Presentation to the CPBI Annual Meeting: De-risking Pension and Benefit Plans
“There is nothing new beneath the sun” Regina, 2011

I grow old... I grow old... I shall wear the bottoms of my trousers rolled...

Quoting from T. S. Elliot’s “The Love song of J. Alfred Prufrock” may not seem like the most appropriate way for a session on de-risking pension plans to begin, but I assure you that it is!

Yes, indeed – I grow old, having practiced in the pension, investment and insurance industry for almost fifty years. And over that period of time, I have seen a great many things – insurance and trust companies come and go, investment management and actuarial consulting firms come and go, (some of you may have worked for one or more of those firms during your career), and ways to meet the pension obligation come and go, and now come again.

To quote from the Ecclesiastes Chapter 1, verse 9 - 11:

"Only that shall happen which has happened. Only that occur which has occurred. There is nothing new beneath the sun! Sometimes there is a phenomenon of which they say: ‘Look, this one is new!’ – It occurred long since, in ages that went before us. The earlier ones are not remembered; so too those that will occur later will no more be remembered than those that will occur at the very end".

How the writers of this ancient text some 2500 years ago knew about de-risking of pension plans in the 21st century in the Common Era is beyond me!

What may seem to many to be a “new and innovative way” of addressing a problem, may in fact, simply be a recycled and repackaged earlier solution to the problem. I shall provide details as I proceed with my presentation. Let me begin by describing the pension world as I found it when I began my career almost fifty years ago. It was dominated entirely by the large Canadian life insurance companies, many of which, like my former employer, Confederation Life are, alas, no longer with us. Pensions were provided by means of an insured group annuity contract. Under this arrangement, employers who wished to provide their employees with a pension in retirement would pay a monthly premium to the insurance company and, at the members’ retirement, the insurer would pay the monthly pension to the employee. Insurance companies would set their premium rates based on estimated interest rates, mortality, expenses and profit margin, and in return, they would assume the entire risk of providing benefits. It should be mentioned as a foot note that, from 1908 until 1979, the Canadian government also participated in this market with the sale of group annuities, and to this day continues to administer those plans for many existing retirees.

As employers became increasingly aware of the opportunities available to them in the capital markets, innovative new products were developed by the insurance industry to attract and retain group annuity business. The “Deposit Administration” contract provided the plan sponsor with a higher current rate of return than was guaranteed under the group annuity contract, while the Immediate Participation Guarantee (or IPG) contract shifted some of the interest and mortality risk to the plan sponsor.

Then, in order for plan sponsors to participate fully in the growth opportunities that were becoming available in the equity markets, insurance companies created Group Pension Fund Investment Contracts. Under these arrangements, the insurance companies allowed the plan sponsor to assume the full investment risk, however they were still willing to take on the mortality/longevity risk when a plan member retired. To this day, it is the annuity purchase rate guarantee included in those contracts that continues to allow insurance companies to compete for pension business.

As plan sponsors became increasingly comfortable with assuming the risks associated with a pension plan, they were prepared to abandon the need for having an external entity guarantee the pension payments – namely, an insurance company. This gave rise to the non-insured contracts, and the corresponding growth of investment counsellors. Many of those investment counsel firms, in fact, grew out of the insurance industry. The decades of the 1970s and 1980s were fertile years for the creation and growth of many of the investment counsel firms, some of which survive to this day.

As long as the capital markets co-operated, (which they seem to have done reasonably well from the 1970’s until 2000), pension plans and their plan sponsors seemed to be quite happy with this arrangement. Over the past ten years, however, the situation seems to have deteriorated – to say the least! Equity returns – regardless of the market – have been anaemic. In fact, in Canadian dollar terms, returns from US and foreign funds have been negative. Fixed income returns have fallen to levels not seen since the 1950s, and improvements in mortality mean pensioners are living longer. Plan sponsors are now pining for the “good old days” of group annuities wherein the insurance companies took all of those risks. So, in this context, let us now look at some of the so-called “solutions” that have been created, and let’s trace their origins.

