Canadian Pension Risk Management

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Canadian Pension Risk Management
Proactively
managing
the health of
retirement
plans
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PASSION, PERSPECTIVE
PURPOSE
Our Purpose is Always to Add Value While Controlling Risk
Controlling risk pervades our approach, as evidenced
by our dedicated risk-management team, our proprietary
portfolio and risk management technology, and our rigorous
investment disciplines. Within this framework, we develop
investment solutions that control risk using traditional
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and other sophisticated techniques like overlays, liabilitydriven investing and low volatility equities.
Let Us Put Our Passion and Perspective
to Work for Your Organization.
VANCOUVER â CALGARY â TORONTO â MONTREAL
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Phillips, Hager & North Investment Management is a division of RBC Global Asset Management Inc. ® / TM Trademark(s) of Royal Bank of Canada.
Used under licence. © RBC Global Asset Management Inc., 2014. IC1402136
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Advertising Supplement
Sponsors
BlackRock Asset Management Canada Limited
161 Bay Street, Unit 2500
Toronto, ON, M5J 2S1
Eric Leveille
Managing Director, Head of Canadian Institutional Business
416.643.4000
[email protected]
www.blackrock.com
Phillips, Hager & North Investment Management
Waterfront Centre, 200 Burrard St., 20th Floor
Vancouver, BC, V6C 3N5
John Skeans
Vice President
604.408.6238
[email protected]
www.phn.com
Pyramis Global Advisors (A Fidelity Investments Company)
483 Bay Street, North Tower, 3rd floor
Toronto, ON, M5G 2N7
Michael Barnett
Executive VP Institutional Distribution
416.217.7773
[email protected]
www.pyramis.ca
Sun Life Financial
225 King St. West
Toronto, ON, M5V 3C5
Heather Wolfe
Managing Director, Client Relationships, Defined Benefit Solutions
416.408.7834
[email protected]
www.sunlife.ca/DBSolutions
TD Asset Management, Inc.
161 Bay St., 34th Floor
TD Canada Trust Tower
Toronto, ON, M5J 2T2
Mark Cestnik, CFA
Managing Director
416.983.7088
[email protected]
www.tdaminstitutional.com
Contents
4
Facing Down the Risk Challenge
With mark-to-market accounting and
just five years to make up funding
shortfalls, Canadian plan sponsors
know they need to work hard
to minimize funding volatility
and ensure plan health
6 Target-Benefit Plans: A Creative
Approach to a Perennial Problem
8 Letters of Credit:
A Funding Alternative
10
Finding the Right
Investment Approach
With many Canadian plans
close to full funding, plan sponsors
are considering more robust
risk management measures
12 Plan Transfers: The Prospect
of Pension Settlements
14 Longevity Risk:
The New Canadian
Mortality Tables
Canadian Pension Risk Management
3
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Facing Down the
Risk Challenge
C
anada faces the same triptych of
pension problems of most developed economies with funded retirement systems: increased longevity, a
shrinking workforce and a challenging market
environment. It’s enough to concentrate the
minds of plan sponsors. And concentrated
they are – on quantifying the risks associated
with running defined benefit pension plans.
Accounting and regulation changes mean
that pensions and pension risk aren’t just a
treasury afterthought for companies. “Risk
management is increasingly important to Canadian DB funds because of the events of the
past decade and the mark-to-market nature
of funding and accounting regulations,” says
William da Silva, Senior Partner and Practice
Leader, Canadian Retirement Consulting at
Aon Hewitt. “Companies are very focused on
the risks in their programs and even in the
public sector, pension risk management has
become more important.”
That’s because pension risk in the last
decade has been considerable. The funding
roller coaster has hit companies hard, particularly now that they are responsible for funding
any deficits with cash contributions. “CFOs
4
Canadian Pension Risk Management
and treasurers are focused on managing pension risk,” says François Pellerin, LDI Strategist
at Pyramis Global Advisors. “Plan sponsors
have been hurt so hard in the last decade or
so – average plan funding dropped 40% in
2001 to 2002, 30% in 2008 and 20% in 2011.
Plan sponsors have gotten the joke! And they
are now more focused on managing funded
status rather than return on assets.”
Last year’s buoyant equity markets
proved a boon to Canadian DB plans. “The
Mercer Pension Health Index stands at 106%
at December 31, up from 82% at the start of
2013,” says Brent Simmons, Senior Managing
Director, DB Solutions, Sun Life. “This will drive
many sponsors to look for risk management
solutions to crystallize their good funding
positions and avoid bad news in the future.”
Only time will tell if this time plan sponsors
and their sponsoring organizations have gotten the message that just focusing on returns
won’t alleviate potential pain in the future.
“For many plan sponsors who have experienced a tremendous turn around in the health
of their pension plans, they are saying, how
do I protect this good funding situation?” says
Aon Hewitt’s da Silva. “We are seeing more
plan sponsors realizing that they are close to
being fully funded and are finally executing
on their de-risking plans. They have learned
the hard way from experience that the situation can turn around quickly.”
Significant impact
That said, not all companies face the same
risks from their pension plans. “DB pension
plans can have a significant impact on a
company’s business, and managing pension
risk is especially important for plans that are
large compared to the size of the sponsoring employer,” says Sun Life’s Simmons. For
companies where the assets in the plan are
small, or where the workforce is young and
there are few retirees, pension plan risk may
be minimal. Nevertheless, these plans are
exposed to the same range of risks as others,
albeit less materially.
The message is clear: Companies need to
think about pension risk as another corporate
risk that needs to be managed. “Even though
funding ratios have improved dramatically
over the past year, managing risk remains a
key concern for plan sponsors,” says Michael
Augustine, Vice President and Director of TD
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With mark-to-market
accounting and just five years
to make up funding shortfalls,
Canadian plan sponsors
know they need to work hard
to minimize funding volatility
and ensure plan health
Asset Management. “While interest rates are
slowly rising, they are still at historically low
levels and the potential for future market volatility remains. Sharpening their focus on risk,
more sponsors are beginning to fold pension
risk into their broader enterprise risk management, as the funding level of the pension plan
impacts the organization as a whole.”
So how should plan sponsors approach
the pension risk management dilemma?
“We’ve seen a philosophical shift in the U.K.
market, and we believe that it will come to the
Canadian market,” says Sun Life’s Simmons.
