While the global pandemic crisis, at least for a while, created a tough environment for defined benefit plans as it impacted both their core business and their pension plan, they are now refocused on reviewing and implementing de-risking strategies, said Mathieu Tessier, Senior Managing Director of Client Relationships and Innovation in Defined Benefits Solutions at Sun Life, speaking at Pensions & Investments’ Canadian Pension Risk Strategies virtual series in October. “The way we see it, that could bring a winning trifecta—less pension headaches for plan sponsors, better benefits security for plan members, and improved returns for shareholders.”
FIX THE ROOF WITH DE-RISKING STRATEGIES
“The classic quote here is that the best time to fix the roof is when the sun is shining, and currently, plan sponsors have caught their breath a little bit,” said Tessier at the session titled the ‘Impact of the Current Economic Environment on De-Risking.’ Aon's median solvency ratio for Canadian defined benefit plans was at 102% at the beginning of the year; it fell all the way down to 89% at March end; was back up to 95% as of June 30th, and likely even higher by now, he noted.
“We're seeing that plans are getting back in the game, closer to full funding, although they're not quite there yet, and they're using this window to reassess their pension risk. For many plan sponsors, it's time to reduce the risk and perhaps make funded status a little bit less volatile,” he said. Other plan sponsors are thinking about maintaining or even increasing risk, he said, adding “There is still some downside risk here, so I would still categorize the latter as a more risky bet.”
Canadian pension plans’ traditional risk strategy of mismatching assets and liabilities in the hope of generating excess returns hasn't paid off over the last two decades, pointed out Tessier. He quotes Statistics Canada that from 1999 to 2018, plan sponsors put in $158 billion in contributions to shore up deficits. Over the same period, the Mercer Pension Health Index showed no material improvement in funded status. “Maybe that result isn’t all that surprising. The typical asset strategy has involved making a lot of bets on equities, interest rates, credit conditions, foreign-exchange rates, even life expectancy. But it's very difficult for plan sponsors to win all those bets consistently. And they truly need to win them all, otherwise, the gains from the good bets just get wiped out by the losses from the bad bets,” he noted.
The global pandemic has created more uncertainty and markets are even less predictable today, Tessier added. “It feels like once-in-a-lifetime events now happen every decade or so, like the tech bubble in 2001 or the global financial crisis in 2007-08. Plan sponsors are taking into account this increased global uncertainty when thinking about de-risking strategies and, for a lot of them, it still means trying to reduce risk, even in this challenging implementation environment.”
“At their core, de-risking strategies are meant to make DB funding levels less volatile or more flat. They try to reduce the mismatch between the pension plan’s assets and liabilities. And it doesn't necessarily mean removing all of the risks. It means being a bit more deliberate about selecting the risks where you can reasonably expect to reap a reward,” Tessier explained. One way is to ensure the DB plan has adequate hedging assets, which may involve moving some return-seeking assets to hedging assets. Plans with a good allocation to hedging assets have done well in the last six months with more stable funding levels, he said. Another way to reduce risk is to purchase annuities. “Annuities will hedge perfectly the covered liabilities. They'll remove investment risk and longevity risk. Even for underfunded plans, annuity buy-ins have interesting characteristics such as not triggering settlement accounting or not requiring top-up contributions, he said.
Plan sponsors can also do an asset strategy check-up to determine if it had made or lost money in recent years for the pension fund. “This exercise can really shine a bright light on what's working and what's not and look into de-risking considerations from a different perspective,” Tessier said. For instance, looking at all deficit contributions made to the plan in the last 15-20 years and comparing that with the change in funded status. “If the funded status has not increased more than the additional money put in, perhaps that means the asset strategy wasn’t so successful and even may have reduced shareholder value.”
Plan sponsors who may find it too expensive to de-risk by increasing the fixed income allocation in this low interest rate environment could consider using derivatives as an overlay strategy to reduce the asset-liability mismatch, said Tessier, adding, “It also might be interesting now to look into actively managed bonds as opposed to passive bonds, to unlock some more value.” Also, bond portfolios have appreciated in value relative to annuities, he noted. “In other words, it takes less bonds to purchase an annuity so far this year, so that can create some value for a DB plan in being able to more successfully execute de-risking strategies even in this low rate environment.”
“At the end of the day, a plan sponsor needs to figure out what's the total level of risk they want to take for the plan and then decide which risks should be hedged and which other risks they want to diversify away. We think that diversification is still a pretty sound guiding principle, even in fixed-income assets, which we haven't seen a whole lot in the past,” said Tessier. With fixed income asset diversification, sponsors are looking at different credit assets, trying to first get more credit exposure, and go beyond Canadian provincial bonds into long investment grade corporate bonds. Investors can also look outside Canada, at high quality corporate bonds around the globe and swap back to Canadian conditions to get some additional value, Tessier said. Another avenue is to hunt for the illiquidity premium, as with private debt and commercial mortgages. “All these have good hedging properties that can get you a little bit of extra yield, so look at the interesting risk-return profiles,” he said.
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