Many employers would like to reduce the risk in their DB plan so that the level of pension risk meets the company’s overall risk management objectives. One of the reasons employers may be waiting to de-risk is because they intend to “lock in” future gains resulting from strong investment returns (which increase plan assets) or increasing bond yields (which decrease plan liabilities). However, it’s important to recognize that de-risking opportunities may emerge quickly and could be short-lived.
There are a number of approaches an employer can use to de-risk, including changing the plan’s investment strategy to reduce the amount of return-seeking assets (such as equities) and increase the amount of assets (such as bonds) that better match changes in the plan’s liabilities. Another example of a de-risking approach is to settle a portion of the plan’s obligations by purchasing group annuities from an insurance company.
Despite the desire to de-risk, fully implementing a de-risking strategy is typically not affordable for employers due to the significant underfunded status of most pension plans. While a number of employers may not be taking de-risking action now, they plan to begin de-risking when the funded position of their plan improves. A review of the funded status of an illustrative pension plan during the first half of 2013 provides interesting insight into the speed at which de-risking opportunities may emerge.
Illustration of change in funded status
For this illustration, the pension metric that matters most to the employer is the ratio of plan assets to solvency liabilities (or solvency funded ratio), which was 75% on Dec. 31, 2012. The plan’s asset mix is 50% equities and 50% long-term bonds. (Half the equity allocation is in the Canadian market, and one-fourth is in each of the U.S. and non-North American markets.)
The chart below shows the daily solvency funded ratio of the plan during the first half of 2013, along with the percentage change in plan assets and solvency liabilities:
* = percentage point
Sources: PC-Bond, a business unit of TMX Group Inc.; Bank of Canada
The following are some observations about the chart above:
- U.S. and non-North American equity markets performed well from the beginning of the year until late May, while the Canadian equity market was relatively flat during this period. Due to the positive performance of foreign equities, the market value of plan assets increased during this period and peaked on May 21 at 6% above its beginning of year value.
- In June, Canadian and non-North American equity markets retreated and the value of the plan’s bond portfolio decreased. This caused a decrease in the market value of plan assets during June, and on June 30, the market value was only 1% higher than the beginning of year value.
- Long-term Government of Canada bond yields increased during January, which caused a 3.5 percentage point decrease in the plan’s solvency liabilities. Yields then remained relatively flat for a period but decreased from mid-March to early May. From early May to late June, yields increased by approximately 0.7 percentage points. Consistent with the pattern of bond yields, the pension plan’s solvency liabilities increased from mid-March until early May, when they peaked at one percentage point above their beginning of year value. From early May, the liabilities started decreasing and, by the end of June, were five percentage points lower than the beginning of the year.
- The plan’s solvency funded ratio, which started the year at 75%, increased early in the year and reached 79% by mid-March, then started to decrease until it reached 77% by mid-April. In mid-April, the funded ratio started trending upwards until it reached a peak of 81% on June 3 and ended June at 80%.
- A plan’s solvency funded ratio can change quickly. The funded ratio increased by six percentage points (from 75% to 81%) in just over five months. This included an increase of two percentage points within a couple of days and an increase of four percentage points during a one-month period. While the solvency funded ratio of the plan improved rapidly in the first half of 2013, employers are painfully aware that solvency funded ratios can also deteriorate rapidly. Therefore, for employers that wish to lock in positive financial experience by taking de-risking actions, the windows of opportunity may be short.
- In order to maximize de-risking opportunities, employers should focus on both plan assets and liabilities (i.e., it’s not sufficient to focus on assets or liabilities in isolation). While the illustrative plan asset value peaked on May 21 and solvency liabilities were at their lowest point on June 25, the solvency funded ratio was at its highest level on June 3.
- The change in an actual plan’s solvency funded ratio during the first half of 2013 may have differed significantly from the change for the illustrative plan. Factors that could affect this change include the manner in which the plan assets are invested, the sensitivity of the solvency liabilities to changes in bond yields and the amount of contributions made to the plan during the period.
Lessons for de-risking
For an employer that intends to de-risk in the future, this illustration highlights the importance of establishing a detailed journey plan that outlines the following:
- The frequency of the monitoring of the pension metrics (e.g., solvency funded status) that matter most to the employer. The appropriate monitoring frequency will depend on the particular circumstances of the plan. However, common practice of monitoring key pension metrics annual or quarterly may not be frequent enough for some plans to capitalize on a rapid improvement in the plan’s financial health.
- The trigger points for taking de-risking action. For example, the journey plan could specify that de-risking action will be taken when the solvency funded ratio reaches 80%, 85% and 90%. In the case of the illustrative plan, a trigger point would have occurred in early June when the solvency funded ratio reached 80%. Specifying the trigger points up front in the journey plan avoids undue delays that may be caused by “second guessing” at the time that gains occur as to the appropriate time to take de-risking action.
- The actions that will be taken upon attainment of the de-risking trigger points. For example, the journey plan could call for a movement of a portion of the plan assets from equities to bonds, lengthening the duration of the plan’s bond portfolio or the purchase of annuities in respect of a portion of the plan’s retirees.
- The internal pre-approvals needed to take swift de-risking action when windows of opportunities present themselves. There is a significant risk that opportunities will be lost if, for example, each de-risking action must be approved at a quarterly pension committee meeting. Also, being able to take action quickly when de-risking opportunities arise may lead to “first mover” pricing advantages.
The funded status of pension plans can change rapidly. Employers that establish a journey plan that provides for swift and decisive action will be in the best position to benefit from future de-risking opportunities that may be short-lived. When it comes to de-risking, timing really does matter!