“The old view was that the purpose of the
pension plan is to make bets on markets and
take risk. The pension plan should mismatch
its assets and liabilities in an attempt to
generate excess returns. The new view is that
the purpose of the pension plan is to provide
promised benefits. Risk is better taken in a
company’s core business where the company
has a competitive advantage. The pension
plan should match its assets and liabilities
closely, and not be a source of surprises.”
This approach is not as widespread as may
be imagined. “After the 2008 crisis, Canadian
pension plans became more aware of the
need to manage risk,” says Eric Leveille, Managing Director at BlackRock.
Two tiers
In contrast to the trend in the U.S., more
Canadian DB plans are open and even those
with a long-term intention to terminate,
follow a slower path. “When eliminating exposure to future DB liabilities, many Canadian
organizations tend not to freeze, but rather
close to new hires,” says Aon Hewitt’s da Silva.
“This creates two tiers within the workforce.
Those that decide to freeze future accruals
under their DB plans tend for a sof t freeze (i.e.,
discontinuance of future service accruals but
continued accrual of future pay increases) as
some provinces won’t allow the plan to put a
hard freeze in place. So the prevalence is for
the soft freeze. Some organizations are also
implementing a sunset approach whereby a
plan that is being closed to new hires will also
provide notice of say, five years, at the end of
which all plan members will no longer accrue
any additional benefits under the plan.”
The situation with public sector plans
is different. “DB coverage is higher in the
public sector,” continues da Silva. “Many nonunionized companies have closed their DB
plans and moved to DC. In the public sector,
most DB plans remain open because of the
unionized nature of these workforces, the cost
and risk sharing model in place and the belief
that DB plans are more effective in delivering retirement income, but the sponsor has
to deal with the volatility. If the volatility can
be managed, sponsors believe a DB plan will
provide the best income to workers.”
That said, most DB plan sponsors have
made decisions about the future of the plan,
however long it may take to accomplish the
goal. “By this point, most plan sponsors have
already decided whether or not they are getting out of the pension business,” says Paul
Purcell, Managing Director at BlackRock. “That
ship has already sailed. Those that are sticking
with DB are keeping their plans open. Others
have already decided to make the move to DC
and are closing their DB plans to new hires.”
Onerous impact
“It’s been a difficult decade for pension plan
sponsors,” says Étienne Dubé, Vice President
at Phillips, Hager & North Investment Management. “Now that many plans are close to 100%
funded, it is a perfect time to increase focus
on risk management. This is a particularly
opportune time for closed and aging plans to
implement de-risking strategies have been on
the radar for some time.”
The risk management habit is being reinforced by accounting and regulation changes
regarding pensions. “International accounting
standards (IAS) has only just been recently
introduced in Canada,” says Aon Hewitt’s da
Silva. “As plan sponsors begin to realize that
they no longer get the benefit of recognizing
an equity risk premium in determining their
pension expense, it will drive many Canadian
plans toward de-risking actions. What we
expect over the next couple of years is that
plans will be rewriting their statements of
investment policy to move away from returnseeking assets in a measured way and possibly
making plan design changes to optimize their
risks under the new accounting standards.”
“Canada adopted IAS in 2011, which in
combination with the new pension accounting standard in 2013, will drive more interest in
pension de-risking,” says BlackRock’s Purcell.
Pension funding regulations have also
become tighter. “Solvency is an important issue for Canadian plans, since deficits typically
have to be liquidated over relatively short
time horizons such as five years,” says Phillips,
Hager & North Investment Management’s
Dubé. “However, corporate plan sponsors
are also concerned about financial statement
volatility. The potential need to manage
between competing liability objectives means
that there is no one right answer to p ortfolio
strategy. Some asset classes, for example
corporate bonds, can play more prominent
features in portfolios depending on the
primary liability focus.”
The push to think about risk is complicated. “The removal of the ability to take credit
for future expected equity out performance
has removed an important disincentive for
plan sponsors to reduce the amount of equity
in their pension plan,” says Sun Life’s Simmons. For those plans following a de-risking
path, it may seem contradictory to reduce equity risk on the one hand and increase credit
risk in the bond portfolio, set up to hedge the
liabilities.
Viable funds
It is still early days with these developments.
“Companies are still digesting how the
changes to accounting will impact the P&L
and the balance sheet, we haven’t seen a lot
of investment changes yet, but the conversations are happening,” says TD Asset Management’s Augustine. “On the regulatory side,
companies have more flexibility in funding,
thanks to letters of credit, some smoothing is
allowed and the ability to delay contributions
in certain circumstances. There is a recognition among regulators that there needs to be
flexibility in order to make these funds viable
for the future.”
For corporate sponsors, the developments
in accounting and regulation mean that they
need to reassess their plan objectives. “Plan
sponsors need to decide how they want to
implement their de-risking strategy,” says
Patrick De Roy, Institutional Portfolio Manager
at Pyramis Global Advisors. “Do you want
to minimize contribution risk or accounting
risk? The LDI solution would be different
continues on page 6
Canadian Pension Risk Management
5
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depending on the answer. In the past, Canadian accounting rules allowed plans to use
amortization of gains and losses and discount
their liabilities based on expected return on
assets. Now with mark-to-market international
accounting standards, we have the last nail in
the coffin. It is putting more pressure on CFOs
and Treasurers to minimize accounting risk
and use LDI strategies. There’s less potential
upside in having a lot of equity in the pension
portfolio. It’s a game changer so we expect to
see more corporates de-risking over time.”
For many plan sponsors, this may be the
third time they have been tantalizingly within
reach of full funding. “Since many plans now
find themselves close to or fully funded, sponsors are also concerned with managing ‘regret
risk’ – the risk that they don’t take action now
and find themselves facing another funding
shortfall and all the volatility that brings,” says
Sun Life’s Simmons.
