Indeed, the number of plans on the OSFI watch-list rose to 84 at the end of last year, from 75 plans in September 2005—nine more underfunded plans in only three months. To make matters worse, plan sponsors might be forced to reduce pension benefits to members in the future if the situation doesn’t improve, according to OSFI, the regulator of pension plans under federal jurisdiction.
The Top 100 pension funds face a tough road ahead. No matter how hard they work to ensure their assets perform well, fighting mounting liabilities is a tough proposition—and the situation is getting worse.
Click here for a complete list of the Top 100 pension funds of 2006.
But no one’s too shocked about the current state of affairs at Teachers’: after all, such issues have been looming for a number of years. When asked whether he’s surprised about Teachers’ situation, Steve Gendron, a partner in the retirement practice with Eckler Partners in Toronto says: “Not really.” He feels the discount rate actuaries use to calculate liabilities has been going down fuelled by historically low longterm bond yields. “When that happens,” he says, “liabilities go up and that will have a far bigger impact on a plan than return on assets.”
It’s a major conundrum and it means OSFI’s watch-list could get longer. “We feel that many sponsors will probably be facing higher costs this year based on information that we’ve seen so far,” says Jean-Claude Primeau, manager, policy and actuarial, private plan division at OSFI in Ottawa. Nor is the regulator ruling out a reduction in benefits promised to retirees. “Under our legislation, the superintendent has the power to authorize a reduction of benefits,” he says, stressing that this would only be done following a very extensive review and as a “last resort.”
That being said, Primeau points out that OSFI has had a few applications from plan sponsors for permission to reduce benefits to members— something he says hasn’t happened much until recently. “We’ve had more activity in that area,” he says. “But it’s still relatively small,” potentially affecting the benefits of about 1,000 members. “That’s out of the almost 500,000 members under federally registered pension plans with a defined benefit,” he adds.
WAITING GAME
Whether or not OSFI’s warning will have any impact on Minister Flaherty remains to be seen. The Throne Speech was notably devoid of any references to pension plans and many sponsors are waiting to hear what, if any, follow-through will occur on the consultation period initiated under former Federal Finance Minister Ralph Goodale. That process took place in May 2005 and Canadian plan sponsors wholeheartedly offered up suggestions, ideas and insights on how regulators can offer relief to help Canada’s ailing DB plans.
Ian Markham, director, pension innovation with Watson Wyatt Worldwide in Toronto, isn’t surprised there was no mention of pensions in the throne speech, but he’s pretty disappointed. “It’s difficult to get any information out of [OSFI and the Ministry of Finance] at the moment,” he says. “They do say that they are progressing but it seems to me they can’t go too far on it until the [Federal Finance] Minister has been brought up to date—and there is of course a federal budget to prepare for.”
Right now, it’s a waiting game, with sponsors of DB pension plans eager to see if the consultation process will actually bear fruit in the form of new legislation in key areas such as solvency and surplus rules. For example, says Gendron, regulators recently lent a helping hand to Air Canada by allowing their solvency funding to occur over 10 years instead of the normal five: “That’s where most plans are being hit right now,” he points out. “A five-year amortization period means huge cash contributions are required.” Extending 10 years to other plan sponsors could alleviate some short-term problems, Gendron says.
There is also a sense in the industry that surplus rules have got to change. During the consultation process that took place under Goodale, plan sponsors had a lot to say about them, particularly after the Monsanto case in Ontario left a lot of plan sponsors concerned about the whole question of the imbalance between risks and rewards(known increasingly as “asymmetry”). Says Markham, “If a company decides to put more money into a pension plan than the bare minimum necessary, then it should be allowed to take the extra money out if, at some point, the plan goes into surplus again. Chief financial officers would see that as very fair.”
Gendron believes that relief could come in the form of changes to the funded ratio: “Right now, there’s a rule that prohibits funding to pension plans if the funded ratio is greater than 110%,” he explains. “If that had been increased to 125%, it would have allowed plan sponsors to put more in and add a bigger cushion.”
Plan sponsors are also waiting for news on other potential fixes for plans such as the “letter of credit” solution proposed during the consultation process for financing solvency deficits already in force in Quebec. A letter of credit is effectively a promise to a company by a financial institution: if the company runs into financial trouble, and the financial institution refuses to renew the letter of credit, the trustee will call the letter of credit(unless the plan no longer needs the assets). The financial institution will then pay the monies into the pension fund and subsequently seek reimbursement from the company. Says Markham, “This is definitely a fix for some companies. But it may not be a fix for companies that have already used up their entire line of credit.” Markham also notes that companies without a stellar credit rating can face high bank charges for the letter of credit year after year—in such cases, a letter of credit may not be a big help. While Markham acknowledges it’s a bandaid solution to the asymmetry problem, at least it’s a step in the right direction and many plan sponsors would like to see it adopted uniformly across Canada.
