Enjoying recent gains, pension funds are turning their attention to a new challenge: keeping them
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Put on your dancing shoes, kick up your heels and turn up the music…Canada’s DB pension funds had a terrific year in 2013. Building on gains in 2012, the Top 100 pension funds continued to see funding improvements last year due to generous equity returns. As a result, many pension funds are now focusing more clearly on how to manage their risk so they can be better prepared for the inevitable: when the party’s over.
According to data from the Canadian Institutional Investment Network, in 2013, the total assets of the Top 100 pension funds reached $975 billion—a year-over-year increase of 11.4%. Not bad, considering the carnage of 2008.
“The majority of plans are pretty close to fully funded on a solvency basis,” says Terry Kirby, senior vice-president, institutional investment services, with Franklin Templeton Institutional. But this funding improvement is not uniform, with pension plan design being a major reason for the variations. “Where we had DB plans with cost-of-living adjustments, the improvements may not have been quite as great as was hoped,” explains Tom Lappalainen, director of strategic advice with Russell Investments.
The Morning After
Now that they are in a better position to do so, pension funds are focusing on how to better manage their risk at a time when the 2008 global financial crisis still casts a shadow.
Some are doing it by keeping their eye on the long term and using liabilitydriven investing (LDI), which involves reducing exposure to equities and acquiring more fixed income assets whose duration matches the duration of the plan’s liabilities.
“Equities don’t move in the same direction as the plan’s liabilities, so if you have equities in your pension plan, you have this chunk of assets that can give you really good news or really bad news,” says Brent Simmons, senior managing director of DB solutions with Sun Life Financial. “Most of the challenges over the last 15 years with pension plans have been the result of them taking a lot of equity risk and not having matched their bond portfolios to their liabilities, thereby exposing themselves to interest rate risk and credit risk as well.”
The Healthcare of Ontario Pension Plan (HOOPP) (No. 4 on the Top 100 Pension Funds list) credits mainly LDI for its 2013 going-concern funding ratio of 114%. This strategy—which the pension plan has actually been employing for the last decade—is the best hedge against inflation, equity and interest rate risks, explains Jim Keohane, the plan’s CEO.
Under its LDI strategy, HOOPP has divided its portfolio into two segments: a liability-hedging portfolio and a returnseeking portfolio. The liability-hedging portfolio comprises assets that match the plan’s obligations, such as real estate and real return bonds. The return-seeking portfolio takes equity risk through derivatives and credit risk through credit default swaps. “What we’re trying to do is ensure that our assets outperform our liabilities over the long run—and if we can do that, then we’ll be able to write pension cheques no matter what happens,” Keohane explains.
Despite increasing interest from plan sponsors, LDI hasn’t been broadly adopted to date. “It’s still a fairly new strategy in the Canadian marketplace,” explains Simmons. However, Kirby says even plans that do not currently use the strategy have started thinking about it—and that if interest rates rise significantly, the LDI conversation will be front and centre.
Shake It Up
Another popular risk management strategy for pension funds is investing in alternative asset classes, such as real estate and infrastructure. It’s an approach that works well for the Colleges of Applied Arts & Technology (CAAT) Pension Plan (No. 29). “When we did our asset/ liability studies, we introduced various alternative asset classes, [and they] showed positive traits when tested against our liability structures,” says Derek Dobson, CAAT’s CEO and plan manager.
And some pension funds that are already investing in infrastructure and real estate are looking to further diversify within alternatives by eyeing assets previously considered more exotic, such as hedge funds. “I wouldn’t say they’re [all] banging down the door to buy hedge funds,” says Kirby. “But they’re certainly welcoming the conversation to learn more about hedge funds—how to utilize hedge fund strategies and which type of hedge funds are available in the marketplace.”
A major reason for the growing appeal of hedge funds is that the transparency issues plaguing them until recently have now almost completely disappeared. The catalyst for change was the 2008 financial meltdown, including the investment scandal surrounding former NASDAQ chairman Bernie Madoff, whose Wall Street firm ran an elaborate Ponzi scheme. After these events, investors grew reluctant to put capital in any hedge fund that would not provide full transparency because the risks were too high, explains Kirby. As a result, many hedge funds complied with these investor demands and now provide transparency.
