In Aon Hewitt’s 2011 Global Pension Risk Survey, Canada is the region most heavily committed to open DB plans, while plan sponsors in the U.K. continue to close or freeze their DB plans at a relentless pace. One would then think that Canada would be a leader in adopting liability driven investing (LDI) strategies in order to manage the risks stemming from all these open plans, but the survey says otherwise. For example, the U.K. and the Netherlands lead the global responses in the use of derivative-based solutions covering both interest rates and inflation. Canada is behind the U.K. and the U.S. at getting out of equity markets.
Why is Canada lagging when it comes to adopting pension risk solutions? The answer may be that many plan sponsors have bought into two myths about de-risking—in which case, it’s time for a little myth busting!
Myth #1: Now is not the right time to de-risk (interest rates are too low/are going up)
Many plan sponsors have resisted diversifying into asset classes that better match their liabilities (such as long bonds) because of their view that interest rates are bound to go up, which would decrease the value of bonds. But in fact, there is a lot of pent-up demand for long bonds that acts as an opposite force on yields. As at December 31, 2010, the DB pension plan market in Canada amounted to $975.7 billion, according to Statistics Canada, much larger than the long bond market ($266.2 billion from government and corporate issuers) and the real return bond market ($61.1 billion) (figures sourced from DEX). As soon as yields start increasing, the demand for long-term bonds will push yields down again. And that’s not counting foreign investors who have been buying Canadian bonds as a safe haven against the recent economic turmoil (and pushing yields down at the same time).
Another factor to consider is that the hedge ratio of most pension plans is so low that plan sponsors would benefit from an increase in the ratio whether interest rates go up or down in the future. The hedge ratio measures the extent to which the assets of a plan will move in tandem with liabilities as interest rates fluctuate. For example, a hedge ratio of 20% means that, for a $100 shift in liabilities due to interest rate movements, assets will only move by $20. If a plan sponsor increases its hedge ratio and rates drop (and liabilities increase), the plan’s assets will be more responsive and the funded ratio of the plan will be better protected. Even if rates increase, plan sponsors will still benefit since the liabilities will decrease more than assets as long as the hedge ratio is less than 100%, resulting in an improved funded ratio.
Finally, even if plan sponsors don’t believe now is the right time to de-risk, there is no better time to develop a strategy so that they are ready to act when (and if) interest rates finally increase.
Myth #2: It is too expensive to de-risk (less risk means higher cost)
Myth #2 stems from the fact that as a pension plan shifts from growth assets (such as equities) to liability matching assets (such as bonds), the actuary for the plan will value the liabilities and normal cost using a lower discount rate, pushing up the cost of the plan. But some asset class shifts have little or no cost impact, such as a move from Universe bonds to long bonds. In fact, even without changing the mix between growth and the liability matching components, optimization of each component can reduce expected cost and risk. The following example demonstrates this point.
The chart below looks at an illustrative pension plan, where the present value of future contributions over 10 years plus the unfunded liability at the end of the 10 years have been calculated. The chart compares the cost (shown on the vertical axis as the expected present value of contributions plus unfunded liability) against the risk (average present value in the worst 5% of outcomes) for different portfolios. The chart shows that the plan sponsor can reduce both cost and risk (i.e., move down and to the left in the chart) as it goes through the optimization process. Starting from the current portfolio, optimizing the growth component results in a portfolio with both lower cost and risk. Similarly, optimizing the liability-matching component will reduce both cost and risk. Only the final step, the introduction of the glide path, results in a change in the mix between growth and liability-matching components. The glide path allows a plan sponsor to move to a portfolio with a higher allocation to liability-matching assets as the funded ratio of the plan improves, which also reduces both cost and risk.
Finally, the chart below looks back over the past decade to see how a glide path would have performed after the tech bubble through the 2008 financial crisis and the summer of 2011’s “perfect storm.” Starting from the same point at December 31, 2002, the funded ratio of the plan with a glide path would have been 97% as at August 19, 2011 versus 87% in the scenario of a plan with a static investment policy. The difference of 10% in the funded ratio for a $100 million pension plan translates into a $10 million lower funding gap.
The myths of timing and higher de-risking costs do not stand up to analysis. Waiting for interest rates to rise to de-risk will actually increase the length of time a plan is exposed to equity market risk. Optimizing asset mix and implementing a glide path is the best way for plan sponsors to lower their expected costs and risk. The time to act is now!
André Choquet is a senior consultant with Aon Hewitt in Toronto. andre.choquet@aonhewitt.com