Longevity risk
In terms of considering how investment risk
works in concert with enterprise risk, lessons
can be learned from plan sponsors in other
countries. “Globally, DB plans are further
ahead in managing pension risk. They understand the impacts of key capital market risks
and are developing strategies to optimize
these risks,” says Aon Hewitt’s da Silva. “In
Canada, plan sponsors are acutely aware of
the risks in their pension plans and are now
putting in place strategies to manage and
optimize their unique risks. For many sponsors, market risk is the number one concern;
that is, managing investment and interest rate
risk. For those that have pension benefits that
are indexed to inflation, they are also worried
about how vulnerable the health of their plans
is to unexpected changes in inflation. Finally,
the new risk on the horizon is longevit y risk –
and they will need to be more worried about
Target-Benefit Plans: A Creative Approach to a Perennial Problem
The problem is clear. Many sponsoring organizations cannot afford to offer defined benefit pension
plans to their workers. Yet these plans are known to provide good retirement outcomes, and perhaps better outcomes than some defined contribution plans. Often led by the public sector, the search has been on
for a better alternative than the either/or of DB and DC. In the U.S., some states have devised hybrid plans.
Canadian provinces are exploring the target-benefit model.
While New Brunswick is the only province that currently has the full legislative structure to operate
such a plan, other provinces are considering the option and awaiting the establishment of a regulatory
framework. “From the employer standpoint, a target-benefit plan is a DC plan,” says William da Silva, Senior Partner and Practice Leader, Canadian Retirement Consulting at Aon Hewitt. “The employer puts in a
set percentage of pay and all plan assets belong, collectively, to the plan members. The mechanisms built
into the design of a target-benefit plan manage the level and delivery of predictable and stable, though not
guaranteed, benefits to members. However, it is still early days with this structure for many jurisdictions.
New Brunswick recently put in place a shared-risk model for plans within that jurisdiction, but it still hasn’t
been fully tested. There are a number of good examples within the Canadian pension landscape whereby
target-benefit like designs have been implemented and have succeeded. We are expecting more provincial policymakers to be introducing and implementing new regulations to pave the way for target-benefit
plans.”
The initiative is welcomed within the pension community. “Target-benefit plans may be a solution to
the problems that sponsors have with DB plans,” says Patrick De Roy, Institutional Portfolio Manager at
Pyramis Global Advisors. “Instead of putting all the risk onto members, as a DC plan does, the risk is shared.
It’s a DB plan with DC-like contributions. The proposed plans are different in each province but share the
same objectives. The question is whether target-benefit plans will see widespread adoption. It is a good
thing from an actuarial standpoint, so it will be interesting to see if it goes well.”
Most agree with this wait-and-see attitude. “It’s early days for target-benefit plans,” says Rachna de
Koning, Vice President and Director of TD Asset Management. “They could prove to be a good addition to
the pension landscape in Canada. It’s a happy medium between DB and DC.”
A happy medium it may be, but it won’t be an easy transition. “In pension plan evolution, target-benefit plans are an interesting idea,” says Paul Purcell, Managing Director at BlackRock. “It strikes me as a fairer
and more honest way to go. The plan sponsor says, ‘We’ll manage the fund as best as we can, and we’ll give
you the best estimate of your pension as often as we can. But for the sake of our financial health and fairness
to our employees of all ages, we can’t promise a certain outcome.’ But I don’t know how we get from here to
there, especially since many DB plans are already in their sunset period.”
6
Canadian Pension Risk Management
this in the coming years.” (see box on page 14)
Pension plans run a range of investment
risks, some of which are compensated and
others uncompensated. The new focus on
pension risk management zeroes in on the
uncompensated risks – and ways to figure out
how to minimize these. “Many plan sponsors
are most concerned about interest rate risk,”
says Phillips, Hager & North Investment Management’s Dubé. “For a typical plan, interest
rate exposure represents about about onethird of the overall risk budget and yet it is
an unrewarded risk; however the low level of
interest rates has been a barrier to minimizing
this risk. Market risk is two-thirds of the risk,
largely because Canadian pension plans are
heavily exposed to and invested in equities
that have no direct relationship to the liabilities. This mismatch represents a significant risk
that plan sponsors are looking to mitigate.”
This sounds like a recipe for disaster, but
that’s just what plan sponsors are looking to
avoid. “Many plan sponsors are taking the
opportunity to step back and rethink their
risk budgets,” says Pyramis Global Advisors’
Pellerin. “How much risk does the company
want to take in its pension plan versus the rest
of the company? One valid way to limit the risk
can be in diversifying into low volatility strategies and alternative assets. Canadian pension
funds are looking into these strategies more
and more these days.”
Low volatility strategies, also sometimes
called minimum variance, encompass a
number of equity strategies designed to
smooth out the ups and downs of investing in
the stock market. They have been particularly
appealing in this era of increasingly volatile
stock markets, though they do mean giving
up some upside in return for protection on
the downside. “Low volatility strategies have
been hugely popular in Canada,” says Rachna
de Koning, Vice President and Director of TD
Asset Management. “We have C$7 billion in
low volatility assets as of February 2014. This
reflects the changing risk attitude, as plan
sponsors are focused on volatility and Sharpe
ratios. These are long-term investors and they
are picking these strategies for the right reasons. Low volatility assets should produce the
same return with two-thirds of the risk.”
Not all managers have seen the same
interest from plan sponsors. “We’ve seen a lot
of discussion of low volatility strategies over
the last four years,” says BlackRock’s Leveille.
“At the moment, it is evolving from minimum
volatility 1.0 to minimum volatility 2.0. But
continues on page 8
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it’s still a niche strategy. It’s too early to tell
whether it will become mainstream.”
Smart portfolios
“The general idea behind low volatility strategies is to provide equity return with a fraction
of the equity volatility,” says Pyramis Global
Advisors’ Pellerin. “In many cases, it is to be
seen if this asset class will consistently deliver
on its enhanced risk/return trade-off profile in
the long-run. Or indeed whether it will remain
low in volatility during a tail event. It’s also
important to realize that a plan will likely need
to invest a sizebale portion of its assets in this
strategy in order to make a measurable difference in the portfolio’s volatility.”
“DB plans are focused on managing downside risk,” says BlackRock’s Leveille. “They
realize the importance of solutions that help
to mitigate this risk-such as minimum variance
strategies. We have seen some clients building
portfolios that have a lower expected return,
but a limit on downside risk. However, we
don’t see many looking to explicitly manage
tail risk because of the price of that kind of
insurance.”
Canadian pension plans are increasingly
expanding their alternatives allocations as
a way to capture additional return. “We see
a significant demand for real estate, private
equity and infrastructure,” says BlackRock’s
Leveille. “These strategies offer diversification
and can protect on the downside. This is appropriate for investors that have a long term
investment horizon.”
