With the end of 2013 in sight, I can safely say “de-risking” is this year’s hottest pension buzzword. What, though, do I mean by de-risking, and how new is it really?
For employers that contribute to DB plans, the recent focus has been on financial risk. Historic low interest rates have exacerbated plans’ reported funding shortfalls and depressed bond returns. Volatility, in turn, has been the norm for equity returns. All of these factors have spurred a wider movement to de-risk funding obligations for DB plans’ active members and retirees. Common strategies have included plan conversions, amendments to reduce or eliminate indexing, or introductions of less-generous benefit formulas.
To those firmly in the throes of financial de-risking, there have been a number of interesting developments this year.
In August, the Financial Services Tribunal released its decision in The Royal Ontario Museum Curatorial Association v. Ontario (ROMCA). The Tribunal held that the Ontario Pension Benefits Act and the plan text in issue permitted the employer, the Royal Ontario Museum, to introduce for active members a less generous DB formula, including for service before the effective date of the amendment, so long as the application of the new formula would not reduce the commuted value of affected members’ benefits accrued and calculated as of the effective date. The evidence showed that the amendment would reduce this relatively small plan’s solvency deficiency by about $900,000 over two to seven years following the effective date.
ROMCA contrasts with the Alberta Court of Appeal’s 2010 decision in Halliburton Group Canada Inc. v. Alberta, in which the court held that, under the plan text in that case, the employer could not reduce a benefit formula, including with respect to future service. While never binding in Ontario, the Alberta decision caused many Ontario employers to think twice about whether to de-risk ongoing pension costs through changes to their plans’ benefit formulas. ROMCA now gives greater comfort that they may do so, subject, as always, to the plan text and any collective agreements.
Separately, the movement to de-risk financial obligations to retirees has imported to Canada two novel strategies that are more common in the United Kingdom: the annuity buy-in and the longevity hedging contract.
Under an annuity buy-in, the plan administrator purchases one or more annuity contracts that it holds as an investment of the plan. In exchange for the purchase, the insurer agrees to pay periodic payments to the plan equal to its projected periodic benefit payments. Benefits at all times remain the plan’s ultimate responsibility, but the insurer’s periodic payments mitigate longevity risk (the risk that retirees will live longer than expected) and investment risk (the risk of insufficient investment returns). Earlier this year, the Canadian Wheat Board announced that it had completed a $150-million inflation-linked annuity buy-in with the Sun Life Assurance Company of Canada.
A longevity-hedging contract, which includes arrangements commonly called longevity swaps, is a still more exotic strategy. To date in the U.K., a common form of this contract involves an agreement with a counterparty, such as an investment bank, under which the administrator agrees to pay the counterparty fixed amounts based on the plan’s expected mortality experience, and the counterparty agrees to pay the plan floating amounts based on the plan’s actual mortality experience. If retirees live longer than expected, the plan comes out ahead. Otherwise, the counterparty comes out ahead. I am not yet aware of any contract of this nature in Canada, but the Office of the Superintendent of Financial Institutions has pre-emptively published for comment a draft policy addressing them.
Financial risk, however, is not the end of the story. It’s only one of the many kinds of risk that affect pension plans and their stakeholders.
As a pension lawyer, I have to point out that there is also legal risk. For all plans, legal risk includes the risk of successful claims against the employer and administrator for misstatements or omissions in plan communications and employer-prepared option and election forms. For member-directed DC plans, there is an additional layer of legal risk of claims for insufficient investment and financial education, high or insufficiently clear investment management and recordkeeping fees, and inappropriate default options. Increased legal risk can, of course, lead to increased financial risk, but the ways to approach it are much different.
Less discussed is reputational risk; that is, the risk that decisions or performance under the pension plan will reflect poorly on a business with its shareholders, employees, regulators and the broader public. While hard pension restructuring decisions are sometimes necessary, especially in today’s challenging business environment, poor execution can hit a company’s reputation, and, ultimately its bottom line.
Some have even floated the idea of regret risk. If employers and administrators don’t adequately consider decisions—including decisions to de-risk—before making them today, there’s a risk that they will come to regret those decisions tomorrow. For example, fully annuitizing a DB plan’s liabilities in today’s low interest rate environment may remove the liability from the company’s books, but it will also eliminate the possibility of a much less expensive annuity purchase, perhaps even with leftover surplus, when interest rates rise in the future.
All of these areas of risk are interconnected, and, while the strategies to address them are evolving, the risks have always been with us. Today’s buzz around de-risking is, therefore, nothing new. Many of us have been thinking about de-risking all along, whether the risk has been financial, legal or reputational. What is new, though, is the complexity of today’s risk management strategies. A world of ever more sophisticated investments, legislation, regulatory policies and stakeholders calls for ever more comprehensive risk management. That’s what discussions on de-risking should focus on today.