Our look at pension plan de-risking strategies will include several elements:

  • conversion or wind-up of the existing DB plan,
  • use of a more conservative asset mix (dynamic de-risking),
  • investing in longer duration fixed income securities and/or cash flow matching,
  • annuitization of some portion of the plans’ liabilities – either directly or indirectly,
  • longevity bond,
  • use of derivative instruments and/or alternative asset classes, and
  • de-risking defined contribution plans. Many of these will have a familiar ring to them as we look at them in greater detail.

    Plan Conversion or Wind-up

    Recently released data from OSFI confirms the trend that has been in place in Canada for many years – DB pension plans are on the decline, while membership in DC plans is increasing. This is particularly notable in the private sector where there has been the most dramatic decrease in membership. This is by no means an ideal solution to the “risk” problem, but it does offer many plan sponsors a solution that is “affordable”. Often, when faced with the choice between reducing benefits and making greater contributions to support the existing level of benefits, DB plan sponsors “throw in the towel” and opt to wind up the plan. Many in the actuarial profession have taken a strong position against such wind-ups and conversions to DC, but it appears to have been of little use. Today, less than one in four employees in the private sector is a member of a pension plan. When I began my career, fully 40% of private-sector employees enjoyed benefits under a pension plan. To quote Malcolm Hamilton in the March issue of Benefits Canada:

    "The traditional DB pension plan is best viewed as a noble experiment that failed".

    He goes on to provide a host of reasons why this is so – many related to the nature of the investments under those plans, and the actual demographics of DB plans.

    The situation was made worse, in my opinion, by efforts of various jurisdictions to “address” the pension problems that were perceived to have existed. It could be argued that the pension reform legislation, introduced in Ontario in 1987, and copied and adopted by other provinces shortly thereafter, has led to the decline in coverage under DB plans. So-called “pension reform” created additional financial burdens for those employers who already had pension plans, and did nothing to encourage the establishment of new pension plans. By increasing membership and vesting requirements, adding the “50% rule” and introducing the solvency valuation, the regulators added a further financial burden to plan sponsors. The accounting and (alas) the actuarial profession also had a hand in contributing to the decline of DB plans. Onerous reporting requirements, complex funding and solvency rules, and IFRS all had a hand in driving the nails into the DB coffin.

    Asset Liability Matching

    Let us now deal with the concept of “Asset/Liability Matching”.

    For many years, pension plans seemed to be focused on the principles inherent in Modern Portfolio Theory (MPT). Introduced in the 1950’s by Nobel Prize winner Harry Markowitz, MPT proposes that investors, including pension plans, may minimize market risk for an expected level of return by constructing a diversified portfolio constructed along the “efficient frontier”. Fundamental to MPT is the belief that a greater risk is associated with an asset class that has a greater expected rate of return.

    This method of investing looked primarily at the asset side of the balance sheet, without paying sufficient (if any) attention as to why those assets existed – the plan liabilities. That was the actuary’s responsibility, and fund managers rarely spoke to the plan actuary. Consequently, many pension plans had an asset mix policy which included exposure of 60 - 65% to equities and only 35 – 40% invested in fixed income securities. And as the demographic profile of the pension plan shifted from being primarily for active members – those who were working and still earning pension credits – to the more mature structure we find today in many plans – wherein fully 60 – 80% of a plan’s liabilities are in respect of members who are receiving benefits – the asset mix remained largely unchanged. Did no one think to consider what the assets were intended to do? Apparently not!

    So now, somewhat belatedly, we find that pension plans are “restructuring” their asset mix by shifting assets way from the so-called “riskier” assets (equities) to less risky fixed income. The focus is then shifted away from measuring performance of the fund from asset based benchmarks to having the fund performance measured against the plan’s liabilities. The principle driver behind adopting LDI strategies is compliance with the new accounting rules.

    One, cynically, would argue that this move is too little, too late to be of any use, and at a time when returns from fixed income investments are at their lowest level in over 50 years.

