Brighter days

De-risking can take several forms—from switching to a DC plan to creating a new funding policy (see “De-risking Activities of Public/Private Sector Plans” below). But the de-risking action that plan sponsors are most likely to undertake in the near term is shifting their investment mix away from equities.

However, as this chart shows, there are differences in perspective between public plan and private plan sponsors. This is not a surprise, given their different risk tolerances, time horizons and funding regimes. Private sector pension plans face more challenges that are pushing them to consider the de-risking journey—or even to exit the DB plan world altogether—but certain challenges are holding them back from starting that journey.

Risk Reduction Versus Higher Returns
Many plan sponsors believe that the price to de-risk remains too high, despite today’s higher bond yields. Indeed, according to the Pension Risk Survey, the desire by private sector sponsors to seek higher returns as a means of increasing the plan’s funded ratio is somewhat higher this year than last year, whether or not it’s in combination with some degree of risk reduction (see “DB Plan Sponsor Objectives” below).

Clearly, the investment strategy requires a balanced position between reducing risk and seeker higher returns. And that position will greatly influence the investment policy details.

Accounting and Expense Reporting
In the past, accounting rules presented a barrier to de-risking via an investment strategy change. The annual pension expense was offset by the expected return on plan assets, which reflected an expected risk premium from equities and other return-seeking assets. In effect, those accounting rules encouraged plan sponsors to take on investment risk.

However, for companies reporting under International Accounting Standards Section 19 (IAS 19), the recent revisions (which took effect this year) have removed some of the barriers to pension de-risking. Since the expected rate of return is now equal to the discount rate on the liabilities, sponsors that take on more investment risk can no longer take advantage of being able to assume a higher expected rate of return on their assets, which would have reduced their pension expense in the past.

And previously, when pension plans settled their liabilities through annuity purchases, sponsors would have had to recognize potentially large unrecognized losses immediately on the corporate balance sheet. The revised IAS 19 rules require immediate balance sheet recognition of all annual changes in the surplus or deficit position of the plan. No unrecognized losses from previous years, therefore, remain on the balance sheet waiting to be recognized. This means that annuity purchases may be less onerous from a financial statement perspective.

On the other hand, there are many Canadian sponsors that account for their pension plans under the U.S. accounting rules. For these sponsors, the barriers of the potential change in the expected rate of return on assets and the unrecognized losses remain. However, if the U.S. adopts similar standards to the IAS, these barriers will be removed.

A further accounting barrier has been the volatile gap between the cost of buying annuities and the plan sponsor’s pension accounting liabilities. The cost of annuities has historically been 5% to 15% higher than the cost of pension accounting liabilities—in part because insurance companies price their annuities to reflect their view of the most current experience and expected future improvements in mortality. The Canadian Institute of Actuaries released a draft Canadian Pensioners Mortality Report on July 31, 2013, and, as a result, most sponsors will be changing their mortality assumptions to reflect longer lifespans, which will narrow that gap.

Design and De-accumulation
Over the past 10 years or so, many private sector sponsors have changed the design of their pension plans for new hires by closing their DB plans and replacing them with DC plans. Increasing numbers of sponsors that had closed their DB plans to new hires are now freezing these plans so that future pension accruals are also on a DC basis. This strategy does serve to decelerate the growth of their DB liabilities, but the legacy of those liabilities will remain a material force affecting the volatility of financial statements and cash flows for decades. Many such sponsors are seeking solutions to loosen that financial noose around their necks.

Some sponsors have taken steps to amend their plans to allow for the option of a lump sum settlement upon retirement. For example, the Canadian Auto Workers union (now Unifor, after the merger with the Communications, Energy and Paperworks union) agreed with some of the large automakers last year to change their pension plans so that members will have the option to elect a lump sum settlement rather than a monthly pension upon retirement. Lump sums at retirement transfer the risk to the retiring members and reduce the growth of the DB liabilities for the sponsor. Indeed, the 2013 Pension Risk Survey revealed that if the law so allowed, 40% of sponsors would offer current retirees actuarially equivalent lump sums in lieu of their pensions.

