Risky business: Evaluating your company’s pension risk

Published on September 28, 2016

For defined benefit (“DB”) plan sponsors, pension risk exposure has been a hot topic of discussion in recent years. How that risk is defined differs by organization. Some classify pension risk as volatility derived from either:

  • Cash contributions (determined on a regulatory basis) or
  • Pension expense (determined on an accounting basis)

Others consider it to be a measure of their funded position (plan assets compared to obligations) either from a balance sheet or regulatory (i.e. cash funding) perspective.

The one thing that all sponsors should agree on is that pension risk is a significant concern that needs to be analyzed, quantified and addressed in the broader context of their business.

There are two key pension risk drivers:

  • Longevity risk – as the current and future life expectancy of pensioners increases, the number of payments and ultimately their total obligation will increase.
  • Investment risk (can be broken into asset and interest rate components)
    • Asset - if the pension assets suffer losses or increase at a slower rate than the obligations, the plan’s funded position will deteriorate.
    • Interest rate - the rates used to discount future pension payments are linked to bonds. Lower interest rates, like those in the current bond environment, result in higher obligations.

Given the fact that organizations have a limited risk budget, some experts believe companies should transfer as much risk as possible from their pension plans and move it instead to their core business.

One fundamental reason for this view is that pension risk is asymmetrical. That is, while a sponsor’s access to plan surplus is very limited (and could bring pressure from employees for benefits improvements), they bear the full burden of plan deficits. This argument is particularly strong for companies with well-funded plans: why take risk that cannot be (fully) rewarded?

Others view the low current interest rate environment as prohibitively expensive to completely de-risk, whether it’s through investing in bonds matching the duration of a plan’s obligations or purchasing annuities from an insurer. Further, they believe that with the appropriate resources and expertise, these risks can be managed effectively.

Both views are valid but need to be weighed in the context of a company’s overall pension risk management strategy.

De-risking actions are generally grouped into three broad categories:

1. Plan design

One approach to reduce risk is to share the total cost of the plan between the sponsor and the employees by requiring them to make contributions. Other plan design changes can also be used to de-risk, ranging from closing DB plans to new members and enrolling them in a defined contribution (“DC”) arrangement to adjustments to plan provisions for current members (e.g. early retirement subsidies). More comprehensive approaches like freezing or reducing future benefit accruals for current members or the creation of hybrid plans (those combining aspects of both DB and DC plans) also fall under this category.

2. Investment strategy

In the past, it was very common for plan sponsors to invest from an “asset only” perspective, where funds were managed to exceed an arbitrary benchmark return without consideration of the obligations. After the “tech” crash in the early 2000’s, the financial crisis of 2008, and the persistent low interest rate environment, sponsors came to appreciate that the “asset only” perspective was insufficient for their pension asset management, and that they needed to consider the obligations they were funding. This is known as liability-driven investing (LDI). While LDI approaches can vary greatly in complexity, the ultimate objective is to ensure that assets and liabilities move and grow in the same way. This is often undertaken by what is known as a “glide path” or “journey plan” whereby volatility is gradually reduced as a plan’s funding position improves. As a consequence of LDI, many plans have incurred the following changes: increase in fixed income assets in the overall portfolio, lengthening of the fixed income term and diversification into new asset classes such as infrastructures, private placements, and derivatives.

3. Risk transfer strategies

These strategies transfer risk through a transaction. This can happen on an individual member basis, for example, through bulk lump sum settlements, where plan participants are given the option to elect a lump sum settlement in lieu of future pension payments. On a larger scale, risk for a covered group of members is often transferred out of the plan through the purchase of annuities from an insurance company.

Annuity purchases are broken into two categories:

  • Buy-out annuities, the traditional approach, where a sponsor pays a lump sum premium to an insurer to transfer all the risks for a group of pensioners. The insurer becomes the direct payer of the retirees. As a result, the balance sheet obligation relating to the specified pensioners is essentially sold to the insurer.
  • Buy-in annuities, the more recent trend, are similar to buy-outs in that they transfer the risk to the insurer. However in this case, the plan remains the direct payer of the retirees’ benefits and thus the buy-in transaction is generally viewed as a (perfectly hedged) plan investment. From accounting and regulatory perspectives, because the buy-in transaction is financed through an “investment” rather than sold, it does not trigger a settlement on the balance sheet or result in additional regulatory contributions (like a buy-out could).

