One way of looking at pension risk is to think about your DB pension plan as a division in your company, which provides a product (an annuity) to a group of customers (your pension plan members).
The business strategy of many DB pension divisions is to take risk in equity and bond markets. The hope is to earn excess returns and reduce the cost of providing pensions.
There are innovative, affordable de-risking solutions that can help you manage these risks in your pension plans.
Your DB Pension Division
Customers: pension plan members
If your business strategy succeeds...
If your business strategy fails…
The business strategy involves taking lots of risk, which can offset each other. For example, a successful bet on equities could be offset by a bad bet on interest rates. In order for the strategy to be successful, the pension plans need to get all these bets consistently right.
So how have most DB pension divisions performed over the last 20 years?
Not well. According to Statistics Canada, many DB pension plans destroyed shareholder value for many Canadian companies.
The DB Pension Division - risky strategies have proven costly
~ $158 BILLION in deficit contribution
Let’s have a closer look at these risks.
Over the past 20 years, just how well have most Canadian pension plans performed? Not well.
This Pension Health Index graph shows that the funding levels of most pension plans went on a wild roller coaster over the past 20 years. Since 1999:
(Source: Mercer Pension Health Index published October 1, 2020)
Interest Rate Risk
Pension liabilities are determined using interest rates. Fluctuating interest rates can affect the level of cash contributions that you are required to pay into the plan and the pension costs disclosed in financial statements.
Credit Mismatch Risk
The discount rates used to calculate liabilities reflect a large proportion of credit such as corporate bonds. If your plan does not have enough credit, your assets may not move the same way as your liabilities.
Canadians are living longer than ever, which is great news for society. But for pension plans, this increase means higher costs as pensions need to be paid longer:
Graphic formula describing 1 year increase in age 65 life expectancy is equal to 3 to 4 percent a year for increases in costs
|1 year||=||3 - 4%|
|Increase in age 65||Increase in cost|
There is no crystal ball, but huge investments in medical and anti-aging research could have a significant impact on longevity. Curing diseases like cancer could improve life expectancy by 2.2 years. (Source: Center for Disease Control, 2013)
This risk occurs when the assets and liabilities do not move together when inflation changes. Because pension increases can be linked to inflation, a change in inflation could lead to a change in funded status and required contributions if assets are not also linked to inflation.
Pension plans that invest in equities expose themselves to additional risk because pension liabilities don’t behave like equities. Plans with a lot of equities generally experience more volatility in funded status and contribution requirements.
Yield Mismatch Risk
The yield on the assets in your pension plan should be at least as great as the liability discount rate. If there is a mismatch, you could find your plan’s funded status slipping as your asset returns are not keeping up with your liabilities.
Foreign Exchange Risk
This risk occurs when the assets and liabilities do not move together when foreign exchange rates change. If assets and liabilities aren't in the same currency, a change in foreign exchange rates could affect each of them differently. This could lead to a change in funded status and required contributions.