Coping with underfunded pension plans

Defined benefit pension plans in Canada are currently about 80% underfunded on a solvency basis. This means that today plan assets are sufficient to cover only 80% of the pension benefits employees and retirees have earned. Next year, if interest rates rise or the stock market improves, the percentage that is underfunded might decline. But it might not – there are a whole lot of other factors that can affect a plan’s financial position. Some of the factors that could make a plan’s financial position worse include a reduction in the workforce, a significant increase in average salaries, increased use of early retirement provisions, and an increase in inflation. These are all possible in our current economic climate coupled with a shrinking workforce.

These factors – workforce, salaries, retirement, and inflation – all lend themselves to scenario testing. Risk management methodologies can support this work.

Risk management can also help on the financial side. Here are a few ideas to consider:

Assets

• Keep the focus on risk. By 2007, the biggest risk for many plans was the possibility that the equity markets and interest rates could both decline. Unfortunately, too many sponsors and trustees accepted the efficient market hypothesis and correlations between asset classes. These theories suggested that, if you had a long enough horizon, you could afford to take on the volatility in equities. Sadly, it wasn’t true.
• Pension investing has always used a long lens to view the world but with the focus changing to solvency, a match of assets to liabilities is a better starting point.
• Consider borrowing money to fund the plan. It’s tax efficient and interest rates are low. It could also relieve some of the plan’s leverage on the corporate balance sheet if the money is used to better align assets with liabilities.

Contributions

• Recognize that current economic conditions may substantially alter the employer covenant and the funding of deficits. In this context, security is itself a benefit and as such has a cost – extra security in funding may lead to lower benefits.
• DB pension plans are maturing. In many plans, the retired population significantly exceeds in size the active population. In these cases, the plan’s expenditures may exceed its receipts. The cost of benefits for active employees is of less relative importance than making investments that match the pension payment outflows each month.
• Historically, pension funds have relied on the growing wealth creation of the sponsors to cover future benefit obligations. In many sectors wealth creation has slowed significantly and may not return to former levels. Now may be the time to bite the bullet and be honest about what the sponsor can afford.

Social Pensions

The World Bank recently published an analysis of demographic and pension coverage throughout the world in a book called called "Closing the Gap". While focused mainly on underdeveloped and developing countries, the book devotes a chapter to social pensions in the 30 member countries of the OECD - these are the high income countries.

Some of the key indicators of the OECD countries include:

• an older population structure than the rest of the world,
• relatively high life expectancy (at birth, age 75 for boys, age 81 for girls),
• the male/female gap in life expectancy has persisted,
• 90% of the labor force contributes to the compulsory pension scheme,
• most OECD countries have a system of credits that enable coverage for those outside the labor force - unemployed, working-age students, people caring for children and older family members, and
  
• the countries usually have some kind of floor for old-age income.

Compared to the OECD averages, Canada has a slightly younger population, longer life expectancy for both men and women, a narrower life expectancy gap, and slightly better labor force coverage of its programs.

The chart below shows the taxonomy of the pension systems. The World Bank analysis focuses on the first and second tiers, which are the mandatory components. In Canada, the first tier includes the OAS (basic) and GIS (resource-tested), and the second tier includes the CPP and QPP (public - defined benefit).




The first tier programs are called "social pensions". These pensions are worth, on average across OECD countries, about 29% of national average earnings. About 18 countries are bunched around this average, providing social pensions worth 25% to 35% of average earnings. Canada's first tier programs are worth about 31% of average earnings.

A number of the OECD countries made major changes in recent years to their social pensions. These changes tended increase the linkage to earnings for average earners, while increasing benefits for low earners. However, some former communist countries abolished their minimum pensions, in the belief that this would help to reduce labor market distortions. These changes place more emphasis on second tier pensions.

Compared to the other OECD countries, Canada places more emphasis on first tier benefits than most. All of the G8 countries, except the UK, place a greater emphasis on earnings related pensions. This may argue that, if Canada were to change its social pensions, its starting point should be a review of the CPP and QPP benefits, rather than the benefits provided by other programs. For example, is Canada competitive in the coverage of those who are not in the workplace? Should more be done for those caring for children and older family members? Should a mandatory program be introduced to cover employees who do not have an employer sponsored plan?

Housing and retirement

The Society of Actuaries' Committee on Post Retirement Needs and Risks has just issued a new monograph containing papers that provide varied perspectives on housing and retirement issues of concern to financial professionals, policymakers, and homeowners, among others. An overview provided by Anna Rappaport and Steve Siegel highlights key takeaways under various topics: wealth, spending, options and types of housing, fraud and improper loans, housing related to the financial crisis, and use of equity and products.

Here's a sampling of takeaways:

• Housing assets are an extremely important component of total wealth in both the United States and Canada, particularly for middle income households. Home equity is greater than the invested financial assets of many older adults and it has been often converted to cash and used to finance other spending, sometimes leading to financially detrimental results and longer term problems.
• Housing is a major part of spending and the largest item of spending for most retirees. Traditional ideas about what is affordable have been displaced in recent years by a “spend more and borrow more” philosophy.
• Many of today’s retirees get by on a combination of a paid for house, social security and some emergency funds.
• Housing values do not always increase and in fact, can decline a great deal. Housing bubbles and over inflated prices are not new, and a review of financial history would have warned that upward housing prices are not guaranteed.
• Reverse mortgages may offer significant income potential to some households, but at relatively high cost and risk. They may help older households remain in their homes, but they limit future housing choices.

The studies included in the monograph demonstrate that housing issues must be considered alongside other critical issues including longevity risk, potential changes in health, and inflation. Combining these and other factors, accompanied by the decrease in housing wealth, dramatically increases the instability of financial security in retirement. This situation poses significant challenges to financial professionals engaged in retirement planning.