Chaos Theory

To top things off, some economists are predicting that the Canadian economy will fall into a recession in the first quarter of 2009. And there are other headline concerns as well, such as tight credit, weak consumer spending, unemployment, falling wages, slumping housing prices and declining commodity prices.

What Happened?

In very simple terms, banks and other financial institutions south of the border issued mortgages on houses that were massively overvalued to people who could never hope to pay off the loans. Those mortgages typically had very low interest rates for the first year or two (referred to as “teaser rates”) and significantly higher rates (e.g., 10% per annum) in years three and beyond.

In the first two years, the mortgage payment was affordable and many people who otherwise could not have afforded to purchase a house became buyers. Unfortunately, once the mortgage hit the third year, many of these people had no choice but to default on their payments, walk away from their homes and hand over the keys to the mortgage lenders. And, since house prices are really a function of supply and demand, the mortgage defaults killed the demand for houses and created a huge hole that forced prices down.

All of this activity is having a dramatic impact on stock market prices. First, the credit squeeze is bottling up economic activity. Financial institutions have stopped lending money, so neither individuals nor companies can borrow. Since many healthy companies need to be able to borrow on a short-term basis to smooth out cash flows, they now face serious problems as a result of the credit freeze. Some businesses will soon be in trouble without access to credit, and investors are reacting to this uncertainty by selling off stocks. This situation has created investor panic and a loss of confidence that further exacerbates the selling of stocks.

Second, consumer spending is slowing. Since much of today’s spending is by way of credit, with lending being so restricted, consumers have less spending power. This enforced frugality means less spending on high-ticket items and lower profits for many retailers and manufacturers. The chain reaction extends to job layoffs and plant closures, and to less money in consumers’ pockets. This, in turn, deepens the loss of consumer confidence and further restricts spending, causing more and more job losses and plant closures.

How Are Pension Plans Affected?

Markets tend to overreact, and some of the recent paper losses will undoubtedly be recouped as things calm down. How much will be recouped? We just don’t know. But several factors suggest that values will be recouped over a longer rather than a shorter time period. Before the crisis, markets were overpriced, fuelled by spending and high levels of debt. Market values were not sustainable and created unrealistic stakeholder expectations. And, in the future, international competition from new markets such as China and India will hinder domestic growth.

In the meantime, pension plan sponsors must ask themselves three key questions in connection with the market turmoil: What is the financial position of the pension plan? What can we do about it? And what can we learn from this experience?

For both cash funding and pension accounting purposes, the financial position of the plan is based on the fair or market value of assets at a fixed point in time. For many plan sponsors, the fiscal year-end and the next required valuation filing are as of Dec. 31, 2008—only weeks away. From a cash perspective, the fortunate plan sponsors will be those that recently filed an actuarial valuation report and are not required to file again for another two to three years.

If your plan’s next required actuarial valuation is as of Dec. 31, 2008, then the cash contribution requirements are almost certainly going to be higher—probably significantly higher if the plan’s solvency financial position is below 100%.

From an accounting perspective, your plan’s funded status and coming year’s pension expense will likely be worse than it was last year but probably not as bad as you might expect, depending on the date of your fiscal year-end. With corporate bond yields increasing to adjust for the higher likelihood of defaults, the resulting drop in liabilities (higher interest rates mean lower liabilities and lower current service costs) could offset much of the damage on the asset side.

What Should We Do Now?

Plan sponsors can take a number of actions to help manage the situation while waiting for investment values to recover.

1. Cash funding and expense – From a cash funding perspective, assess and budget for any cash contribution increases expected for 2009 for any pension plans required to file a new actuarial valuation as of Dec. 31, 2008.

You will also need to assess and budget for any pension expense increases expected in the next fiscal year, based on the current market value of assets and corporate bond yields. If you are a public entity, it might be to your advantage to adopt convergence to the International Financial Reporting Standard in 2008 or 2009 instead of waiting until Jan. 1, 2011.

With the help of an investment consultant, you may also consider increasing plan sponsor contributions. This will improve the financial position of the pension plan and may provide an opportunity to find some oversold stocks to help boost future returns.

2. Investments – From an investment perspective, now is the time to review the pension plan’s asset mix and conduct scenario testing to understand the impact of continued market volatility. However, it is important not to panic and liquidate investments at what could be the low point in the market. Instead, look to have investment income from bonds and equities paid in cash rather than rolled into unit prices, and use that to meet cash flow to the extent that contributions are insufficient.

Consider selling bonds rather than equities, and focus on yield. Some of the equities that were hit hard will continue to pay dividends, and that yield will now be hard to beat elsewhere, so take care with any selling decisions. It might also be time to look at passive managers. Good investment advice could be key in restructuring your portfolio to benefit from changes in the long-term economic outlook.

3. Communications – Now is the time to inform all relevant parties—banks, shareholders, employees, trade unions, plan members and pensioners—about the security of the pension benefits. If changes are likely, keep the lines of communication open now and throughout the process. It’s also a good time to get some employee recognition for having a defined benefit pension plan.

4. Plan design – Review plan provisions to better understand the options for future changes that might be needed to contain operating costs. Look at the cost of your employee benefits package and consider the options available to you—for example, introducing or increasing member contributions, or amending the plan to remove overly generous ancillary benefits (e.g., unreduced early retirement).

5. Defined contribution (DC) plans – If you have a DC plan, talk to your supplier about what it has been doing to address employee concerns and ensure that you are coordinating employee communications. Review your governance model. Is it working or does it require adjustment due to recent events? Finally, review your investment offerings. Are there funds that did not stand up well during the volatility? If so, why?

Good governance and stewardship will help to prepare plan sponsors for these types of disasters, and plans with strong governance models are coping much better today than those without. Understanding the financial position of your pension plan—and taking action on the items most relevant to your situation—will help arm you for whatever else the financial markets and the economy may throw your way.

Cameron J. McNeill is president and chief executive officer of Buck Consultants, an ACS company, and Kevin M. Sorhaitz is a principal and consulting actuary in Buck’s Toronto office.
cameron.mcneill@buckconsultants.com; kevin.sorhaitz@buckconsultants.com

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the December 2008 edition of BENEFITS CANADA magazine.