It’s hard to believe that just recently, people weren’t cutting their own hair or binge-watching Tiger King.
At the beginning of the year, defined benefit funding levels were at record highs and many pension plan sponsors were considering reducing their pension risk.
Fast forward a few months and the novel coronavirus has turned the world on its head.
As I write this in May, many pension plan sponsors are catching their breath and wondering if their DB plans have dodged a bullet. After seeing steep declines in funding levels in March, April brought sharp rebounds. Funding levels are still down from the beginning of the year, but many DB plans are once again nearing full funding.
Some plan sponsors are wondering if now is the time to reduce DB plan risk and make their funding level a little less volatile. After all, no one knows where the market will go from here. For those that are ready to get off the funding roller coaster, here are a few ideas to consider.
Estimate your current funding level. The first step for many plan sponsors will be to estimate their plan’s actual funding level. The typical DB plan bounced back during April, but each plan’s characteristics are different. And markets are moving quickly. You will be better able to consider your options with an up-to-date funding status picture.
Revisit your pension risk strategy. Some DB plans mismatch assets and liabilities in the hope of earning excess returns. These excess returns can be used to pay pensions, reducing the cost of the DB plan.
Unfortunately, this strategy hasn’t paid off over the last 20 years. According to Statistics Canada, between 1999 and 2018, Canadian plan sponsors contributed $158 billion to shore up deficits in their DB plans. Yet, when looking at the Mercer Pension Health Index for the same period, pension plans did not see a material increase in their plans’ funded statuses.
Perhaps this result isn’t surprising given once-in-a-lifetime events seem to be happening every decade – whether it’s the technology meltdown of 2001, the global financial crisis of 2007/2008 or the coronavirus pandemic of 2020. These events dramatically affect financial markets and make it difficult to earn excess returns.
Plan sponsors should consider this new level of uncertainty as they think about their pension risk strategies. For many, it may be time to take less risk.
Consider better matching investments. One way to take less risk in a DB plan is to shift some return seeking assets to hedging assets. DB plans with a large proportion of hedging assets have seen funding levels remain fairly constant over the past few months. These plan sponsors have been able to concentrate on their core businesses without having to worry about their plan members’ benefit security.
Think twice about passive bonds. There’s a lot of uncertainty in the markets right now and some economists are predicting low interest rates for a very long time. In this environment, it may be helpful to consider actively managed bonds rather than passive bonds.
Consider transferring risk. Another way to reduce risk is to purchase annuities. Annuities perfectly hedge liabilities and eliminate investment and longevity risk.
The good news is that annuities are currently on sale relative to many plan sponsors’ bond portfolios. That is, many bond portfolios have appreciated in value relative to the price of annuities since the beginning of the year, meaning it takes fewer bonds to buy an annuity, creating value for the DB plan.
Plan sponsors with underfunded plans who are interested in purchasing annuities can always opt for annuity buy-ins. Annuity buy-ins have a number of helpful characteristics in today’s environment, including not triggering an accounting settlement and not requiring top-up contributions. In addition for federally regulated plans, annuity buy-ins are not subject to the Office of the Superintendent of Financial Institution’s temporary annuity freeze.
Plan sponsors have enough to worry about in a crisis without having to worry about funding levels and the benefit security of plan members. Now is a great time to revisit risk management and look for options to reduce pension risk. That way, the next time a once-in-a-lifetime event occurs, they can concentrate on their core business and worry less about the pension plan.
Brent Simmons leads Sun Life’s defined benefits solution team. These views are those of the author and not necessarily those of the Canadian Investment Review.