Is it time for an asset-strategy check-up?
August 27, 2020
At the time of my last column in May, many pension plan sponsors were catching their breath after watching funding levels take a roller coaster ride. After a steep drop earlier in the year, funding levels were slowly recovering. However, market uncertainty remained and it wasn’t clear what was coming next.
Thankfully the last few months have brought continued good news to pension plan sponsors with equity markets climbing steadily. This has resulted in a sharp rebound in funding levels. Aon’s Median Solvency Ratio fell from 102.5 per cent at the end of 2019 to 89.1 per cent as of March 31, before rising to 95.4 per cent as of June 30. Funding levels are still down from the beginning of the year, but many defined benefit plans are once again nearing full funding.
Forward-thinking plan sponsors are using this window to reassess the risk in their pension plans. For example, some plan sponsors are considering reducing risk by better matching their assets with their liabilities or purchasing annuities.
In their latest group annuity market pulse, Willis Towers Watson wrote that annuities may represent a buying opportunity in today’s environment. This is welcome news to plan sponsors wondering how to get off the funding roller coaster. The market is still very uncertain and it would be helpful to have less volatile funding levels when the next downturn occurs.
On the other hand, we’re hearing that some plan sponsors are considering maintaining or even increasing the risk in their plans. After all, some provinces have relaxed solvency funding rules, which can reduce the impact of future investment losses on required contributions. It may make sense – the thinking goes – to double down and hope that making bets in the pension plan solves the deficit problem.
But history has shown that taking too much risk doesn’t pay off. A typical pension plan’s strategy involves making multiple bets on equity markets, interest rates, credit conditions, foreign exchange rates and life expectancy. Companies need to win these bets consistently as the gains from good bets can be wiped out by the losses from bad bets. And making multiple successful bets consistently is very hard to do – especially given the increased unpredictability of the markets over the last 20 years.
The Mercer Pension Health Index shows that a typical DB pension plan is at the same funding level as it was 20 years ago, even though Canadian plan sponsors made billions of dollars of deficit contributions during that period. As a result, plan sponsors who are considering maintaining or increasing pension risk may find it helpful to test if their plans had this typical experience. That is, did their asset strategy make money or lose money? Were bets on some risks rewarded while others weren’t? This exercise can shine a bright light on what’s working and what’s not. It can then help plan sponsors make better asset strategy decisions in the future.
Doing an asset strategy check-up would involve adding up deficit contributions over some reasonable period of time – say the last 15 or 20 years – and comparing this result to the change in the plan’s funding level over that same period.
Simply put, it determines whether the plan’s funding level has improved by more than the deficit contributions. If not, then it means that investment losses or mismatches ate up some or all of the deficit contributions, which reduces shareholder value.
In reality the calculation can get quite complex and plan sponsors may want to engage their consultants. The calculation should adjust for other factors such as longevity experience, any benefit improvements or contribution holidays and the mismatch between solvency and going-concern normal costs. It could be performed by risk, showing which risks were rewarded and which risks weren’t.
The asset strategy check-up may lead to frank discussions. For example, if a plan sponsor’s asset strategy hasn’t created value in the past, why would it now? Even if it has created value in the past, will it work in the future when increased market volatility seems to be the new normal?
Hopefully plan sponsors that go through this exercise will find that they’ve created value for shareholders and benefit security for plan members. If not, they should likely look to change the strategy as opposed to doubling down on it.
The market rebound has given plan sponsors a perfect opportunity to revisit pension risk and explore options to reduce it. The outcome may be a winning trifecta: fewer pension headaches for plan sponsors, improved benefit security for plan members and better returns for shareholders.
Brent Simmons leads Sun Life’s defined benefits solution team. These views are those of the author and not necessarily those of the Canadian Investment Review.