    Dynamic De-Risking

    The process of “Dynamic De-risking” involves the adjusting of the pension plan’s asset allocation as the funded position of the plan changes over time. The pension plan sponsor develops a long-term funding policy involving gradually transitioning the plan’s asset mix. It involves moving assets from “risky” (typically equities) to “less risky” assets (typically bonds) as the funded status of the plan improves ie the funded ratio approaches 1.0. The path of transitioning can be customized to each plan, but the fundamental strategy is the same – take risk “off the table” as the funded level of the plan improves. The particular combination of de-risking strategies that a plan uses will be determined by the plan sponsors desire to de-risk the pension plan, the current funded status of the plan, and the economic outlook. As well, the size of the pension fund may limit the availability of some of the investment options, particularly in the category of alternative investment.

    This is another import from the UK where it has attracted considerable attention. A recent study conducted by AON-Hewitt of UK-based pension plans found that about 75% of those plans had either adopted or were considering adopting some form of de-risking strategy. Of note is that fully 90% of DB pension plans in the UK are now closed to new members (or soon will be). Furthermore, the number of plans where future DB accruals have been curtailed is now almost 30% of all plans.

    While this strategy will likely reduce the volatility of the funding requirement as is intended, the overall cost to the plan sponsor will likely increase. This is a direct consequence of having more of the plan’s funds invested in assets that may likely have a lower rate of return. This could prove to be a costly strategy in the long run, although it will likely achieve its objective – namely reduced volatility in the funding contribution in the short term. While de-risking strategies may make sense, plan sponsors may want to implement such strategies at a more opportune time.

    At present, several investment managers have created products and strategies specifically targeted at plan sponsors who are trying to de-risk. Time will tell if this is a strategy that is embraced by plan sponsors.

    Longevity Bond

    Another recent “innovation” created by the insurance industry is a product known as a longevity bond. In effect, what this “bond” does is it assumes the longevity risk of retirees. For example, a pension plan will pay a premium to the insurance company, and in exchange, the insurance company will agree to pay some future annuity payments. This protects the pension plan assets from the impact of retirees who live too long!

    I’d like to quote a recent piece that was sent out by Benefits and Pension Monitor- Longevity Threat Recognized:

    Longevity risks are being recognized as a major threat to UK pension funds and the companies who sponsor them. And most funds are considering de-risking their liabilities over time and finding that it might be more cost efficient to de-risk by using more than one tool, says a report from Clear Path Analysis. “Pension De-risking: Longevity Hedging and Buying Out” found more than 80 per cent of its clients with liabilities between 100 million and 300 million pounds are considering de-risking their pension funds. The methods to achieve this include combining pensioner buy-in and an index-based longevity swap on non-retired pensioners, with some form of liability-driven investment (LDI) strategy to achieve a DIY buy-out.

    While I applaud the creativity and packaging ingenuity of the insurance companies, a longevity bond is simply a pure deferred annuity contract of the sort that has been around for over 100 years, and that most plan sponsors moved away from 50 years ago.

    I will not deny that mortality, especially among females has been improving. Data suggests that in the western countries, mortality has improved by roughly 2.5 years every decade for the past 160 years – or an improvement of 40 years life expectancy over that period. Extrapolation of that data, however, may not be reasonable. At any rate, longevity bonds are yet another example of an old product that is being “spruced-up”, repackaged and sold as a new solution.

    Liability-Driven Investing

    The next phase involves so-called “Liability Driven investing” or LDI. Perhaps motivated by the coming IFRS rules, which will affect financial reporting for all corporations, plan sponsors are now awakening to the reality that fixed income investments in a “Universe” bond fund (with a duration of perhaps five or six years) may not be the best match for a pension plan’s retired life obligations (which may have a duration of 12 – 15 years).

    This has led to either cash-flow matching or to bond immunization – both of which are techniques which date back to the 1950’s! At any rate, this has provided an opportunity to many investment managers today to be able to offer such products to pension plans on either a pooled or customized basis. At least one major Canadian insurance company has created a highly customized (or one could argue – over engineered) product to match the disbursement pattern of smaller pension plans.


