Defined benefit (DB) plans represent a substantial risk to many organizations, according to a recent study.
Almost 60 per cent of financial executives surveyed said that their pension plan posed either a moderate or substantial risk to their organization, found the study by the Canadian Financial Executives Research Foundation (CFERF).
At the end of 2012, only about one in 20 Canadian DB pension plans were fully funded on a solvency basis. By far, the biggest factor in the decline is the fact that long-term interest rates have plunged to their lowest levels in 60 years. Disappointing asset returns, demographic pressures and the increasing maturity of pension plans have also played their part, found the study.
“The results indicate that hope for better days is not enough and that Canadian corporations must stop depending on investment returns or increasing interest rates to cover pension funding deficits. Organizations need to plan ahead to lower risk to their plans, through a combination of strategies,” said Michael Conway, chief executive and national president, Financial Executives International Canada.
To de-risk their pension plans, DB plan sponsors could consider the following:
• Risks could be transferred to another party such as an insurance company through an annuity purchase for some or all the plan members.
• The benefit policy could be changed to transfer or share risks with employees, such as moving to a defined contribution (DC) plan or a target benefit structure.
• Investment policy could be changed to reduce the mismatch between assets and liabilities, or to protect against extreme events.
• Funding policy strategies could be employed in order to manage the amount and plan the timing of contributions.
“Each of the de-risking strategies have their pros and cons — some take effect quickly but are very painful to implement, some will likely only defer the pain, and others are very effective in the long term but do not provide much short-term relief,” said Manuel Monteiro, a partner in Mercer’s financial strategy group. “This suggests that an effective de-risking strategy will often involve the use of multiple approaches working in concert.”
Many plan sponsors are looking to modify their plan design as part of their risk reduction strategy. Of survey respondents with DB plans, 58 per cent remain open to all employees, 37 per cent are closed to new entrants with existing employees continuing to accrue DB benefits, and six per cent are closed to new entrants, with no further DB accruals for current employees.
Almost one-third of participants said they were either somewhat likely or very likely to close existing DB plans to new employees while continuing benefit accruals for current employees. The majority (62 per cent) of organizations which have made or are considering changes to their DB plans cited the level and volatility of funding contributions as a very important driver of that change.
Plan sponsors should map out a de-risking strategy in advance so that decisive actions can be taken when de-risking opportunities present themselves, said the report.
One such approach is a dynamic de-risking strategy, under which the asset mix is shifted gradually from equities into bonds, as the funded status improves. One-half (48 per cent) of respondents said they were very likely or somewhat likely to introduce dynamic de-risking strategies in the next two years.
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