Some companies sponsor several DB plans, often as a result of past acquisitions. In Ontario, for example, many have decided not to merge their plans, due to the complicated rules and approval process. Even if they do merge their plans, the Financial Services Commission of Ontario requires them to retain all of the various historical pension accrual formulas. In July 2013, the Ontario government released new draft asset transfer regulations that will make it easier for companies to merge their retirement plans. Depending on the details of the final regulations, this may inspire some solutions to curtail financial risk.

Funding and Surplus
After the severe effect of the 2008 financial crisis on plan funded status, many sponsors had the desire to de-risk. But they realized that de-risking reduces the ability to earn higher returns from return-seeking assets. With such low funded ratios, many sponsors were not willing to give up on their natural desire to maximize the proportion of plan assets that could benefit from an eventual market upturn. They also realized that once their funded ratios reach close to 100%, any further investment gains on return-seeking assets could end up being “trapped” as surplus in the plan, with the sponsor having only partial access to the surplus if and when the plan is terminated in the future. Many sponsors, therefore, made a conscious decision to continue to take investment risk and to watch for signs of the market driving their funded ratios up toward 100%. But long bond yields kept falling, and the journey to fully funded status became more painful.

Finally, in the past few months, sponsors are seeing hope in the markets. If interest rates remain at or above current levels, and equity markets stabilize or grow between now and the end of 2013, many sponsors will finally experience reduced minimum required contributions.

However, sponsors may want to consider maintaining their current level of contributions so they can get to a fully funded plan sooner, which will allow more flexibility to de-risk. Sponsors that contribute more than the minimum required can create prepayment reserves in some jurisdictions such as Ontario, which can be used to offset future required contributions at a time when such an offset is more advantageous to the sponsor’s business. Accelerated funding can be part of a plan member communications strategy and can be presented to unions as part of negotiations. But this strategy diverts cash from elsewhere in the business and potentially increases interest on debt.

Liability Size
The thinking used to be that “jumbo” plans (those with pensioner liabilities above $500 million) were too large to be settled in the Canadian annuity market, and plans with liabilities in the range of $200 million to $500 million needed to settle their liabilities in tranches over time.

In 2012 in the U.S., however, plan sponsors witnessed annuity settlements of $26 billion for General Motors and $7.5 billion for Verizon. There are some international insurance companies and banks that are interested in taking on or reinsuring Canadian longevity and/or annuity risks and may help Canadian insurers complete larger annuity deals. So the option of de-risking through annuity settlements may now be available to sponsors that previously assumed their pension liabilities were too large to be settled.

Continuing Regulatory Barriers
Pension regulators in all jurisdictions except Alberta and B.C. take the position that if a sponsor settles a portion of its pension liabilities for an ongoing plan through an annuity, the members included in the annuity purchase must still be treated as members of the plan. This means these members must be included in funding valuations, and premiums to the Ontario Pension Benefits Guarantee Fund (PBGF) must be paid with respect to Ontario members. In the unlikely event that the insurance company becomes insolvent, the sponsor would be on the hook for any pensions not covered by Assuris, the insurance guarantee system funded by the Canadian insurers. This is called “boomerang risk.”

The 2013 Pension Risk Survey revealed that, if the law so allowed, close to half (47%) of plan sponsors would consider a group annuity purchase to fully relieve themselves of future DB obligations. If Ontario, for example, were to eliminate boomerang risk through new regulations, this may well reduce the risk to the PBGF. Now that the economic environment has improved for pension plans, sponsors need to focus on managing their plan risks. Sponsors that don’t have a strategy to get to the desired level of retirement risk should consider implementing one to “right risk” their plans. Those sponsors that have started the de-risking journey need to be diligent about monitoring their plan and implementing the de-risking steps. With funded ratios moving in the right direction, DB plan sponsors will need courage to resist the obvious temptation to avoid or delay taking the de-risking actions that they have committed to. However clear the view may be today, markets are volatile, and favourable economic de-risking conditions can quickly blow away.

Kevin Tighe is a senior consulting actuary, and Ian Markham is Canadian retirement innovation leader with Towers Watson. kevin.tighe@towerswatson.com; ian.markham@towerswatson.com

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