Pension risk management in challenging times

In recent years, pension plan sponsors were optimistic about upcoming de-risking activity. In a Towers Watson (now Willis Towers Watson) survey conducted in the summer of 2014, 67% of survey respondents indicated they intended to reduce pension risk by 2017.

However, many plan sponsors also said conditions needed to improve in order for them to accelerate their pension de-risking activity. More than half (58%) said they were waiting for an improvement in their plan’s funded status, while 47% were waiting for higher bond yields.

Read: Pension de-risking trend continues

Sponsors that are delaying their de-risking actions until conditions improve believe that, by waiting, they will be able to reduce pension risk at a lower cost. Some of these sponsors have established formal de-risking “glide paths,” which provide for future de-risking actions to be taken when certain financial triggers are met (such as when the plan’s funded status or bond yields reach certain thresholds).

A year and a half after the 2014 risk survey, it’s instructive to review how conditions have evolved and what this means for future de-risking activity:

  • The funded status of most pension plans has deteriorated. The funded ratio (value of plan assets divided by liabilities) of a typical pension plan on a solvency basis has decreased by about 10% during this period.
  • Bond yields are lower. For example, Government of Canada long-term bond yields decreased by approximately 0.75% during this period.
  • There is less optimism today about increases in long-term bond yields during the next few years.
  • Equity markets were very volatile and lost value in early 2016.

Read: Pension plans feel effect of January’s volatile markets: survey

But what will plan sponsors do next? There will continue to be those that wait for conditions to improve, even though meaningful improvement may not occur in the foreseeable future. There is still a lot of risk imbedded in many pension plans which, if not addressed, may come back to haunt these plan sponsors in the future.

So, what are sponsors likely to do next when it comes to pension de-risking? Different sponsors will adopt different approaches, but we expect to see more organizations re-assessing their options, despite the challenging economic environment.

Other sponsors will focus on the activities needed to prepare for de-risking action, such as cleaning their membership data and clarifying the de-risking approval processes within their organization, so that they are ready to act when conditions improve.

Some sponsors will conclude they’ve been sitting on the sidelines for too long, and that it’s time to take action. These sponsors can benefit from new options to refine their risk management strategy that may not have been viable a few years ago. For example, a sponsor can use some of the liability hedging assets in its pension fund (such as bonds) to purchase a buy-in group annuity. A buy-in group annuity, which has become a more popular de-risking tool in recent years, is still an investment of the pension fund, but provides a better hedge than a typical bond portfolio against the plan’s pension obligations.

Read: Sun Life completes combined annuity buy-in

There will also be sponsors that have already established a de-risking glide path and are likely seeing their de-risking action trigger points drift further into the future due to the deterioration in their plan’s funded status and persistent low bond yields.

This means that no de-risking actions will be taken in the near to mid-term under their current glide path. Some of these sponsors will likely ease their de-risking trigger thresholds, especially trigger thresholds based on bond yields, so that de-risking action in the near-term under their revised glide path is more attainable.

Finally, there will be sponsors that conclude there’s still too much risk in their pension plans, and they can’t afford to wait for conditions to improve before acting. These sponsors will push forward with de-risking activity, regardless of the funded status of their plan and the level of prevailing bond yields.

Given the financial risk that remains in most pension plans and the current challenging times, plan sponsors are encouraged to carefully consider their next steps with respect to risk management, as action may be warranted. Regardless of where a plan sponsor lands with respect to their next steps, it’s important these steps are consistent with the risk management objectives of the sponsor’s business and are based on thoughtful, realistic and practical considerations.

Read: When is it a good idea to de-risk your DB plan?