Defined benefit (DB) pension plans in Canada face many challenges and have been a thorn in the side of employers in recent years.
With DB plans, employers need to manage the assets and risks of the plans in the face of issues such as unpredictable life expectancies, volatile investment returns in an uncertain economy and changing accounting rules.
The good news is there are several solutions available to help plan sponsors reduce some of the DB plan pain.
What is de-risking?
De-risking is the new buzzword in DB plan circles. Recent events have highlighted the risks inherent in many DB plans. Key risks include operational risk, investment risk, longevity risk and inflation risk (for indexed plans).
Pension de-risking means implementing strategies to remove or reduce these risks so employers can focus on the core business. Strategies range from retaining the risks (but better managing them) to fully transferring them to an insurer.
Employers around the world are de-risking pension plans to reduce the volatility of cash contributions and earnings per share, and to reduce management time and attention for the DB plan.
Employers in the United Kingdom have been on the de-risking journey for many years, and the numbers are staggering — since 2006, more than £40 billion ($64.6 billion) of U.K. DB pension liabilities have been transferred to insurance companies.
Canadian employers are just beginning the journey and, as more plans take action, many developments are expected. In 2011, $1.4 billion of pension liabilities was transferred to Canadian insurers — the largest amount seen in one year.
Why is de-risking gaining momentum?
There are several reasons why de-risking is gaining momentum.
The impact of pension risk can be significant: For example, longevity risk can have material financial consequences. A one-year increase in life expectancy can increase pension liabilities by three per cent to four per cent.
But one year may not be enough. It’s estimated curing three major diseases (heart disease, cancer and respiratory disease) would increase life expectancy by six years, according to a 2007 study led by Vladimir Kaishev of the Cass Business School at City University London in the U.K.
Solutions are becoming more affordable: The rate of return on an annuity can be higher than the expected rate of return on a matching bond portfolio. This means the longevity and investment risk protection provided by annuities can be free.
Benefit security: Insurance companies are highly regulated and carefully managed to ensure employees’ benefits are well-protected. Pension risk is reduced and employers can do what they do best and focus on the core business.
De-risking can improve share price: U.K. companies that have de-risked their pension plans enjoy an average increase of more than 10 per cent in their share price, according to DB Pension Plan De-Risking by Kelvin Wilson at Grant Thornton in 2011. Removing pension risk reduces future earnings volatility and allows management to concentrate on the core business.
High-profile companies are taking action: In June, General Motors announced it was de-risking its salaried pension plan and reducing its pension obligations by US$26 billion through a combination of lump sums and annuities. This is the largest pension de-risking transaction ever announced. It signals a shift in the way organizations think about pension obligations.
There is no single solution or quick fix to de-thorn or de-risk Canadian DB plans. While the road to lower risk can be a long one, it’s important to start the journey and take advantage of the de-risking opportunities that are now available — before market volatility or regulatory changes create new, unforeseen pains.
Employers need to take action or DB pension plan pain may be with them for years to come.
Brent Simmons is senior managing director of defined benefit solutions at Sun Life in Toronto. He can be reached at email@example.com or (416) 408-8935.