken a much more active role in pension plan management.”
And recent research supports this analysis. According to the Watson Wyatt/ Conference Board of Canada’s 2008 Survey on Pension Risk, when respondents were asked to indicate the influence of their HR and financial functions on plan design decisions, 50% said that financial considerations currently outweigh HR issues. However, when asked what the situation would be in five years, only 30% said this would be the case, and 58% stated that HR and financial functions would play equally important roles in plan design decisions.
Second, is the somewhat negative reputation of defined benefit (DB ) plans, as plan sponsors may cut back on benefits to reduce the risk of underfunding. “Unfortunately, it’s reinforced the trend for why DB plans have been getting a bad rap,” says Pitcher.
Brooke Smith is associate editor of Benefits Canada. email@example.com
For a PDF version of this article, which includes all the rankings of the Top 100 Pension Funds, click here.