These strategies provide risk management in the form of diversification, as well as
in some cases the added benefit of liability
matching. “Investment strategies that combine risk management with enhanced returns
are in demand and sponsors are considering
alternative fixed-income like investments (private fixed income, commercial mortgages and
real estate) as a way to better match assets to
liabilities while still enjoying higher returns,”
says Sun Life’s Simmons.
Diversification within the core fixed
income allocation is also increasing. “As plan
sponsors increase their fixed income allocations, we’ve also seen an increased interest
in alternative asset classes to enhance yield,”
says Sun Life’s Simmons. “Asset classes such as
real estate, commercial mortgages and private
fixed income are gaining in popularity.”
Larger Canadian plans keep the prospect
of hedging liabilities front and center. “In
Canada, many of the larger plans have become more diversified over the past decade,”
8
Canadian Pension Risk Management
says Aon Hewitt’s da Silva. “They have gone
global and moved into emerging markets.
They are using alternatives, primarily real
estate and infrastructure, many to hedge their
pension liabilities. And they may also be using
private equity and hedge funds within their
alternatives allocation. Jumbo plans will have
larger allocations to alternatives because they
are able to generate better return opportunities in private markets.”
Some managers add a note of caution.
“For plans considering alternatives, it is
important to assess liquidity requirements,”
says Pyramis Global Advisors’ Pellerin. “If they
have a longer time horizon, then investing in
alternatives might be a way to diversify the
portfolio and harvest some illiquidity premium. However, if the plan is expected to be
terminated within the next two or three years,
then alternatives might not be warranted.”
Shrinking domestic equity
“Canadian plans have been diversifying
globally for years,” says BlackRock’s Leveille.
“Twenty years ago, Canadian plans had 30% to
40% in Canadian equities; now that allocation
is below 20% and still shrinking. The endpoint
will probably be 10% or 15%. That money has
been moving into fixed income, alternatives
and global equity.”
Problems come however with repatriation
of income. “Emerging markets and high yield
each represent good opportunities and ways
to increase yield within the portfolio,” says
Phillips, Hager & North Investment Management’s Dubé. “But for Canadian investors, the
currency and foreign interest rate exposure
embedded in these strategies mean they are
not a direct replacement for domestic bonds
as hedging instruments for liabilities that are
denominated in Canadian dollars and influenced by domestic interest rates.”
“Some plans are looking abroad for
opportunities to manage risk, by using alternatives and diversifying into global bonds,
for instance,” says TD Asset Management’s
Augustine. “Though in some cases new
risks – such as liquidity, lack of transparency,
currency and foreign economic risks may be
introduced and need to be considered.”
Letters of Credit: A Funding Alternative
Even as pension plans de-risk and diversify, many in the past few years have had to dig in their pockets
to fund deficits. Putting up cash can be painful, and in this volatile environment, expensive in more ways
than one. “Letters of credit could be a good way to reduce the short-term volatility associated with contributions,” says Étienne Dubé, Vice President at Phillips, Hager & North Investment Management. “It’s a way
to buy time instead of making cash contributions.”
Letters of credit are a relief option in what is a complex regulatory regime. “Regulations allow plans
to use letters of credit to fund deficits,” says William da Silva, Senior Partner and Practice Leader, Canadian
Retirement Consulting at Aon Hewitt. “In general, Canadian plans must fund deficits within five years. It
can be difficult for a cash-strapped company, or one that has other uses for the cash, to fund the deficit
entirely with cash especially in the midst of the current historically low interest rate environment. So the
company can fund up to 15% of the deficit using a letter of credit, which would only be triggered if the
company were to declare bankruptcy. It is also a way to avoid overfunding the plan, which can happen if
the assets increase in value quite quickly. This can be a big issue for many plan sponsors as retrieving the
overfunding in Canada is not a trivial task.”
Given the rising funding levels of plans, it is perhaps not surprising that letters of credit are not commonly used. “In some jurisdictions, it is possible to use letters of credit instead of cash contributions to cover
funding deficits,” says Paul Purcell, Managing Director at BlackRock. “It was a major victory for plans to be
allowed to do this. Cash-strapped companies could use this facility. Or those that have the view that their
funding status is going to improve and want to avoid overfunding, the letter of credit tides them over. But
despite this, it is extremely rare to see them used in practice.”
Using a letter of credit is not without risk. “Some provinces allow letters of credit to be used for funding,
though use is not widespread,” says Patrick De Roy, Institutional Portfolio Manager at Pyramis Global Advisors. “It could provide security for plan members in the case of bankruptcy, as the bank, not the company
would be required to pay for the value of the letter of credit. The plan sponsor would have to pay a premium
to the bank for the value of the letter of credit, depending on the credit quality of the plan sponsor. It could
be an advantage for a plan sponsor who does not want to risk becoming overfunded.” For instance, if a plan
had used a letter of credit to fund a portion of the shortfall in 2011, it might have been able to cancel it once
equity markets made up the difference in 2013. It would not be able to recover the premium, however.
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“Canadian plans are diversified globally,
but mainly on the equity side,” says Aon
Hewitt’s da Silva. “They currently are not heavily invested in global bonds. This may change,
though, unless the relatively thin long bond
market in Canada expands. There may be
better opportunities for yield pick-up in bonds
from other geographies, but you would have
to deal with the basis risk. Yields are at historic
lows and there are opportunities globally for
the sophisticated bond buyer.”
Most Canadian pension plans are not sophisticated bond buyers – yet. “Frankly, when
Canadian plans go outside Canada for fixed
income, they do it from their return-seeking
portfolios,” says BlackRock’s Purcell. “It is not
typical to go outside Canada for liabilityhedging strategies.”
Nevertheless, all the assets in the plan
need to work for a living and sometimes plain
vanilla bonds aren’t up to the job. “Plans are
trying to get value-added from their fixed
income portfolios versus the liabilities,” says
Pyramis Global Advisors’ Pellerin. “So they are
looking at using U.S. high yield, global high
yield, floating rate debt, emerging market
debt and other non-traditional fixed income
investments. In addition to investing in bonds
that mimic liabilities, sponsors can also use
active non-traditional fixed income strategies
to increase returns. That said, the hedging
efficiency of those ‘exotic’ bonds needs to be
carefully analyzed.”
