One of the major determinants of an investment strategy is the investment time horizon. How long an investor has to invest the money before it is needed greatly affects the way the money is invested. The conventional wisdom is that a longer time horizon allows for a greater allocation to riskier investments with a higher expected return. This is the philosophy that underlies target-date funds as well as most asset/liability modeling for DB plans.
DB pension plans should be long-term investors. For a plan that is not closed or planning to close, the investment time horizon is arguably eternal: members retire and new employees are hired to take their place. If such a pension fund is managed on a going concern basis, then it should be able to get a higher return by investing for the very long term.
However, Canadian DB plans are schizophrenic. While the going concern valuations establish them as long-term investors, the accounting and solvency valuations drive them to a much shorter investment horizon. The requirement to present an annual snapshot funding position may lead them to invest more in fixed income and less in riskier assets, in order to manage the volatility of these snapshots.
If we believe the basic investment tenets that there is a relationship between risk and reward and that long-term investors can achieve a higher return than investors with a shorter time horizon, then the focus on solvency funding or accounting measures will, in the long run, end up costing pension funds a lot of money. Or even worse, it may make many DB plans unfeasible, resulting in employees losing the retirement certainty these plans provide.
For this reason, Canadian regulators have, in recent years, offered plan sponsors solvency relief measures, including deferral of solvency payments, extension of solvency amortization schedules, temporary (or in some cases, permanent) exemptions from solvency and letters of credit in lieu of actual cash funding.
Unfortunately, which relief measures a plan sponsor might have access to depend on where the plan is registered. Also, a cynic might say that some of the solvency relief amounts to governments letting public or quasi-public employers off the hook, while still imposing solvency requirements on the private sector. Not only is such a regulatory double standard horrible, it does nothing to stem the tide of corporate DB plan freezes, wind-ups and conversions.
Of course, the solvency measures are in place for a reason. If the plan sponsor is no longer able to fund the pension plan, it is the plan members and, in Ontario, the Pension Benefits Guarantee Fund who will take the hit. From an investment viewpoint, solvency is an unfortunate constraint on our ability to maximize return, but there still needs to be an adequate safety net for the short term to permit us to seek long-term returns.
The letter of credit appears to offer the most viable solution to this problem. It provides assurance that, in the worst-case scenario, the solvency deficit will be covered, but can eliminate or reduce the actual short-term cash infusion needed to meet the solvency funding requirements. It can buy us time, permitting us to be longer-term investors.
Not actually funding the solvency deficit makes sense only if we believe the solvency deficit is a temporary situation—an aberration brought on by a low interest rate environment and a somewhat prolonged downturn in the stock markets. This belief is supported by the fact that many plans currently have a solvency deficit but a going-concern surplus. If the going concern assumptions really are valid, then it makes sense to manage to this long-term funding scenario.
If long bond interest rates rise or those long-term riskier investments finally pay off, then the solvency deficit might quickly evaporate. Unfortunately, we have been waiting for over a decade for either of these two winning scenarios. The short term can take a very long time.
This brings us back to our original premise. What really is the investment time horizon of the DB plan? Even if the plan is managed as a going concern with no intention of ever closing it, the fact is it may not be able to continue indefinitely. The nature of the plan and its relationship to the plan sponsor is constantly changing. The demographics of the plan and ratio of active members to retirees change over time. The dollar size of the plan relative to the financial strength of the plan sponsor changes over time.
So, as much as we may want to focus on the long term, and as useful as a vehicle such as a letter of credit might be in getting us past short-term solvency concerns, we still cannot plan an investment strategy that is immutable and does not shift over time with changing circumstances. We need to design a glide path rather than a static asset mix policy.
In the best of all possible worlds, DB pension plans are long-term investors that engage in long-term planning. Such planning needs to be much broader than the simple snapshot provided by a standard closed-group going concern valuation. Those DB plans that wish to invest for the long term should, in the interests of inter-generational equity, conduct a sustainability review, examining all factors that will affect funding over the next fifty years and how they might change.