© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the February 2005 edition of BENEFITS CANADA magazine.
 
Plan sponsors are asset-focused when it comes to benchmarking the performance of their pension fund. But looking at the pension liability return offers a clearer picture.
 

When plan sponsors review the performance of the pension fund, they tend to focus only on the assets. In a defined benefit(DB)pension plan, however, the assets do not exist in isolation. They are there to ensure that the liabilities of the pension plan are secured. As a result, plan sponsors should take a “balance sheet approach” to performance measurement by looking at both assets and liabilities.

The question they should really be asking is: What was the impact of investment performance on the financial position of the pension plan? Performance measurement reports must, first and foremost, answer that question.

Most plan sponsors evaluate the performance of their pension fund by comparing the total fund return against one or more of the following benchmarks:(a)a realreturn target, typically 3% to 4% above inflation;(b)the fund’s ranking against a sample of other pension funds; or(c)the average of returns on market indices weighted by the fund’s long-term asset mix policy—the so-called asset-mix policy return.

These benchmarks provide much useful information, such as how the fund has performed relative to its “peer group,” and whether or not investment strategies have added value. They do not indicate whether or not the fund is achieving its fundamental objective of securing the liabilities of the pension plan. Indeed, the information they do provide may at times be misleading. The performance measurement report, for example, may show the fund as doing well, even though the financial position of the plan may, in fact, have deteriorated.

THE PENSION LIABILITY RETURN
In order to measure the impact of a fund’s investment performance on the plan’s financial position, the return on assets should be compared against the return on liabilities. Pension liabilities are affected by changes in capital markets— specifically, interest rates and inflation—the same factors that also drive changes in the value of pension assets. It is possible to calculate a “return” on pension liabilities just as one calculates the return on pension assets.

The pension liability return measures the change in the value of pension liabilities resulting from changes in the liability discount rate and inflation. It represents the return that pension assets would have to earn to keep pace with changes in the value of pension liabilities. As such, the pension liability return is the ultimate benchmark for measuring the performance of the pension fund.(Of course, pension liabilities can also change as a result of benefit improvements, actual mortality and retirement experience, and changes in plan membership, but these are unrelated to investment performance.)

The pension liability return is unique to each pension plan, since it depends not only on the discount rate used in the plan’s actuarial valuation but also on the relative proportion of the plan’s active and retired liabilities, the durations of these liabilities and the extent to which plan benefits are indexed to inflation. The pension liability return can be calculated quarterly, or even monthly, on both a funding and on a solvency basis.

AN EXAMPLE
The significant decline in the funding and solvency positions of pension plans in recent years illustrates clearly the importance of using the pension liability return as a benchmark to measure the performance of pension funds.

Consider the following example of XYZ Company Ltd. which offers a DB plan that is 50% indexed to inflation. About 60% of plan liabilities are for employees and the remaining 40% for retirees. The last actuarial valuation as of year-end 2000 assumed a discount rate for funding purposes of 6%(reduced from 6.5% in the previous valuation)with an assumed inflation rate of 3%. The solvency discount rate was based on the yields on long-term nominal and real return Canada bonds. The pension fund followed an asset mix policy of 55% equities, 45% bonds, revised from 60/40 as of July 1, 2001.

The performance measurement report as of Dec. 31, 2003, shows that by most conventional standards, the performance of the pension fund would be judged as being more than satisfactory (see Performance Measurement Results”):

• The total fund return was 14.5% for the latest year;
• While the return was more modest over three and five years, it was, nevertheless, above the rate of
inflation;
• The total fund return also exceeded the asset mix policy return in every period, with the investment
managers outperforming their benchmarks and by more than 2% a year over three and five years;
• Finally, the fund ranked in the second quartile over one and three years and in the first quartile
over five years.

The subsequent actuarial valuation, however, showed that the XYZ plan, which had a modest surplus on a going-concern basis three years ago, was underfunded as of year-end 2003. The solvency picture was even more alarming, having deteriorated more than 13% over the three years.

Measuring the total fund return against the pension liability return would have provided an early warning of the deterioration in the funding and solvency position of the plan(see “Impact on Financial Position”).

The liability return measured on a funding basis was slightly above 5% a year over one and three years, below the discount rate of 6%, as inflation during the period was less than assumed. Over five years, the funding liability return was just over 7%, reflecting the impact of the decline in the discount rate from 6.5%.

The liability return on a solvency basis was much higher, especially over one and three years, due to the significant decline in yields on longterm bonds, particularly real-return bonds, during this period.

The impact of investment performance on plan funding and solvency was positive in 2003, given the rebound in equity markets. Nevertheless, it remained significantly negative over the last three years and was negative even when measured over five years(see “Cumulative Impact on Plan Solvency”).

This chart shows the cumulative impact of fund performance on the plan’s solvency during this period. It indicates that the impact on solvency peaked in mid-2000 and then declined more than 40% over the next two and a half years. The improvement in 2003 was not enough to offset the earlier negative impact of fund performance on the plan’s solvency position.

THE PENSION BALANCE SHEET
Pension liabilities respond to changes in capital markets just as pension assets do. Conventional measures of pension fund performance look only at the asset side of the “pension balance sheet,” and thus do not tell the whole story.

Plan sponsors should insist the measurement report show the return on the liabilities unique to their pension plan. By looking at the return on both assets and liabilities when reviewing the performance of the pension fund, plan sponsors would get a far more accurate picture of the financial health of their pension plan.

Arif Sayeed and Dan Markovich are principals of Toronto-based ARDAN Fund Oversight Inc. asayeed@ardan.ca; dmarkovich@ardan.ca