These types of strategies are being used
in other markets, but often not by corporate
plans that are focused on de-risking. In Canada, too, more active approaches to fixed income are concentrated in public sector plans.
“We see a lot of interest in unconstrained fixed
income in the U.S.,” says BlackRock’s Purcell.
“The objective of this strategy is expressed as
cash plus 3% or 5%. We’re just starting to see
interest in it in Canada.”
It isn’t just the investment risk and return
that are garnering attention from plan sponsors. They are more aware of the operational
risks associated with pension plans and are
taking appropriate steps to manage these
risks as well. “Plan sponsors want to understand what risks they are taking at the macro
and micro level,” says BlackRock’s Leveille.
“They want to know how the portfolio is being
built and for instance, what embedded credit
risk there is in the equity portfolio. We see
plan sponsors doing more extensive operational due diligence, wanting to understand
counterparty risk for instance. This is true for
plans of all sizes. Larger plans do this them-
selves and smaller plans ask their consultants
to do it for them.”
Tolerating volatility
Plan sponsors are also taking the opportunity
to assess the adequacy of their investment
policy statement and overall approach
to investing the plan assets within a risk
framework. “Asset classes that do not match
liabilities (e.g., equities) will still be used, but
these asset classes will be recognized as introducing funding and accounting volatility,”
says Sun Life’s Simmons. “This volatility will be
modelled so that the plan sponsor understands the risks that it is taking. At the same
time, pension investment policies will contain
a discussion about the pension plan’s need
for excess returns (such as those that could be
generated by equity). Even if a plan sponsor
official in the investment policy statement
(IPS) varies.”
Plan sponsors are focused, though. “Derisk, re-risk, risk neutral,” says TD Asset Management’s de Koning. “Plan sponsors need
to think about risk not just reward. They are
moving from a static asset allocation that they
look at every three years to a more tactical,
more dynamic approach using risk budgeting
in order to better manage all the risks associated with the plan.”
Other larger plans are exploring different
ways to express their plan objectives and
approach to pension risk management. “Our
larger clients are becoming more outcomefocused, either for the plan or for the tota l
organization,” says TD Asset Management’s
Augustine. “Now they are articulating goals
in terms of risk budgets, surplus volatility or
Plans are adding elements to their IPS, like LDI,
where they make sure that duration never
strays out of a certain range and as funded status
improves, they will seek to dial down the risk
can tolerate the volatility associated with chasing excess return, it may not make sense to
do so as the excess returns may not be able to
be put to good use. For example, in a frozen,
fully funded plan, it may not make sense to
attempt to generate excess returns as there is
no apparent use for these returns.”
“The old 60/40 long term strategic asset
allocation is, for the most par t, gone,” says
BlackRock’s Purcell. “The new asset allocation
tends to be more globally diversified and
include alternatives. For larger funds, there
tends to be more latitude to make active bets
against the strategic asset allocation.”
Having clear metrics against which to
judge progress is important. “We see more
plans acknowledging, in their investment
policy statements, that funded ratio volatility
is the issue to focus on,” says Pyramis Global
Advisors’ Pellerin. “Benchmarking customization is a growing trend. Sponsors are adopting
bespoke liability benchmarks that help them
track the true performance of their hedging
programs. Sponsors are also adopting dynamic risk management frameworks by which
steps will be taken to reduce funded ratio
risk as the plan’s funded status improves. The
degree to which such frameworks are made
tracking directly to the liabilities. Another idea
in use is tolerance to volatility, expressed as
short-term downside risk to funded status
and allocating units of risk across various asset
classes.”
“We do see a handful of plans looking at
factor exposures, such as an inflation-sensitive
bucket and an economic exposure bucket,”
says BlackRock’s Leveille. “But this is unusual.”
Not all plans will move away from the
status quo in their IPS. “Building portfolios
and monitoring them by asset class will
remain the norm for investment policy
statements in Canadian pension plans
because it is a simple and well-understood
technique,” says Phillips, Hager & North
Investment Management’s Dubé. “However
this approach may not appropriately capture
exposures to different market factors across
asset classes that can lead to unidentified
positive correlation of returns. Risk budgeting based on market risk factors is one way to
overcome limitations in the traditional asset
mix approach. Increasing the role of active
management across managers with different
investment styles or processes is another way
to further diversify sources of returns within
the portfolio.” ‡
Canadian Pension Risk Management
9
Advertising Supplement
With many Canadian plans
close to full funding,
plan sponsors are considering
more robust risk
management measures
Finding the Right
Investment Approach
R
isk is all about context. For the plan
sponsor, the biggest risk is that there
won’t be enough assets available to
meet the liabilities of the plan – the
future payments to beneficiaries. But this risk
has many facets – enterprise risk, investment
risk and the dreaded risk of having to make
cash contributions to the plan.
The thinking about how to manage these
varied risks has evolved in the past 20 years,
as defined benefit plan sponsors around the
world have sought a long term, viable solution. The most common answer is the strategy
known as liability driven investment or LDI.
Canadian pension plans are well down the
route of using this strategy as a pillar of their
pension risk management strategy.
But LDI is a bit of a slippery concept. It can
mean quite different things, depending on the
objectives of the plan. Some pension plans
often view it as a glidepath to termination,
while others view it as a partial immunization
strategy that will allow them to keep the plan
open and functioning. And then there are the
many stages of LDI implementation. “Most
plans are now talking about LDI – although
the application of LDI varies widely,” says
Brent Simmons, Senior Managing Director, DB
Solutions, Sun Life. “Some plans are increasing their allocations to fixed income and/or
extending the duration of their fixed income
portfolios while other plans are developing
sophisticated overlay and key rate duration
strategies.”
Just how many Canadian plans are using
LDI is hard to quantify. “The use of LDI is prevalent,” says Rachna de Koning, Vice President
10
Canadian Pension Risk Management
and Director of TD Asset Management. “But it
is difficult to put a number on it, because LDI
means different things to different people. All
these approaches agree in the need not to be
asset-focused, but some use LDI to just mean
more long bond exposure. We think it should
involve the overall plan objectives, and that
plan sponsors should be thinking about all the
plan’s investments and its funding requirements.”
Some observers suggest that Canadian
pension plans are a bit late to the LDI party.
