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.