Morneau Shepell has developed a pension risk index to illustrate the potential impact of pension plans on an organization’s financial results.
“The index allows a plan sponsor to measure the financial risk of its pension plan, compared to those of other companies in the same industry,” says Patrick De Roy, partner and national leader of the risk management practice for Morneau Shepell. “The sponsor can use this knowledge when shaping the plan’s investment or funding policy, or even the plan design.”
De Roy warns that any significant deterioration in a pension plan’s financial position could endanger a company’s financial stability. The 2008 financial crisis and persisting low interest rates have motivated analysts and rating agencies to increase their scrutiny of pension plans.
The index, which is updated annually, is the product of a Morneau Shepell study that examined the impact of pension plans on the financial results of 100 Canadian public companies. It combines the results of three risk measures: the size of unhedged liability, liquidity and the pension expense.
“Each company surveyed receives a score indicating how a change in the plan’s financial position impacts the company’s financial results,” explains Yann Lussier, principal and risk management consultant for Morneau Shepell. “In comparing companies we note that aside from those with average scores, the level of risk varies greatly from one company or sector to another. The industrial products sector is one where companies are most at risk. The sectors least at risk are energy, consumer staples and financial services.”
One of the major risks faced by plan sponsors is the risk of a mismatch between plan assets and liabilities. Many plans are currently in deficit, with a significant portion of assets invested in equities. However, actuarial liability is measured based on current bond yields.
“Even though an equity-focused investment strategy would make it possible to reduce costs over the long term, the return on equity investments in the short term could be significantly lower than the growth of the actuarial liability. That is what happened so dramatically during the last financial crisis in 2008 and in recent months,” says De Roy.
For those companies that face significant risks, policies can be adopted to better protect a company and its shareholders against deterioration in their plan’s financial position. This might call for an investment policy where the target asset allocation differs significantly from a typical pension plan’s portfolio.