Year-end surprise

Everyone expected that their pension plan’s financial status would be bad, and their expectations were met. However, this year will be different. Through the end of September, Canadian equity returns were 30%, and all other asset classes had positive returns, even with the appreciation of the Canadian dollar. In spite of this, when corporations prepare their financial statements for this year end, their pension plans will likely show a worse financial condition than they did last year end. This could be a surprise.

What is the cause of this deterioration in financial condition? The answer is falling discount rates. While long-term Government of Canada bond yields have increased since the end of last year, corporate bond yields, which are the basis for accounting discount rates, have fallen. At the end of last year, participants in the bond market (and others) were very concerned about the future of many businesses. As a result, they demanded a higher yield to hold corporate bonds.

The concern about the impending doom of the economy has more or less abated. As a result, the yields on corporate bonds have reduced. For a typical pension plan, the impact of this on the discount rate is a reduction of 0.80% or more since the end of last year. While this may not sound like a lot, the impact of a drop of 0.80% in discount rate is a 12% increase in liabilities for a typical pension plan.

Let’s take a closer look at a typical plan’s experience from January 1 to September 30, 2009.

• The return on Canadian equities, based on the S&P/TSX Composite, was 30%.
• The return on Global equities, based on the MSCI World Index, was 8.6%, even with the appreciation of the Canadian dollar that would have wiped out over 10% of return if it was not hedged.
• The return on Canadian bonds was between 5.5% and 7% depending on the type of bond mandate.
• The overall return for a plan with a typical 60%/40% asset mix would be about 13.5%.

So far, this looks like good news. Based solely on investment returns since the beginning of the year, you would expect an improvement in funded position of 5% to 7% even before taking into account the significant additional contributions that were made to many pension plans as a result of their underfunded status.

However, the effect of the drop in discount rate is roughly double the effect of the gain on the investments, in percentage terms. What matters to a pension plan—and the company that sponsors the plan—is the combined effect of both assets and liabilities, not just good asset performance.

While this review of 2009 experience is interesting, the bigger issue should be: what do we do now? So far this year, many plan sponsors have reviewed both the impact of the temporary solvency relief that has been available in some jurisdictions, as well as their plan’s investment policy.

Temporary solvency relief by its nature only addresses near term financing issues., Investment policy, on the other hand, is the tool by which long-term risk is managed. The capital market events since the beginning of the credit crisis have caused many plan sponsors to reconsider the appropriate amount of risk to take. Their comments are generally couched in terms like the following.

• I cannot manage a year-over-year increase in my pension contributions of more than $x million.
• If my pension expense increases by more than $y million one year over the next I will have extreme difficulty in my discussions with investors.

These are expressions of risk management objectives that are actionable by changes to investment policy. While there can be no guarantee of pension costs, short of a complete transfer of risks to another party such as an insurance company, many plan sponsors are of the view that the current amount of financial risk that they are underwriting in their pension plan is too large.

Over time, the market should expect a gradual reduction in the proportion of equities held within pension funds and a gradual increase in the degree of “matching” of bond investments to liabilities. Few plans will try to eliminate all of this financial risk, but more plans will try to target the “right” amount of risk given all of the circumstances of the plan—its size in absolute terms and relative to the sponsor, the proportion of liabilities in respect of pensioners (which dictates, in part, the degree to which changes in the discount rate affect the plan liabilities), and its funded status both today and the anticipated trend over time.

By managing risk appropriately through investment policy and whatever short-term measures are available, pension plans and their sponsors can avoid surprises. Make sure that you are not caught out.

Steve Bonnar is a principal with Towers Perrin in Toronto.

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