The pension plan of the Toronto Transit Commission (TTC) (No. 45) invests in hedge funds, although Vincent Rodo, chief financial and administrative officer of the TTC, describes the plan as “relatively conservative.” “In the hedge fund environment, we’re big on hedge fund of funds,” he says. “So instead of buying any one hedge fund, we’re more likely to look at a manager that has a fund of, say, 30 to 50 individual hedge funds.” Rodo adds that hedge fund of funds offer more diversification than a single hedge fund and are easier to administer. About 4% of the pension plan’s total portfolio is allocated to hedge fund of funds, and about 2% of its total portfolio is invested in the secondary hedge fund market.
A Toast to the Birthday Girl
With Canadians living longer, pension plans are also looking to control the risk of improved longevity. This February, the Canadian Institute of Actuaries released the first-ever mortality tables and mortality improvement scales based on pensioner mortality experience in Canada. (Previously, Canadian pension plans used the American standard mortality table and improvement scale.) Under the new Canadian tables, life expectancy for a 65-year-old man is currently 22.1 years— up from 19.8 years. For a woman age 65, it’s 24.4 years, compared to 22.1 previously.
While it is always present, longevity is a slow-moving threat that may not be top of mind for pension plan sponsors every single quarter the way interest rate risk is, for example. “On a relative basis, it’s not as big, and it changes very slowly over long periods of time,” Keohane says. “We have improved longevity in our assumptions, so it’s just a question of whether we assumed the rate was high enough or not.”
Making correct longevity assumptions is important because if plan sponsors miscalculate the risk, trouble will ensue down the road, warns William da Silva, senior partner and national retirement practice leader with Aon Hewitt. “Einstein reportedly said that the 8th wonder of the world is compound interest. If you are mispricing your longevity, it will continue to compound year over year,” da Silva explains. “It’s not like capital markets, where it reverts to a mean that should be net positive for the plan over the long term.” Da Silva adds that, even if the mispricing of the longevity risk is only 0.5% or 1% per annum, it becomes a significant risk after a number of years, making the catch-up quite material.
Have Your Cake and Eat It, Too?
When it comes to keeping risk under control and ensuring long-term sustainability, some DB pension funds are interested in solutions beyond asset diversification and a focus on future obligations. They are considering changing plan design. One type of structure that has recently piqued the interest of plan sponsors is the target benefit plan (TBP)—a pension arrangement in which the risk is shared between the employer and employees.
A hybrid between DB and DC plan design, a TBP aims to collect defined contributions in order to secure a target benefit in retirement. But, under this shared-risk structure, benefits and contributions change over time depending on the plan’s performance. If the returns are lower than expected, the plan sponsor can increase contributions and/or reduce benefits. If the returns are higher than expected, the plan sponsor can increase benefits or reduce contributions.
This past April, Ottawa unveiled TBP legislation that would allow certain companies to voluntarily adopt a TBP structure. The arrangement would be available only to Crown corporations and federally regulated private sector industries, such as transportation, telecommunications and banking. Employers outside of this domain would not be allowed to adopt the new design. But despite this restriction, Ottawa’s proposal will encourage many eligible plan sponsors to look at TBPs—and, in many cases, to adopt them, predicts Fred Vettese, chief actuary with Morneau Shepell, explaining that the absence of enabling legislation in most provinces has been a limitation. “I think TBPs are going to be the plan of choice in place of defined benefit in the long run.”
TBPs can be a hard sell to DB members. However, these plans offer greater benefit security than a switch to a DC arrangement. “The main argument against TBPs is that there will be less security for members. Well, that ship has sailed,” comments Vettese. “In the private sector, only one employee in 10 right now is covered by a DB plan. And that ratio is not improving any time soon.”
