Cost Volatility: A Major Influence Driving the Future of DB Plans

The respondents included 45 publicly-traded companies, 44 for-profit private companies, 17 not-for-profit companies, and 41 public sector organizations. Over half have between 1,000 and 10,000 employees in their Canadian operations, and 15% have over 10,000 employees. Just under half of them sponsor DB plans alone—the others’ pension arrangements all include DC assets.

Interestingly, while two-thirds of respondents still believe there is a pension funding crisis in Canada, the percentage of CFOs who feel that the crisis will be long-lasting has declined significantly, from 61% in 2006 to 48% in 2007. It is suspected that this decline is largely due to the improvement in market values of DB funds over the last year or so, in combination with higher long bond yields applying to their accounting and solvency liabilities—this combination has virtually eliminated the deficits faced by many plans, thus reducing the pressure on decision-makers to take drastic action.

Nevertheless, the experience of the last six years has taught the decision-makers a valuable lesson. What goes up may come crashing down again. The recent improvement in financial conditions may have given them breathing space, but there is still an air of urgency when considering the future of their DB plans. Furthermore, 63% of the publicly traded respondents believe that their plan deficits create a risk to their credit rating, and they probably believe that the upcoming move to marked-to-market pension accounting will exacerbate that risk. However, these sentiments may be exaggerated, since credit rating agencies have been reflecting pension debt in their analysis for some time. In a way, pension accounting is catching up to the way in which credit rating agencies view DB pensions.

Of course, this volatility is the product of an investment policy that accommodates a significant equity content in the typical DB fund—amongst 112 of the larger companies that follow Canadian accounting standards, the median equity content is 60%. A move towards a higher bond content could lessen the volatility concerns, if the resulting assets are more aligned with the accounting and solvency liabilities. However, it would come at a considerable cost, as the going concern funding contributions are based on an actuarial discount rate that would typically increase as equity content diminishes. So if volatility is the main threat to their DB plans, what investment strategy changes are the survey respondents making?

Over the next 12 months, 19% have indicated that they intend to increase their plans’ exposure to alternative investments. Only 9% are considering increasing their plan’s bond weighting, while 5% intend to decrease their bond weighting. Clearly there is considerable interest in seeking higher returns, despite the extra risk. However, a quarter of the respondents indicated that they are considering a move towards liability driven investment(LDI)in the next 12 months, to immunize their plans from solvency deficits and stabilize costs.

Investment policy is the primary tool for managing the legacy liabilities—that is, the liabilities of the pensions already accrued, which are carefully protected through legislation. Typically, investment policy is influenced heavily by the finance side of the plan sponsor, even if the decisions are ultimately made by a pension committee. Increasingly, however, plan redesign is also being used to manage costs, even though in reality this generally only affects the future benefits being accrued by active members. And of course plan redesign needs the involvement of the HR side of the house.

Of those respondents with some form of DB arrangement for future service(with respect to their largest non-bargained plan), 41% have made a plan design change in the past 24 months, or plan to make such a change in the next 12 months. Indeed, the changes are more likely to apply to future service for both new hires and current plan members, than just to new hires alone. The most common plan design change being contemplated in the private sector is a DC/Group RRSP conversion for some(but not all)members’ future service. This is followed by the reduction of the benefit accrual rate, early retirement benefits and ancillary benefits.

Amongst the respondents from publicly traded organizations, 15% plan to convert their DB plan formula to DC for all members’ future service. Five respondents indicated that they had recently fully wound up their DB plan(s)or are planning to do so.

DC arrangements hold some attraction, and yet respondents see threats to managing these arrangements, such as the ability to communicate effectively with plan members and provide adequate education on members’ investment decisions, as well as the risk of inadequate pension benefits. DB plans are the respondents’ preferred vehicles for attracting and especially retaining key individuals. Respondents also showed that they need to be able to manage the pattern of employee exits from their organizations, and that a DB arrangement is better suited for this.

The bottom line is that there is significant activity underway to study and manage the costs and risks of sponsoring a DB plan, and finance and HR are increasingly working together to put together the recommended package. But plan sponsors face a dilemma as to how to mitigate the risks. Many are tempted to accept additional risk and hope to reap the higher investment returns that come with it. It really depends on how much risk the sponsoring organization can afford to take—if they have a large risk budget(that is, they can absorb considerable downside swings in pension costs), their strategies will be considerably different than if their appetite for risk is small. It is definitely important for a plan sponsor to consider its pension risk tolerance in the context of its entire enterprise risk.

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