“LDI is not as prevalent in Canada as it is in
some parts of the world,” says William da Silva,
Senior Partner and Practice Leader, Canadian
Retirement Consulting at Aon Hewitt. “Many
plans have adopted glidepaths, but there are
still a number of plans that have not implemented a risk management strategy within
their pension plans. Last year was a tremendous year – the average Canadian plan is now
93% funded on a solvency basis, compared
to 69% at the beginning of the year. The tremendous improvement in funded status for
most plans were driven partly by interest rates
which rose 90 basis points and global equity
markets which experienced their best year
since 2009. Given the capital market dynamics
that we experienced in 2013, plans without
a full LDI strategy actually benefited. It was a
year when plan sponsors were rewarded for
having risk on.”
Intention to de-risk
The stop-start approach to LDI, depending
on market conditions, is a phenomenon seen
in all countries with DB plans. “Because of
the low expected return environment, many
plans have delayed de-risking and continue to
maintain a decent amount of return-seeking
assets,” says Étienne Dubé, Vice President at
Phillips, Hager & North Investment Management. “They have the intention of de-risking
and may even have adopted a dynamic, riskadjusted glidepath or hedge path. But they
may not have implemented it yet. They may
instead have used some risk mitigation techniques in the return-seeking portfolio, like low
volatility strategies and liquid alternatives.”
Those that have used LDI may have
done so because of pressure from global
parent companies. “Many private plans that
are subsidiaries of U.S. or global companies
implemented LDI first,” says TD Asset Management’s de Koning. “Also some larger Canadian
plans did de-risk before 2008 and enjoyed the
benefit of that decision, so now those plans
have the luxury of reconfirming if that is still
the right approach going forward. Now that
funded status has improved, it is the other
plans, that didn’t implement before the crisis,
that are getting a chance to re-think their position on LDI.”
One reason that LDI usage is hard to quantify is that it is a long-term risk management
solution. “Many plans are on an LDI journey,”
says Patrick De Roy, Institutional Portfolio
Manager at Pyramis Global Advisors. “They are
managing interest rate risk by moving to lon ger bonds. Some are also considering partial
or full risk transfer to an insurance company in
order to right size the pension plan.” (See box
page 12)
continues on page 12
MANAGING PENSION RISK
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Sun Life Financial has been in the risk transfer
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Not all pension plans will adopt LDI.
“We expect to see the use of LDI increase in
corporate plans over the next few years now
that these plans are more fully funded,” says
Phillips, Hager & North Investment Management’s Dubé. “It’s a different story in public
plans, which are generally still open. The end
game is different and the risk tolerance within
these plans often is higher.”
This is largely because of different accounting and regulatory regimes. “Report-
ing risks for many public plans are not as
prominent as for corporate plans, and this
can influence how these plans think about
risk,” continues Dubé. “Ultimately, however
public and corporate plans are focused on the
economic objective of delivering incomes to
beneficiaries. For this reason, the process for
developing investment and risk management
strategies for public and corporate plans is
fundamentally the same.”
But solvency remains a key issue for
corporate plans. Lessons can be learned from
other financial institutions. “Some Canadian
plan sponsors are recognizing that they are
really running a mini insurance company and
are looking at the strategies that insurers use
to manage pension risk,” says Sun Life’s Simmons. “Canadian plan sponsors are considering more customized LDI strategies (like those
used by insurance companies) to reduce risk
by keeping their assets and liabilities aligned.”
continues on page 14
Plan Transfers: The Prospect of Pension Settlements
For plan sponsors that have lived through recent turbulent times, the question remains whether they want to be in the DB pension plan business at all. It
may be that a corporate sponsor makes the decision to concentrate on its core
business and considers the pension an unwelcome distraction. In this case, the
idea of pension buyout may appeal.
Equally, the plan sponsor may think that a DB plan poses too high an overall
risk to the enterprise, but they still want to have the pension benefit. Then a pension buy-in, where a certain class of beneficiary is carved out and annuitized, may
be the answer.
Each of these ideas is part of the continuum of pension settlement solutions
available in the market today. “Plan sponsors are using annuities strategically to
right size their plans and make them sustainable, or to facilitate a full plan windup,” says Brent Simmons, Senior Managing Director, DB Solutions, Sun Life. “The
2013 pension risk transfer market was the largest on record with premiums of C$2.2
billion, double 2012 volumes, indicating increasing interest in pension settlement
strategies. This volume compares favourably to U.S. pension risk transfer volumes,
estimated to be C$3 billion to C$4 billion for a significantly larger pension market.”
Questions remain about the depth of the market for pension settlement
solutions. “We do anticipate more activity around pension settlements,” says
William da Silva, Senior Partner and Practice Leader, Canadian Retirement Consulting at Aon Hewitt. “Once you are close to full funding, it makes sense to think
about what price you would pay to settle. However, the market is imperfect and
inefficient in Canada. Those plans with global parents are likely going to be the
first movers here. The Canadian insurance industry is in the midst of building
capacity for this anticipated demand with some insurers further ahead than others in doing so. We expect to see more pension settlements as funding deficits
continue to decrease.”
It’s certainly on the agenda. “It is becoming more popular to consider risk
transfer options,” says Étienne Dubé, Vice President at Phillips, Hager & North Investment Management. “Longevity swaps, buy-ins and buyouts are in the early
stages in Canada. A dominant issue to date has been whether the market has the
capacity to absorb these deals.”
Plans that wish to pursue these options need to prepare – and those preparations are more obvious today. “We are seeing some companies looking to create portfolios that can be transferred in-kind or liquidated to fund an insurance
company annuity premium,” says Michael Augustine, Vice President and Director
of TD Asset Management. “The decision to pursue a pension settlement is a company specific decision. It ties back to the enterprise risk budget. Some companies
with smaller risk budgets will do a buyout if the price is right. Based on what
we are hearing at the moment, purchasing an annuity might involve crystallizing
past losses, so timing varies by company.”
“We’re seeing this increased interest in de-risking play out in the market,”
12
Canadian Pension Risk Management
says Sun Life’s Simmons. “Last year was the largest Canadian group annuity market on record, and pension plans are shifting out of equities into bonds.”
“Many plan sponsors are planning for a transaction this year, by educating
their stakeholders, lining up their governance processes and adjusting their asset
portfolios,” says Sun Life’s Simmons.
