Not At All Costs

What drives the true cost of having a defined benefit (DB) pension plan? The three most important factors are the cost of the promised benefits, the return on the plan assets that support the benefits and the costs associated with operating the plan.

With this in mind—and with no quick or inexpensive way out of an existing DB pension plan deficit—sponsors are left with a handful of strategies to help them contain costs in the short term. These strategies include reducing future benefit promises, improving returns on plan assets, reducing plan operating costs and using capital more appropriately.

Keep in mind that these strategies deal with surviving today, rather than what might be best for the company in the long term.

Strategy No. 1 – Reduce Future Benefit Promises

It is time for employers to take a hard look at pension plan design. At the core of their considerations should be the benefit multiplier or plan formula, the early retirement reduction formula, the automatic or normal form at retirement, the cost of living allowance or indexing provision and any bridge benefits. Even employers with a unionized workforce must find ways to deal with the DB plan. Any reduction to benefits will obviously be a tough sell to employees, but it may only need to be temporary. And a well-communicated rationale for any changes will go a long way to ease the pain.

For many employers, the current plan design costs a lot of money and may no longer support the company’s talent attraction and retention needs for today. If the so-called “war for talent” is real or is at least a concern in your industry, then perhaps the time is right to remove plan provisions that are costly and encourage employees to retire earlier than you want or need.

Legacy plan provisions, such as a bridge pension and unreduced early retirement options, may be working against your company’s retention goals. If attracting younger talent is the goal, then it may make sense to offer new entrants a defined contribution (DC) plan. While this will not save you much in the short term, it will set you up nicely in the mid to long term.

Some other plan design changes to consider, with an eye to reducing costs, are as follows.
1. Freeze the DB pension plan – This could be either a temporary or a permanent change. There are many options, including whether to freeze credited service, freeze salaries or grandfather current active employees. You may also consider offering a DC component for future service.
2. Reduce the DB formula and add a DC component – Some refer to this as an “A plus B” plan.
3. Use career average pay instead of final average pay – You can provide benefit improvements to track the final average pay when investment returns make it affordable. But be careful—this is not a guaranteed money saver.
4. Introduce or increase employee cost-sharing – This way, for every 1% of pay or $1 of increased employee contribution to the pension plan, the sponsor will essentially save the same amount.

Strategy No. 2 – Improve Returns on Plan Assets

Fast on the heels of a year that left the average Canadian pension plan with a negative 16% return on assets, many plan sponsors have been reminded of what the downside of risk feels like. In many cases, they are coming to grips with the reality that they weren’t financially strong enough to take on the amount of risk they did.

So, how do we deal with that today? The first order of business is to decide whether or not you can handle another year in which the return on assets does not at least equal the increase in liabilities.

Today, many plan sponsors have an asset allocation of roughly 50% equities and 50% fixed income (compared to about 60% equities and 40% fixed income a year ago). While some are fine with the current asset allocation and investment strategy, others are considering a more conservative approach associated with some combination of decreasing the equity exposure, immunizing a portion of the liabilities and moving toward a liability driven investment strategy.

Given today’s increased yield spreads for credit risk, what if a buy-and-hold strategy overweight in quality corporate bond holdings could produce the same expected return as the 50% equity portfolio but with lower volatility? Would you consider it? The cost-containment goal, from this perspective, is to maximize the return on plan assets while minimizing large negative surprises. Too often, we become enamoured with the lottery scenario of huge equity jumps and forget the real-life pain associated with negative returns.

Strategy No. 3 – Reduce Plan Operating Costs

Plan operating costs fall into two broad categories: investment management fees and other service provider fees. A primary consideration, with respect to investment management fees, is the amount being paid for active management compared to passive management. In other words, has your net return (after deducting investment manager fees) been more or less than it would have been if you had held the index? After all, passive management can be obtained for significantly less cost. If an active manager is not producing appreciably more than the index, then why pay fees for active management?

What you really care about is the return that hits your plan assets relative to your plan liabilities. That said, some investment styles—particularly the value style—achieve their benchmark returns with much less volatility than the index. The risk/reward trade-off should be a major consideration in developing your manager structure. If you decide that active management fees are worth it, then the next step is to compare your active equity managers with their peers to determine how your net return measures up. Another area of scrutiny is the costs and returns from your service providers, such as actuaries, auditors, administrators and consultants. Aside from ensuring that your service providers remain competitively priced, it may be to your advantage to enter into a long-term contract in exchange for a discount.