Defined benefit pension plan sponsors using overlay strategies will gain more flexibility amid rising inflation now that the Office of the Superintendent of Financial Institutions has released guidance allowing these plan sponsors to disregard the overlay when measuring going-concern liabilities, says James Koo, a partner in Aon’s wealth solutions division.
In May 2022, the OSFI raised the maximum going-concern discount rate from 5.75 per cent to six per cent for DB pension plans with 50 per cent of their investments allocated to fixed income investments. The regulator recently clarified that pension plans employing an overlay strategy can use the target asset mix of their funds without regard to the overlay strategy to determine the maximum going-concern discount rate.
This means plan sponsors that have a 50/50 split between bonds and equities can use leverage to increase their bond exposure to 75 per cent for a total of 125 per cent, says Koo, noting an overlay strategy can mitigate interest rate risk.
“If interest rates drop, the value of liabilities goes up. If plans only have 50 per cent of [their] assets in bonds, the value of those assets will also go up. But if they only have half of it in bonds, the risk is they’ll have [some] interest rate mismatch. And if interest rates go down, their funded status is going to deteriorate. [An overlay strategy] can reduce plan sponsors’ equity by going 100 per cent in long bonds to not incur any interest rate risk.”
Still, Koo believes the OSFI’s new maximum discount rate could go a little further, particularly since Retraite Québec recently updated its rate to 6.75 per cent. “The change the Quebec regulator put in is probably more in line with what you saw in the markets. Interest rates have gone up two per cent over the last year, so a one per cent increase for a 50/50 split plan seems reasonable; whereas OSFI is being a little conservative in only slightly increasing [the rate].”