In cases where a sponsor is comfortable maintaining the interest rate risk and investment decisions but wants to protect against increasing member lifespans, a longevity swap is another option provided by insurers. Here, the sponsor pays the insurer predetermined monthly premiums and the insurer then makes monthly pension payments into the plan for the duration of existing pensioners’ lives.

These strategies should not be considered as “either/or” propositions, but instead an array of tools that can be implemented to get your pension program to its optimal risk composition, whether it’s long-term sustainability or fully hedged risk. [Please see Figure 1 below.]

*Source: Sun Life Assurance Company of Canada

While all plan sponsors should consider de-risking strategies, some are certainly more susceptible to the risks than others, particularly those where the ratio of their pension assets to their total market capitalization is large. Many of these organizations have inadvertently become as invested in the business of insuring pension as they are in their own industry. Furthermore, sponsors that are heavily invested in equities are especially vulnerable to market fluctuations. In the event of a market shock, they may be required to divert resources to their pension at the most inopportune time from an overall business perspective.

De-risking strategies have grown in prominence in Canada in recent years. Canadian annuity purchases averaged less than $1 billion annually from 2002-2012 but have exceeded $2 billion in each of the last three years, with a record $2.6 billion in 2015 . Still, we lag behind our peers in the U.S. and the U.K. Some experts posit that Canadian sponsors are five to 10 years behind our U.K. peers in de-risking strategies. This suggests we will likely see an increase in the number and complexity of such strategies among Canadian plan sponsors in coming years.

Having a framework to manage your organization’s pension risk is vital. While it’s the board of administration that approves a strategy to manage pension risk, it’s management that must develop and execute it:

  1. Seek an independent assessment of your pension risk:
    • Pensions are a significant (often outsized) portion of company’s total balance sheet.
    • Consideration should be given to your pension obligations as a percentage of market capitalization and the cash needed to transfer those risks.
    • Managing the risks, particularly by using risk transfer strategies, should be approached like any other large business transaction.
  2. Ensure your stakeholders are educated:
    • Are all the risks involved, and the strategies to mitigate them, understood and properly disclosed?
    • Do you have the resources (internal and external) to execute?
  3. Establish a strategy to bring your pension risk into line with your organization’s overall, board determined risk appetite:
    • Once the plan’s objectives and risk tolerance are identified, a roadmap must be drawn to get there.
    • While driven by Finance, HR input around workforce management and communication considerations should be sought.
    • Appropriate timelines and/or triggers to take action must be established.
  4. Monitor your pension risk strategy regularly:
    • How is your strategy working?
    • How are dynamic external factors (e.g. interest rate levels, asset returns) affecting your plan?
  5. Be prepared to reassess and change course:
    • Sponsors should be flexible.
    • As conditions change, both internal and external, so may the best course of action.
    • It is imperative that management communicate the results of the strategy to the board to allow for possible adjustments.

Pension risk management is a significant, comprehensive challenge for organizations. But addressing it is key to ensuring sponsors maintain financial stability and meet their fiduciary duties. Deloitte is here to help – connect with the dot! Feel free to reach out to Max Bazile in Ontario and Martin Raymond in Quebec.

1 From Willis Towers Watson Annuity Purchase Index – Fourth Quarter 2015



Martin Raymond, FCIA, FSA
Martin is the leader of Deloitte’s Canadian Pension Actuarial Advisory practice and is a member of Deloitte’s National Committee on Pension and Benefit Accounting. He has provided services to a number of clients from both actuarial advisory and audit perspectives.
Max Bazile, FCIA, FSA
Senior Manager
Max leads Toronto’s Pension Actuarial Advisory practice and heads Deloitte Canada’s pension de-risking initiatives. He provides advisory services on a diverse array of pension plan issues.

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