In the meantime, all of these questions— along with the many solutions put forward by the pension industry during the consultation process—are sitting with the federal government. Does Markham think anyone in Ottawa is listening? He’s not sure at what level the listening stops these days: only time will tell, he says. “We’ve had input—it’s with the Feds. And now we await their courageous decision,” he notes wryly.
In the absence of any clear signs from the powers that be, plan sponsors are trying to make do with what they have. In Markham’s view, it is increasingly being regarded as a crisis and he sees plan sponsors preparing to deal with further pain. In the U.S., for example, plan sponsors are already moving away from DB arrangements and putting future hires into defined contribution(DC)plans. Moreover, a number of plan sponsors in the U.S. are now putting future accruals for existing members into new kinds of pension arrangements.
The situation hasn’t yet reached that point in Canada, Markham says. But plan sponsors here are making plans: “There’s plenty [of sponsors] doing plan design studies,” he says. Plan design is the mix of features of the pension benefits under the plan, including the pension formula, early retirement benefits, death and termination benefits, inflation protection and employee contributions. “The most extreme action is the wind up of the plan,” notes Markham. Although a regulatory solution that would enable sponsors to keep their DB plans is preferable, Markham believes that many of those studies will turn into action.
FEELING THE PAIN
In the meantime, says Leo de Bever, executive vice-president, Global Investment Management with MFC Global Investment Management in Toronto, plan sponsors need to take a close look at the underlying assumptions their liabilities are based on as well as the models around which their plan is built. That means marketbased ratios, such as price/earnings ratios, that truly show the funding status of a given plan.
How willing have plan sponsors been to re-examine those assumptions? Not very, he says. “I originally thought that providing a better explanation of how things got to where they are would help motivate corrective action,” notes de Bever. “I am now afraid that most sponsors and members are afraid to take the time to understand because what they find is unpleasant. They prefer to hope that the problem will somehow go away.”
To start, de Bever believes that most plans simply don’t charge enough for the benefits they promise: “living longer and wanting to retire earlier has made pensions progressively more expensive over the last 50 years.” He also says DB plans have been trying to make up for that through increased investment of assets in equities—a strategy that isn’t prudent in the long-term. “Markets can disappoint over several decades,” he says. “We had 20 extraordinarily good years before 2000. We might now be faced with 20 mediocre or bad years.”
What’s missing, according to de Bever, is long-term thinking on the part of plan sponsors—to avoid making some painful decisions. “There will have to be some combination of charging more, promising less, and retiring later,” he says.
RISK APPETITE
For Felix Chee, explaining the value of long-term thinking to plan sponsors comes down to helping them find their inner chicken. Chee is president and chief executive officer of University of Toronto Asset Management(ranked 60th on this year’s Top 100 list). Back in 2003, he sat down with sponsors of the endowment and pension funds at Canada’s largest university and asked them some tough questions about their appetite for risk and how much pain they could tolerate.
At that time, the plan’s asset mix specified a very high return requirement and, thus, had a fairly aggressive asset mix to match. Instead of trying to explain the situation in asset mix terms, he used a matrix with pigs and chickens to explain the balance between “greed and pain.” “If you’re really greedy and you have a high tolerance for pain, then you’d be a pig. If you don’t have a high tolerance for pain, then you’d have a small appetite—you’d be a chicken.”
According to Chee, many plan sponsors are greedy for returns but they have a very small appetite when it comes to volatility. Basically, they’re chickens pretending to be pigs. “And you can’t look like that,” he says. “You have to come out of the closet and declare yourself a chicken—and you have to eat like a chicken.”
This approach worked for Chee and the sponsors of the University’s endowment and pension funds. They now have an asset mix that is clearly driven by their liabilities. “It sounds simple,” says Chee. “But it takes a lot of doing to get sponsors to be clear and reasonable about their expectations.”
Like Chee, other plan sponsors are working to make the best of a poor situation. Emilian Groch, chief executive officer of the Alberta Teachers Retirement Fund Board in Edmonton(ranked 43rd in this year’s Top 100 list), says plan sponsors need to “take a breath” and avoid panicking and overreacting to the current situation. Alberta Teachers’ has its own problems, he says, but it is working to fix them, with an eye on the longterm. “Funding is a major issue for us because of our historical pre-1992 unfunded liability, which is sitting at $6.3 billion,” he says. The key, he notes, is to stay focused on the longterm. “Remember that the solvency rules were established in the mid- 1980s during a very different economic scenario,” he says. “Now we’re facing what we haven’t seen in a few decades: the low real rates of return. It’s tough looking forward. But one has to,” he explains.
