Following a difficult 2011, defined benefit (DB) pension plans continued to face the dual challenges of low long-term interest rates and volatile equity markets through the first half of 2012, according to Towers Watson’s DB Pension Index. Not surprisingly, as the costs of the defined benefit promise continue to weigh heavily on the financial performance of the organizations that sponsor such plans, many organizations, especially in the private sector, continue to seek ways to mitigate the risks associated with these commitments, it said.
"The solutions currently being explored and implemented are wide-ranging — from investment strategy shifts to plan design changes to a complete sell-off of the risk. But the catalyst for change in all cases is the desire to reduce financial risk," said Ian Markham, Canadian retirement innovation leader at Towers Watson.
The DB Pension Index has been tracking the performance of a hypothetical fully-funded defined benefit plan started in 2001. The health of the plan is tied to two important measures — investment returns, which boost the amount of assets held in the pension fund, and the level of long-term interest rates, which determines the amount of assets that are theoretically needed today to pay the future benefit promises made to current plan members and retirees.
While stock markets started 2012 on a positive note, investment returns in the second quarter of the year were negative, and as a result, the typical Canadian DB pension plan invested 60 per cent in equities and 40 per cent in fixed income would have earned only 2.3 per cent on its investments for the six months ending June 30, 2012, said Towers Watson.
The combined effects of poor investment returns and decreasing interest rates caused the DB Pension Index to fall 1.4 per cent. This would mean that the typical plan, which was roughly 85 per cent funded at the start of 2012, is likely in no better shape at mid-year, said Towers Watson.
Particularly challenging for pension plan sponsors is the dual effect of the fear and uncertainty currently pervading financial markets. Not only does risk aversion cause instability in stock prices, but for the most part, the "safe" money is shifting to bonds, keeping interest rates low and inflating pension liabilities and costs, said Towers Watson.
"With interest rates seemingly stuck at such low levels, DB plan sponsors have by necessity started to assess more critically the investment tools they've historically used to boost returns and reduce risk," said David Service, director of investment consulting at Towers Watson. "Led by some of the larger, more sophisticated plans, Canadian pension funds are accelerating a trend toward alternative assets such as real estate, private equity and infrastructure."
As the markets evolve, some plan sponsors are also starting to explore ways of using traditional tools in non-traditional ways. For example, alternative approaches to equities market investing can help sponsors boost returns while at the same time reduce volatility.
"Some pension fund sponsors are putting shiny new tools in the toolbox,” said Service. “Others are simply sharpening the tools they already have. There are many ways to manage risk, and plan sponsors would be wise to explore them all."
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