“We expect the usage of risk management strategies like LDI to jump up this
year,” says Aon Hewitt’s da Silva. “The more sophisticated plans are now taking
a good hard look at the next step in their risk management strategy. But there
are problems for very large plans, even if it can afford the premium to offload the
liability through a settlement transaction. There’s no market for really big plans,
leaving them with the only option being self insurance .”
Capacity is one issue, but so is pricing. “Canadian plan sponsors are recognizing that pension settlement strategies are not as expensive as they thought and
there may be a first mover advantage for forward-thinking plan sponsors who
get into the market ahead of the impending wave of demand,” says Sun Life’s
Simmons. “Demand is increasing.”
Other managers agree. “We haven’t seen any big pension settlement events in
Canada so far,” says Paul Purcell, Managing Director at BlackRock. “But we do know
that the life insurance companies are aggressively marketing to pension plans. The
payment that the insurance companies want is higher than the value of the liability
on the books. But for plan sponsors that want out of the pension business sooner
rather than later, it could be time to pay the difference and check out.”
Nevertheless, the statistics show that activity is increasing. “Last year included many notable developments for the Canadian market, including the largest
ever fully indexed annuity purchase, the first in-kind asset transfer for annuity
purchase and a record number of annuity buy-ins, including the largest to date,”
says Sun Life’s Simmons.
“Canadian plan sponsors have embraced the flexible annuity buy-in solution,
with over 15 deals done since the solution came to Canada in 2009,” continues
Simmons. “In contrast, there has only been one annuity buy-in done in the U.S.”
Observers come back again and again to the ability of the insurers to digest
these deals if the numbers increase.
Increasing supply isn’t easy. “The market capacity for risk transfer deals is
limited in Canada. So there have been fewer deals here than in the U.S. and U.K.,”
says Patrick De Roy, Institutional Portfolio Manager at Pyramis Global Advisors.
“However, several Canadian insurance companies now see the need in the market
and are becoming more and more active. So, we could see larger deals in Canada
in the upcoming months and years.”
“In fact, we would not be surprised to see a big pension settlement deal
in 2014,” says François Pellerin, LDI Strategist at Pyramis Global Advisors. “Annuitization and in-kind transactions are increasingly being discussed by Canadian
pension plans.”
Collaboration gets you
from here to there.
As an institutional investor, you’re working to reach specific investment goals. And, through
careful listening and close collaboration, we’re working to help you get there. Our broad
suite of investment strategies has evolved in step with the changing needs of our investors.
Together, we continue to build strategies that are inspired by innovation, strengthened by
expertise, and validated by results.
Let’s work together.
Call 1-888-834-6339 or visit
www.tdaminstitutional.com
TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.
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LDI works because it brings the notion of asset/liability management to the
fore. “Before 2008, many plans missed an
opportunity to de-risk,” says Eric Leveille,
Managing Director at BlackRock. “And the
financial crisis was a more painful reminder
of the risks pension plans are running. LDI is
one of the tools that plans can use to reduce
surplus volatility. Some plans have made the
decision to embark on de-risking, but haven’t
implemented it yet.”
Framework for investment decisions
Many view LDI not as a solution, but as a
mind-set, a prism through which the plan
sponsor looks at the investing world. “If you
go back a few years, plan sponsors did not
have a good understanding of LDI,” says Paul
Purcell, Managing Director at BlackRock. “But
now this has evolved. There is an understanding that assets need to be managed against
liabilities. So far we haven’t yet seen a significant change in asset mixes since most didn’t
want to de-risk when they were underfunded.
But 2014 could be a turning point, as strong
markets and higher interest rates in 2013 have
dramatically boosted funded ratios.
“LDI is more than just extending duration,” says Michael Augustine, Vice President
and Director of TD Asset Management. “It’s
not a product, but rather a framework for
making investment decisions. It has to relate
to the deeper objectives of the organization.
Companies are focused on outcomes. More
of our clients are discussing moving away
from traditional benchmarks to a pension
liability benchmark. So that means thinking
on the one hand about the duration of the
liabilities and how to manage this with rates
so low. On the other side are equities in the
return-seeking portfolio. Here plan sponsors
are making decisions based on volatility and
looking to minimize volatility. Low volatility
strategies tend to lead to better outcomes
here than using strategies based on marketbased benchmarks.”
For those farther along in implementing
LDI, the concept of dynamic asset allocation
comes into play through the use of a range
of more active approaches to managing the
hedging portfolio. “Those plans that previously
implemented LDI passively are looking at more
active solutions,” says TD Asset Management’s
de Koning. “Especially those that expect to
have significant commitments to bonds,
they are looking to give managers discretion
and flexibility to make some investment calls
depending on the markets. Some plans are
14
Canadian Pension Risk Management
Longevity Risk: The New Canadian Mortality Tables
It’s the risk that plan sponsors wish to forget. But it won’t go away, quite literally. Longevity risk – the
risk that beneficiaries live longer than expected – is a clear and present danger in Canadian pension plans.
“Plan sponsors are concerned about mortality risk,” says Patrick De Roy, Institutional Portfolio Manager at
Pyramis Global Advisors. “But this appears to be a secondary consideration at the moment. It may become
more important though, because the Canadian Institute of Actuaries recently published a new Canadian
mortality table, which has the effect of increasing liabilities on the order of 5%. The problem for plan sponsors is that this risk appears in small increments over time, while the impact of equity or interest rate risk is
immediate. Mortality seems like a small risk, but it could be a big one over the long run.”
It’s a risk that is creeping into plan sponsor consciousness. “Plan sponsors are now starting to also focus
on longevity risk,” says Brent Simmons, Senior Managing Director, DB Solutions, Sun Life. “The life expectancy assumptions being used by many DB plans are based on data that’s 25 years old. New mortality tables
have been proposed for Canadian DB plans and the impact has been estimated as a 5% to10% increase in
going concern and accounting costs.”
Other countries are farther ahead in the consideration of longevity risk. “In the U.K., there is increasing
recognition that longevity risk matters and mortality tables and improvement scales are updated regularly,” continues Simmons. “This trend is coming to Canada with the introduction of new mortality tables
and improvement scales. The U.K is widely acknowledged as the leader in pension de-risking and many innovative solutions were created in the U.K. Canadian plan sponsors can now take advantage of a full range
of de-risking solutions, including newer solutions like annuity buy-ins and longevity insurance.”