Clearly, plan sponsors have their sights set on the future—and they’re focusing on making their DB plans work, despite some key barriers. Whether or not the solutions lie with plan sponsors or in potential relief from regulators, only time will tell. While sponsors consider making radical changes to their DB plans—and possibly winding them up completely— it’s hard to think that the environment could get more challenging for the industry. Let’s all hope for better news—and less pain—next year for Canada’s Top 100 pension funds.
The Numbers
• In 2005, the Top 100 pension plans in Canada had amassed $658.6 billion in assets, up 12.4% from the 2004 total of $584.2 billion.
• The total market value of the Top 100’s Canadian equity assets was $129.9 billion, an 18.7% increase from the $109.4 billion held in the asset class in 2004.
• U.S. equity: $63.0 billion, up from $58.1 in 2004 (an 8.4% increase).
• EAFE equity holdings: $65.2 billion, up from $60.0 billion in 2004(an 8.7% increase).
• Global equity holdings: $28.7 billion, up from $16.2 billion in 2004(a 77.1% increase).
• Canadian bond holdings: $149.6 billion, up from $130.3 billion in 2004(a 14.8% increase)
Average asset mix:
- Canadian equities 26.4%(2004: 25.4%);
- U.S. equities 11.9%(2004: 12.5%);
- EAFE equity 11.4%(2004: 10.8%);
- emerging markets equity 0.6%(2004: 0.5%);
- global equity 4.3%(2004: 4.4%);
- Canadian bonds 30.4%(2004: 30.0%);
- international bonds 0.2%(2004: 0.2%);
- high-yield bonds 0.2%(2004: 0.5%);
- real-return bonds 2.7%(2004: 3.0%);
- hedge funds 0.9%(2004: 0.9%);
- managed futures 0.01%(2004: 0.3%);
- private equity 0.6%(2004: 0.4%);
- real estate 3.8%(2004: 3.5%);
- mortgages 1.4%(2004: 1.8%);
- GICs 0.03%(2004: 0.0%);
- private placements 0.2%(2004: 0.4%);
- venture capital 0.03%(2004: 0.1%);
- cash 2.2%(2004: 1.8%);
- non-marketable securities 0.5%(2004: 0.5%);
- infrastructure 0.2%(2004: .2%);
- income trusts 0.3%(2004: 0.2%).
• The S&P/TSX total return index gained 24.1% in 2005.
• The S&P 500 total return index gained 4.9% in 2005.
• The MSCI Europe, Australasia and Far East(EAFE)total return index gained 10.8% in 2005.
Pension to go
Though it’s less pronounced than in the U.S. and the U.K., pension outsourcing is gaining some traction among Canadian plan sponsors.
While outsourcing has been gaining momentum in the U.K. and the United States, providers of such services in Canada are beginning to make inroads into the industry.
The concept of outsourcing in the pension fund management industry isn’t all that new, says Janet Greenwood, managing partner in Investment Solutions with Aurion Capital Management in Toronto.
“Historically, the bulk of pension fund activities have always been outsourced—portfolio management, actuary, custody, recordkeepers provided by advisors or consultants,” she explains.
Moving to a bundled pension outsourcing solution is really just part of that evolution in her view. For one, Aurion has been managing Shell Canada’s pension investments for the last ten years, says Greenwood. Shell,(ranked 59th in this year’s Top 100 List)is an example of a major Canadian pension fund where outsourcing is already fully integrated into the management of the plan.
Indeed, Irshaad Ahmad, director, institutional services for Russell Investment Group in Toronto, says more plan sponsors with limited time on their hands are looking to free up resources: “For many mid-sized companies, running the pension plan is not a full-time job,” he explains.
Managing costs is a major factor behind the push for outsourcing solutions, as plan sponsors strive to shift their focus to managing their core business instead of non-core areas such as pension plan administration.
“Outsourcing gives plan sponsors access to new technology,” says Bob Weinerman, worldwide partner and the Canadian business leader for HR services with Mercer Human Resources Consulting in Toronto. Weinerman also says if a firm loses a main person responsible for managing the pension plan, the provider will still be there to carry on the business of the plan on a consistent basis.
Improving performance
According to Wendy Brodkin, practice leader in investment consulting with Watson Wyatt Worldwide in Toronto, outsourcing can help to alleviate what many experts call the “governance shortfall” that dogs many plans. “Decisions can’t be made quickly,” says Brodkin, referring to the cumbersome decision-making processes that can tie the hands of many pension plans.
Risks and pitfalls
Ultimately, outsourcing does have its risks. In particular, says Ahmad, it should not be used as a “panacea” that will solve all of a plan’s problems. “[Plan sponsors] can never get rid of the overarching fiduciary responsibility they have as the administrator of the plan.”
Whether or not plan sponsors in Canada embrace outsourcing solutions with the zeal their counterparts have in other areas of the world remains to be seen. However, with the issues many face today, it is likely they will look for outside assistance to meet those challenges down the road.
Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com
