Many employers that offer a defined benefit (DB) pension plan may find themselves having to double their contributions or more this year in order to meet solvency requirements, according to Aon Hewitt.
The median pension solvency funded ratio — the ratio of the market value of plan assets to liabilities — is approximately 15 per cent lower this year than at the start of 2011 due to lower interest rates and the stock market decline, said Aon Hewitt. With the solvency position of these plans only in the 68 per cent range — down from around 83 per cent one year ago — plan sponsors that will file an actuarial valuation this year will need to add extra funds to comply with minimum funding rules that assure DB plans can meet their pension promises, it said.
However, not all DB plan sponsors find themselves having to increase their contributions.
"Organizations that have taken steps to manage their plan's risk exposure are likely better funded," said Tom Ault, a vice-president with Aon Hewitt in Vancouver. "Depending on the plan and the approach adopted, sponsors may find that their solvency ratio has dropped by considerably less than 15 per cent in the last year."
André Choquet, an investment consultant with Aon Hewitt in Toronto, outlined some of the possible actions plan sponsors could have adopted at the beginning of 2011 and the effect these measures might have had on their solvency ratio:
Taking less risk: If plan sponsors invested more in bonds and less in equities, they would have experienced a lower drop in their solvency ratio. Increasing investment in bonds from 40 per cent to 60 per cent would have meant a drop to only a 71 per cent solvency ratio, rather than 68 per cent, said Choquet.
"Three per cent may not sound like much, but it means a $3 million smaller shortfall to fund on a $100 million pension plan," he said.
Having a better match between bond and liability duration: Pension plans typically invest in universe bonds, with terms of mainly between five and 10 years. Switching to long bonds, with maturity between 10 and 30 years more closely match the plan's liabilities cash flows and helps assets and liabilities behave in tandem when interest rates fluctuate, said Choquet. If plan sponsors had taken this step in 2011, they would have experienced a 72 per cent solvency ratio.
Adopting a less-risk/long bonds approach: Implementing both measures would have resulted in a solvency ratio of approximately 77 per cent at the end of 2011.
"In order to experience little or no drop in solvency ratio, plan sponsors would have had to remove all investment risk from the plan, and/or invested in derivative products — assets that are even more sensitive to interest rate movements than regular bonds," said Choquet.
Plan sponsors have historically avoided such measures, partially due to the low interest rate environment that currently prevails.
"Given that there will be more economic uncertainty in the coming year, all DB plan sponsors should reconsider their risk management approach now in order to avoid having to make even greater contributions at the end of 2012," said Ault.
In addition to the various investment strategies mentioned above, organizations should take another look at their pension plan design, funding policy and contribution strategy, said Aon Hewitt.
Dynamic investment policies are also becoming more prevalent.
"These policies, in particular dynamic de-risking policies that reduce risk as a plan's funded ratio improves, reduce risk and long-term costs, while taking the emotional element out of asset mix decisions," said Ault. "Such policies can be tailored to a low-interest rate environment, allowing for some downside protection, while leaving room for some improvement if interest rates rise."
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