Hit Parade
The idea of risk-sharing in pension plans isn’t new. A number of DB plans—including the biggest ones, such as HOOPP and the Ontario Teachers’ Pension Plan—are jointly sponsored pension plans (JSPPs). The JSPP design is very similar to the TBP. The main difference is that, under a JSPP, accrued benefits cannot be reduced except in the case of a plan windup.
The CAAT Pension Plan, for instance, is a JSPP with a 50/50 contribution structure. Some risk is also shared with both active and retired members. “For service earned after 2007 in our plan, [inflation] indexation on that service is paid only when the plan is in a surplus position,” explains Dobson. “Our retirees have not experienced any impact to date, as we’ve been in a surplus position since 2007.” Because the CAAT Pension Plan cannot reduce accrued benefits, in the event of affordability and deficit issues, the only option is to change plan design on a futureservice basis, Dobson adds.
At the TTC—whose pension fund is also a JSPP—this design has been critical both for recent funding improvements (the plan is virtually fully funded on a going-concern basis) and for mitigating the impact of previous financial shocks. “With many of the large public sector plans, you take the four or five best years [in terms of] earnings and that represents their base year. For us, it’s whatever four best years our actuary says we have enough assets to justify,” explains Rodo. The choice of the four best years is revised annually, when the plan looks at the market value of its assets and liabilities. On the basis of that, it also calculates the cost of indexing benefits to inflation. If the plan does not have enough assets to cover the cost of revising its base year and indexing its benefits, it doesn’t do so.
“If you go back to 2008, with all the horrible troubles in those markets, the TTC pension plan did not index and did not update the base year,” says Rodo. “Our pension board understands that, and our members understand it. If some plans still had to provide indexing for their pensions and a base-year update, then you’re in a double-jeopardy position. You have no way to control your liabilities, and [they] go up.” This structure is different from some other JSPPs that are mandated to provide indexing and base-year updates, Rodo notes.
Even though the shared-risk JSPP arrangement has been used by certain DB plans for decades, in general, the public still misunderstands how responsibilities are divided in DB plans, according to Keohane. “People’s perception is that the employers put all the money in—which they don’t—and that if [the plan] becomes underfunded, the employer has all the responsibility to bring it back to a fully funded status,” explains Keohane. “That’s not true and never was true.”
What is true right now is that Canada’s DB pension plans had a great year in 2013—a welcome break from the wide funding gaps seen not so long ago. As a result, pension funds are breathing a sigh of relief and regaining confidence in their long-term sustainability. “I think the plans—if they’re run properly and with the proper business model—are sustainable,” says Keohane. “One of the flaws is that people view themselves as asset managers. [They] just ignore the liabilities and try to maximize returns, [so] they end up with a lot of volatility in outcomes.”
So, to avoid that wrenching volatility, plan sponsors need a prudent approach to risk and a long-term perspective. Because, sooner or later, the party will end—and they’ll need a plan to get home safely.
The numbers
- At the end of 2013, assets for the Top 100 pension funds totalled $975 billion, compared with $875 billion in 2012. That’s an increase of 11.4%.
- Only five plans reported an asset decline: General Motors of Canada Ltd. (No. 19), Telecommunication Workers Pension Plan (No. 61), Pulp & Paper Industry Pension Plan (No. 69), Alberta – Universities Academic Pension Plan (No. 77), and United Food and Commercial Workers Union Pension Plan (No. 100).
- Sixty-nine plans reported double-digit increases. The Province of Prince Edward Island (No. 88) had the largest organic growth at 35.3%.
- Fiducie globale des régimes de retraite de la ville de Québec (formerly Quebec City Pension Plans) (No. 93) has re-entered the Top 100 list, and the University of Ottawa (No. 97) is a new entrant to the Top 100.
Note: Data was collected through the Canadian Institutional Investment Network between Feb. 1 and May 17, 2014, with an accounting year-end date of Dec. 31, 2013, unless otherwise specified.
Yaldaz Sadakova is associate editor of Benefits Canada.
Get a PDF of this article, which includes the charts of the Top 100 plans and the Top 10 fastest growing pension plans.
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