Not all these trends have crossed the Atlantic equally. “The U.S. is not looking at longevity,” says William da Silva, Senior Partner and Practice Leader, Canadian Retirement Consulting at Aon Hewitt. “But in
the U.K., they have done a good number of longevity insurance/swap deals. We believe that there will be a
market for this kind of deal in Canada once organizations realize that it may have no choice but to manage
longevity risks within their pension plans.”
At the end of the day, plan sponsors need to work the new data about mortality into their long term
thinking about pension management. “Some plans are looking at taking some of the risk off the balance
sheet by annuitizing,” says Michael Augustine, Vice President and Director of TD Asset Management. “But
this is an area of change because the Canadian Institute of Actuaries has recently released new mortality
tables based specifically on Canadian data. So plan sponsors need to understand their true funded level
versus the annuity pricing they will see in the marketplace.”
also using derivatives to extend duration on
top of return-seeking assets. Others are using
alternatives, low volatility equity strategies, and
diversifying into international bonds.”
Gaining duration
This trend has been apparent in the U. S. for
some years. “Active management in LDI is making its way north of the border,” says François
Pellerin, LDI Strategist at Pyramis Global Advisors. “We now see multiple sponsors migrating
from passive or quasi-passive LDI to active
LDI. This allows for the increased likelihood of
‘keeping up’ with liabilities via the potential for
alpha creation. Furthermore, in many cases,
active management allows for more efficient
management of funded ratio risk.”
All this de-risking activity could pose difficulties. There’s no doubt that LDI implementation requires the use of more bonds in the
portfolio. The Canadian bonds that provide
the closest hedges are in short supply, though
that situation may be changing. “The fixed
income landscape in Canada is unique,” says
TD Asset Management’s Augustine. “It’s a
good moment for issuers and there has been
a shift toward longer bond issuance in the
market. We may even see the introduction of
an ultra long sovereign bond according to the
latest Government of Canada debt management strategy.”
The search for duration extends beyond
physical bonds. “Many of those plans that
need additional duration have been using
derivative strategies such as bond overlays or
interest rate swaps,” says TD Asset Management’s Augustine. “Some plan sponsors do
use non-Canadian bonds to gain duration,
partly because the yields can be better. But
after converting the bonds back into Canadian
dollars, in many cases, the yields aren’t as
attractive. So plan sponsors need to be sure
that they are being compensated properly for
the risks.” ‡
June 22 - 24 | The Waldorf Astoria | New York
As the global population ages and demographics shift . . .
how can we find ways to solve the global challenges of retirement now?
Pensions & Investments is bringing together global leaders in all aspects of professional investing and
retirement planning for this ground-breaking conference — the first of its kind to tackle the issue of retirement
worldwide and explore how investment innovation can drive and improve outcomes for participants universally.
Our advisory board and speakers, who represent the leading international economists, researchers and
investment executives will lead a definitive and thought-provoking discussion about how to address the
challenges facing the retirement industry across the globe.
Here is a sample of what you can look forward to at this landmark event:
AGENDA SESSIONS
PANEL Future of Retirement Solutions
Global industry leaders discuss options governments
and companies are considering to reduce the cost
of retirement to them. Options under review include:
•
•
•
•
Raising the age of retirement
Tax harmonization
Financial education
Customized communications and technology
ROUND-TABLE The Endgame - Retiring With Dignity
Compare strategies of several systems from around
the world that successfully provide replacement
income when people no longer work. We will focus
on what each does differently and what we can all
learn from the variety of approaches.
panelists:
moderator:
PABLO ANTOLÍN-NICOLÁS | France
Principal Economist,
Head Private Pension Unit,
Financial Affairs Division
OECD
speakers:
JIM LEECH | Canada
Retiring Chief Executive Officer
Ontario Teacher’s Pension Plan
OLE SETTERGREN | Sweden
Member of the Board
Second National Swedish Pension Fund
GORDON CLARK | United Kingdom
Director - Smith School of Enterprise
and Environment
University of Oxford
KAREN FRIEDMAN | U.S.
Executive Vice President
and Policy Director
Pension Rights Center (PRC)
ANDREAS HILKA | Germany
European Executive Committee
and Head of Pensions
Allianz Global Investors
ASH WILLIAMS | U.S.
Executive Director
and Chief Investment Officer
Florida State Board of Investment
(SBA)
Be a part of the conversation.
for the full agenda, news and to request an invitation, visit
www.pionline.com/globalretirement
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and
REGISTER NOW
present
June 3 | Toronto | Four Seasons
Managing risk or derisking in today’s environment
In a world of volatile unpredictable markets, institutions have to look at, and manage, risk from a number of different
perspectives. The job is complicated and time-consuming and many feel that defined benefit (DB) pension plans represent
a growing financial risk to their organizations because of the size and volatility of plan liabilities. This enterprise risk and
how to manage it has become a top concern for many institutional investors.
Pensions & Investments in conjunction with Aon Hewitt will provide detailed information on the options available
to pension plans in regards to managing risk or derisking. The conference will broadly examine:
• Pension risk strategies, including return-seeking strategies, such as low volatility, alternative asset classes, risk parity
• Leveraged strategies and how to find returns in a low interest rate environment
• Liability hedging strategies, innovations in LDI, using leverage to reduce risk and inflation risk strategies
• An examination of liability settlement strategies and how to determine if that path is appropriate for a plan
• The DB/DC balance necessary when considering all risk and derisking strategies – how do you find the right
combination of DB and DC solutions for your participants
Canadian plan sponsors will benefit from learning about the latest thinking in pension risk management strategies from
thought leaders and their peers who have implemented these strategies. We will arm them with information that will
allow them to determine how to align liabilities and risks more closely or whether to transfer risk to a third party.
Complimentary registration* at www.pionline.com/canada2014
sponsored by:
Questions? For more details please contact Elayne Glick at (212) 210-0247 or [email protected]
*Registration is only open to pension plan sponsors and a limited number of investment consultants.
All registration requests are subject to verification. P&I reserves the right to refuse any registrations not meeting our qualifications. The agenda for the Canadian Pension Risk Strategies Summit
is not created, written or produced by the editors of Pensions & Investments, and does not represent the views or opinions of the publication or its parent company, Crain Communications, Inc.
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