    Next, we come to annuities and the various iterations thereof. A few insurance companies (actually – there are only a few insurance companies!) have created annuity-like contracts, but the “bottom line” is still the same. The plan sponsor pays a premium to the insurance company, and in return, the life insurance company, either directly or indirectly, pays all or a portion of the pension to the retired plan member. Haven’t we already seen this somewhere before? The key factors in deriving annuity rates – interest and mortality – are both sensitive to current conditions. Improvements in mortality over the past 200 years have been well documented, while we are aware that the level of interest rates that are currently available are the lowest that they have been in over 50 years.

    Annuities still constitute a “bet” with the insurance company. They are the ones who hold all of the high cards, and more importantly, they are the ones with the actuaries!

    Guaranteed Minimum Withdrawal Benefit

    With respect to the DC market, insurance companies are now offering “Guaranteed Minimum Withdrawal Benefits” (GMWB) which, for a price, will “guarantee” to provide the retiree with a minimum annual payout (usually around 5% of the capital amount) with no possibility of outliving his/her money. However, when you analyze the so-called guarantee included in this product and the price that you are required to pay (often as high as 1% per annum), one questions the merit of purchasing this “benefit”.

    While not as misguided as some “insurance” products such as: product warranty insurance, travel insurance, AD&D or critical illness insurance; nevertheless this “guaranteed” product is, in my opinion, simply not worth the price.

    The two contingencies which must be considered by any retiree who fears outliving his money are longevity (living too long) and the fund rate of return that will be earned on his investment. The GMWB “pays off” in only the instance where the member has a very long life – far exceeding his normal life expectancy and the rate of return (net) earned by the assets is less than about 3% per annum. And for this, you must pay an annual fee of 1% of your assets.

    Recently, the Bank of Montreal has also entered this market with a product which pays out 6% of the initial invested amount after a 10 year deferral period, guaranteeing payments for life. For the first fifteen years, payments are deemed to be a return of capital, and are tax deferred. Following the first 25 years (10 year deferral plus 15 of payout), all payments received would be fully taxable. The insurance industry has complained that this is, in reality, an annuity which is their exclusive domain.

    Besides being illiquid for 25 years, the product comes with an annual management fee of 2.75%, almost 2.0% higher than many similar mutual funds that don’t offer this so-called guarantee. Pardon me if I don’t get too excited about this product and encourage my clients to consider it!

    There is currently (March, 2011), a dialogue going on in the financial journals in the US debating the merits of the GMWB by people who are far more knowledgeable about the subject than I. I am glad to see that the merits of the product are being discussed in public.

    It should be mentioning that many of these ideas and products have been imported from the UK where there acceptance has been much greater than it has been in Canada.

    Alternative Investments

    This category covers a multitude on investment products – ranging from real estate and/or REITS, to hedge funds to infrastructure to anything else that doesn’t fit conveniently into a traditional asset classification. Recently, investment managers have tried to facilitate the needs of smaller pension plans by creating pools of these assets so that the little guys can now play along with the big guys! A discussion on the merits (or lack thereof) of hedge funds is the topic for a separate seminar. While enjoying a bit of come back in recent days, the issues that I find offensive about most hedge funds remain, so I won’t be endorsing the use of this asset class any time soon.

    Some Final Thoughts

    This session would, perhaps, have been more timely were it to have been held following the great market sell-off in 2008. With the ensuing economic recovery and gain in global equity markets, pension plan sponsors now seem less inclined to consider or adopt “de-risking” strategies. While de-risking still has appeal to some plan sponsors as it controls funding volatility, it does come with a price – apparently a price that plan sponsors are now not willing to pay!

    Quoting from the 2010 Global Defined Benefit Survey undertaken by Pyramis (a Fidelity company):

    “The financial crisis of 2008 and the investment market volatility that followed have had a substantial impact on the solvency ratio of many [defined benefit] pension plans.”

    The solvency ratio of plans that were surveyed by Pyramis in Canada fell from .975 in 2008 to below .90 in 2009. What lessons did plan sponsors learn from this?

