It has been just over a year since equity markets took a sharp turn downward, one of the many casualties of the global economic crisis. Defined benefit (DB) pension plan sponsors are hoping—and in some cases praying—for recovery from the single most damaging financial punch that has ever struck pension plans. The pension bruise is starting to show on the income statement and it will likely grow, with pain also being felt on the balance sheet. In addition, many plan sponsors are having to fund large pension deficits at the same time that their core business is under significant cash management challenges. As a result, recent events have caused many sponsors to reconsider their short-term outlook on financial recovery and the long-term viability of their pension plan.
Between April and June 2009, CFO Research Services, the research arm of The Economist’s CFO magazine, collaborated with Towers Perrin to conduct their third annual research study to explore the views of senior finance executives on DB pension plans. The 2009 study focused on the impact of the economic downturn and featured responses from 439 mid-size and large organizations (over 130 of which were Canadian) across a broad cross-section of industries. This article refers to several findings from this research study; entitled “A Qualified Commitment to DB Plans” (the full report can be found at www.towersperrin.com).
From an accounting perspective, while the downturn generally resulted in large year-over-year increases in pension expense, the impact was muted somewhat by two key factors: a sharp increase in corporate credit spreads pushing up the discount rates used to measure liabilities and the use of asset smoothing methods by many organizations. Discount rates climbed by 75bp to 125bp during calendar year 2008, bringing down the measurement of the obligations, albeit still not enough to mitigate the decline in assets. According to the research, 63% of Canadian organizations indicated that the economic events caused the pension plan to have a material negative effect on the corporate financial statements. Without the two mitigating factors noted above, the impact would have been far more significant.
As 2009 progresses, we have seen Canadian corporate credit spreads and bond yields contract back closer to the levels seen in the latter part of 2007, which will likely result in sharply lower year-end discount rates for many organizations. While fund performance through the first eight months of 2009 is strong, it will, in most cases, not be strong enough to offset the liability increase resulting from the lower discount rates. In the absence of stellar fund performance over the balance of the year, the unwinding of the credit spreads will put further strain on income statements and balance sheets across Canada. Further, while the deferral of some 2008 asset losses through asset smoothing helped avoid sharper increases in 2009 pension expense, these losses will adversely affect 2010 pension expense.
On the cash management front, most Canadian pension legislators implemented some form of solvency funding relief. However, more significant opportunities for funding relief in most jurisdictions have been tied to the requirement that the sponsor provide letters of credit or obtain member consent. As a result, more than half of Canadian survey respondents indicated that they are not very likely to take advantage of funding relief.
Management of DB cash requirements is expected to be one of the greatest concerns for 61% of Canadian survey respondents. However, it is encouraging that 86% of these respondents do not expect their organization to have problems funding their pension plans for the next two years. It may be that some companies have backed away from targeting full funding and instead are targeting minimum funding requirements for the foreseeable future.
The global economic crisis has provided sobering clarity on the downside of DB pension risk and is forcing many plan sponsors to reassess their perspective on this issue. Before the crisis, many plan sponsors reviewed their asset/liability forecasts and concluded, with 90% or 95% confidence, that they could withstand adverse pension experience. In future, more attention will likely be given to tail risk analysis to determine if an organization, and its pension plan, can withstand significant adverse experience, possibly including a redefinition as to what constitutes adverse.
The research asked respondents to share their longer-term perspective on DB plans, to which 71% of organizations indicated they are more likely to focus on ensuring the long-term viability of their DB plan, with only 29% saying they are more likely to focus on finding an alternative to the DB plan. In regards to pension fund investments, 78% of respondents indicated that they will focus on risk management while the remaining 22% plan to focus on obtaining higher returns. When these two questions are viewed together, a majority (54%) intend to focus on ensuring the viability of their DB plans via risk management techniques.
The survey provides insight into the degree of continuing commitment to DB plans and the increasing awareness of the need to develop an overall risk management framework for DB plans. The reality is that some employers are bound to their DB plans, either because of union agreements or an employee value proposition that calls for DB.
For those organizations that are looking to exit their DB arrangements, many simply cannot afford to do so at this time, as the cash required to fund the pension deficit and/or the expense charge to curtail and settle the plan would be prohibitive. For the sponsors of larger plans, there is also the practical matter that the Canadian annuity market may not be able to support a traditional annuity settlement, effectively forcing ongoing management even if the cash and/or accounting issues could be satisfactorily resolved.
Many sponsors are thinking about these issues as they attempt to recover asset values. As we move into the latter part of 2009, however, the world has not gotten any less risky. Sponsors will need to make sure that they have a keen sense of the short-term risks and long-term opportunities, so they can address pension risk challenges while also seeking optimal returns. By better managing corporate financial risk, plan sponsors will be better prepared for the next financial storm.