First, many of the tax advantages of holding equities are squandered in a tax shelter. Second, in corporate pension plans, particularly in post-Monsanto Ontario, the percentage of the investment gains that plan sponsors get to keep is less than the percentage of the investment losses that they are expected to bear. For that reason, the pension fund is a poor place to take investment risk.
Notwithstanding the strong economic arguments for bonds, virtually every pension fund invests heavily in equities in the belief that equities reduce pension costs—a belief that is nurtured and sustained by accounting practices that use equity risk premiums to reduce the reported cost of a pension plan while simultaneously concealing the related risks.
Malcolm Hamilton is a principal with Mercer Human Resource Consulting in Toronto. malcolm.hamilton@mercer.com
A going concern pension plan’s long time horizon would normally be able to afford the additional risk of equity investments in exchange for the higher return. A diversified mix of stocks and bonds provides an excellent risk-adjusted rate of return over the long term. Historical returns show that, over 25-year periods, a hypothetical portfolio invested in balanced funds has similar volatility to a bond portfolio,
but a higher rate of return. Although pension plan obligations bear many similarities to bonds, a going-concern pension plan has differences: no bonds in the market that are linked to salary increases; and the life contingency of a pension payment stream, the early retirement options, and a plan’s termination experience are all features of a pension obligation for which no matching asset exists. Thus, the asset
liability mismatch risk can never be completely eliminated.
Assuming one can design a bond portfolio to match one’s pension plan liabilities, this would mean valuing liabilities using the current yields in the bond market, or at a discount rate of about 5% to 5.5%—a drop of about 1% to 1.5% in the rate currently used for most pension plans invested in a
balanced fund. Such a drop would mean an increase of 15% to 25% in the pension plan liabilities(for a plan with a 50/50 mix of active and pensioner liabilities)and a 30% to 50% increase in the current service cost.
Will volatility and risk really be reduced in this type of arrangement? In a perfectly matched, fully funded pension plan, any increase or decrease in the assets would be offset by a corresponding increase or decrease in the liabilities, thus eliminating the need to fund future deficits. But is it worth the price?
Charlene Moriarty is consulting actuary at Buck Consultants in Toronto.
charlene.moriarty@buckconsultants.com