    For many, the answer was that they needed to add more downside protection to their fund. As discussed earlier, there are several ways to achieve this result, including annuitizing plan liabilities and duration matching. An equal number of plans reported that they needed to better match the plan’s liabilities and assets. Again, an obvious solution after the fact. Modern portfolio theory is so yesterday!

    Improving risk management was also suggested by many, but implementing this effectively is often difficult.

    How can pension plans best achieve these goals? Many sponsors anticipate a shift in the plans asset mix, either by diversifying into alternative assets, implementing some form of LDI or adjusting the plans asset mix to better reflect the underlying liability structure.

    One concern that I have about such surveys is that they rarely translate into substantive change by the plan sponsors. For example, for many years, research from Greenwich Associates survey Canadian pension plan sponsors. Each year, a fairly limited exposure to alternative assets in general and hedge funds in particular is noted. Furthermore, each year, a large portion of the survey participants indicated that they are “seriously considering ”adding or increasing their exposure to these asset classes, although no such increase arises in the subsequent year. Thus, there appears to be a discrepancy between what plan sponsors SAY they are going to do, and what they actually do when it comes to significant restructuring of assets. The status quo is largely maintained year after year.

    For many plan sponsors, the focus is now shifting from maximizing investment return to reducing the volatility of funding. While the two objectives are not mutually exclusive, there is definitely a trade-off required to achieve the new objective.

    What do I think that pension plans should do? Based on nearly 50 years of experience in the insurance and pension industry, I would caution plans from doing anything drastic, or significantly different from what they have been doing. Over those years, I have seen many “trendy” ideas come and go. For example, who remembers (or has ever heard of) the “Protected Equity Fund”?

    No – wholesale changes to the way pension obligations are met are NOT recommended. I agree that focusing on a plans’ asset mix is crucial, and that better matching of assets and liabilities is desirable. Having said that, we cannot lose sight of the following irrefutable facts:

    1. Asset mix accounts for approximately 90% of the return that a pension plan will earn, and

    2. Equities have enjoyed (and, in my opinion, will continue to enjoy) a higher rate of return than fixed income investments.

    With a maturing liability structure, a more cautious asset mix is in order. However, in order to achieve an acceptable rate of return based on the current market conditions, a continued heavier commitment to equities is required. If a pension plan is sufficiently large, consideration should be given to a meaningful allocation to “alternative” assets, with real estate, infrastructure and possibly high yield debt being worthy of consideration. If fixed income exposure is to be increased, some form of duration-matching product or long duration fund might be the way to go.

    For those of you who are keenly interested in this topic, and would like to know more, for only $1975 plus applicable HST, you can attend a two-day conference in Toronto that will deal exclusively with the topic of Pension De-risking. You will hear learned speakers talk about such things as “developing and implementing LDI strategies”, “looking at de-risking strategies to mitigate exposure during economic downturns”, and “strengthening your pension fund governance framework.” You can explore “Managing Systematic and Active Risk” and “Risk Budgeting to Control Asset-Liability Risk”. And at the end of the two days, you will probably be no more knowledgeable about the subject than you are now!

    De-risking Employee Benefits

    I would be remiss if I didn’t say a few brief words about de-risking of employee benefit plans. Unlike pension plans, for most employee benefit plans, there is no significant pool of assets held by the plan sponsor on behalf of the employees – that’s the role of the insurance company, however there are a few things that may be worth considering.

    Bankruptcies of Eaton’s and most recently NorTel have shown us the perils of self-insuring LTD claims. That’s probably a topic for another day.

    Escalating costs of prescription medication can have a significant impact on the health care premium. Working with the insurance company could potentially reduce exposure to those increasing costs, possibly by excluding some of the newer drugs from the programme.

    The method of funding the employee benefit plans should be reviewed as alternative methods exist, with corresponding levels of risk. Benefit consultants are always eager to explore the options with their clients.

    Re-risking can take many forms. It requires plan sponsors to take a serious look at their pension and benefit plans and determine if they are providing he benefits in the most cost-efficient and effective manner.

    I can’t help but reflect on where we might be today if regulators, actuaries and accountants had been more “hands off” with pension plans, and had simply allowed plans to focus on the long run and meeting pension promises.