Pension crisis centre stage

As GM’s pension deficit hovered in the news, two provincial finance ministers took the floor at the 8th annual IMN Canada Cup of Investment Management in Toronto.

Dismal savings rate
Ontario’s Dwight Duncan says the taxpayer is not on the hook for GM’s pension liabilities; nevertheless he admitted that government programs had “failed to incent people to save.” He favours a supplementary pension plan to the Canada Pension Plan but says there are many question to be answered, such as whether it is funded through taxes, employer contributions, mandatory plan member contributions or voluntary purchases of supplemental coverage.

Alberta and B.C. are already moving in this direction following on the heels of a joint provincial inquiry. Iris Evans, Duncan’s Alberta counterpart, points out that despite the RRSP’s tax advantage, only 8% of Albertans have maxed out their contributions. She proposes a supplemental plan as the “fourth stool” of retirement savings, after OAS, CPP and RRSP/Registered Pension Plan savings. “This generation today cannot afford to pay for the generation that is now retiring,” she warns.

But even those who have maxed out their RRSPs have taken a hit over the past year; and so have pension plans. What makes this all the more pressing is that only 37% of Canadians — the vast majority of them civil servants — have workplace pensions. Private sector pension coverage is only 20% of workers, according to a recent C.D. Howe Institute study.

Now, pension deficits loom.

“We all thought 2002 was a bad year,” recalls Janet Rabovsky, practice leader at Watson Wyatt Worldwide. “Last year was a disaster.” It took until 2007 for defined benefit plans to regain funded status. Now they are only 60% funded.

A hard place
Pension funds are being squeezed between two rocks. The first is equity market declines. The typical Canadian pension plan is a 60/40 mix of stocks and bonds, though some of the larger plans have diversified into alternatives such as hedge funds, private equity, real estate and infrastructure. “All these were supposed to provide protection,” Rabovsky notes. “Last year, they didn’t.” She attributes 16% of the underfunded status to market losses.

But another 11% is due to a decline in interest rates. While declining interest rates can represent a capital gain for an investor, it has the opposite effect in valuing pension plan liabilities. The lower the interest rate, the more money a pension plan has to put aside to meet future obligations. The present value of future benefits is arrived at using the current interest rate on high-quality corporate bonds; the long-term earning power of the plan, however, is priced off 30-year government bond yields.

So pension plans are facing three unpalatable choices. Leona Fields, manager of York University’s pension plan estimates that the university will have to increase the employer’s contribution by 2.5 times the current rate to ensure the long-term sustainability of the plan.

Alberta Teachers Retirement Fund (ATRF) is in better shape, says CEO Emilian Groch, but there were two contributing factors. The government of Alberta assumed all liabilities incurred to August 1992. Second, 25% of its assets were a loan from Alberta that is expected to be called next year.

As a result, ATRF faces the same three options: benefit reductions, increased contributions, or moving the investment policy to match the stream of liabilities to be paid out. In any case, the contribution rate will rise from 18.5% to 23.5%.

Ontario Teachers Pension Plan has faced the same challenges. In April, at a pension summit sponsored by the Conference Board of Canada, pension consultant Keith Ambachtsheer suggested that the value of Ontario’s pension promise implied a contribution rate of 30%.

But both Fields and Groch make it clear that benefit reductions and higher contribution rates are not going to be swallowed easily by plan members.

Scarce options
There are some things plan sponsors can do, but it is a limited palette. One approach is liability-driven investing. It carries a risk, says Charles Gilbert, president of Nexus Risk Management. As plan sponsors move to LDI, they may have to forgo the attempt to recoup market losses by waiting for stocks to rebound.

LDI is more a process than a product, but it involves a number of things. One is to more nearly align the duration of assets and obligations by, for example, matching bonds and expected payouts. In practice, however, it is impossible to do this completely. A 25-year-old nurse might well live till 95. But there is no asset with a 70-year duration.

Another procedure might be to hedge out interest rate risk, which can increase a plan’s liabilities, through swaps. But what is important is to move beyond a consideration of investment risk and take a thorough inventory of plan risk.

In Canada, the choice is still voluntary, but new accounting rules in the U.K. that require companies to mark their pension fund performance to market have led to a widespread adoption of LDI. In Canada, that accounting move has been delayed till 2011, notes Francois Helou, managing director of equity structured products at RBC Capital Markets, something he thinks many companies are going to regret.

One of the best performing pension plans last year was the Hospitals of Ontario Pension Plan. It made a partial transition to LDI in late 2007, says senior vice-president James Keohane. He thinks “liability-driven investing is the most powerful risk management tool we can employ.”

But it has to be employed carefully, vis-à-vis the 25-year-old nurse. It is not bond immunization, such that assets exactly match obligations. Nor is it a total move to bonds, since that would mean giving up the equity risk premium, the 300 basis points that stocks, in the long run, provide above bond returns. That would only increase the actuarial estimate of underfunding.

Instead, the idea is to “mitigate catastrophic risk while retaining the expected return on the portfolio.” Since HOOPP has very little room to fund deficits, the assets have to outperform the liabilities, Keohane says. That is the risk tolerance of his plans board of trustees.

He says that he ran “very many benign scenarios — nothing like last year — where the board’s risk tolerance would be exceeded.”

But with LDI, he found “we didn’t need to take as much risk as we were to be fully funded.”

As a result, HOOPP reduced its exposure to public equities to 30%, increased its long-bond holdings and added inflation-sensitive holdings in real-return bonds and real estate.

As for the happy 2008 results, he says “we’re only part way through our strategic initiative.”

Scot Blythe is a Toronto-based freelance writer.

To comment on this story, contact us.