Swapping out risk

“You have a different perspective of risk depending on where you come from.” For instance, how you view risk will depend on your pension plan’s maturity, the size of your deficit or surplus, and your organization’s ability to finance the plan through cash contributions.

That said, there have been a few developments more recently that have made risk management even more of a focus for plan sponsors, said Legris.

One of the biggest in last 20 years was the impact of IFRS, which have now taken the pension plan and brought it onto the plan sponsor’s balance sheet. There are also a number of external factors, including interest rates and longevity assumptions, which have increased in the last 30 years, Legris said.

“It is universally true that pension promises have ended up costing a lot more than anyone thought when the promises were made in the first place,” said Legris, “which is why there is tremendous interest in reduction of risk.”

But once plan sponsors know and understand where they fit in, in the risk/reward trade-off, they can look to some of the following solutions to help them reduce their risk.

• Choose an investment strategy that’s more in tune with your liabilities.
• Design a more affordable, more sustainable plan as opposed to a pure final salary pension. “The trick here is really about reducing the level of guarantee that exists within the plan, creating the buffer between the contributions that go in and the cost of benefits that are being built up under this guarantee,” he explained.
• Use annuities and the insurance market to settle some parts of your liabilities (e.g., offer transfer value opportunities, such as a transfer into an insurance plan to remove the liabilities from the balance sheet).
• Stop new entrants into the plan. Instead, offer them a different plan, (e.g., a DC plan). Or, freeze the plan to new entrants, as well as those already in the plan.
• If the plan is mature, start settling a portion of your liabilities by buying out annuities or potentially buying out some of your active members. But Legris said this is rare these days because interest rates are so low.
• A more innovative solution is introducing a liability and longevity swap, said Legris. This solution is popular in the U.K., and there’s been some interest in Canada. “In this case, the stream of payments that would be made indefinitely or until the person dies [an indeterminate period of time] can be swapped for a fixed period of time for the payments to be made, and the counterparty takes the risk that the individual is going to live longer than certain assumptions,” he explained. “This is an opportunity to pass the liability from the pension plan, which has no real hedging for longevity risk, to an institution like an insurance company, which can match that longevity and that mortality risk and is better able to manage that,” said Legris.

While there are many options, Legris said that plan sponsors should think about their management of risk and pension risk as a “portfolio of possible strategies.”

Once you’ve decided on a strategy, keep working on it and reviewing it, he said. “It’s rare that there will be one event that solves the problem.”