Poll Highlights. PENSION MANAGEMENT RESEARCH PANEL Poll: DB Pension Management Mid-Year 2014

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1 PENSION MANAGEMENT RESEARCH PANEL Poll: DB Pension Management Mid-Year 2014 Poll Highlights In the summer of 2014, the Pension Management Research Panel conducted a poll to uncover current practices in defined benefit pension management in North America. Finance executives, board members, and investment committee members from 153 organizations shared their views, investment strategies, and challenges in pension management. POLL PARTICIPANT PLAN SIZE Defined benefit (DB) plans continue to exhibit strong financial health. In 2013, funded status improvements in the 6-15% range were attained by 7 of Canadian plans, and 61% of U.S. plans. Canadian plan sponsors continue to be more committed to offering a DB pension, with 7 offering active plans versus in the U.S. Most plan sponsors intend to keep asset allocation strategies static in Roughly one-third will shift equity holdings to fixed income and alternatives in order to reduce risk and better match liabilities. Canadian plan sponsors are more concerned about pension risk; 7 of Canadians state the primary goal in making asset mix change is to reduce risk versus 41% in the U.S. Real estate is the most popular asset class among those investing in alternatives, 7 of Canadian poll participants invest in the sector. The biggest concern related to alternative investing is the increased level of necessary due diligence. The top risk reduction strategy in Canada is use of a glidepath and/or LDI, implemented by 63% of Canadian respondents, versus a lump sum payment, implemented by 6 of U.S. plans. Plan sponsors are most confident in aligning pension strategy with long-term organizational goals (82% confident or extremely confident), and least confident in taking advantage of market inefficiencies in order to increase return and/or mitigate risk. (19% have no confidence, 37% are only somewhat confident). In order to control the impact of the DB plan on organizational finances, when making pension-related decisions, 73% use external resources along with the internal team, 71% state they holistically consider assets, liabilities, and organizational finances together SEI 1

2 Pension health is strong, Canadians committed to DB Most defined benefit pension plans in North America are financially strong. While the drop in long term interest rates through the year has pushed pension liabilities higher, positive (yet volatile) equity markets have buoyed pension assets, keeping funding levels up and pension health afloat. The majority of poll participants saw their funding levels improve in the 6- range in Today, 90% of U.S. plans are at least 80% funded, while 74% of Canadian plans report to be in the same funding category. Poll results also show that 7 of Canadian plans are active versus in the U.S., indicating Canadians are currently more committed to maintaining the DB promise. FIGURE 1: HOW MUCH DID YOUR PLAN S FUNDED STATUS IMPROVE IN 2013? 40% 30% 20% 0% 14% 21% 43% 2 0% 9% 0-5% % 16-20% More than 20% Canada (Solvency Basis) U.S. (PBO Basis) FIGURE 2: WHAT IS THE CURRENT FUNDED STATUS OF YOUR DB PLAN? 30% 20% 0% 4% 2% 22% 22% 31% 30% 2 22% 31% Below 70% 70-79% 80-89% 90-99% 100% or greater Canada (Solvency Basis) U.S. (PBO Basis) FIGURE 3: WHAT IS YOUR PLAN DESIGN STAGE? CANADA U.S. 17% 4% 34% 2% Active: The pension is active and open to new entrants Closed: The pension is currently closed to new entrants, but participants are still accruing benefits 7 32% Frozen: The pension is currently closed to new entrants and participants are no longer accruing benefits Terminating: The pension is closed, accruals are frozen and the termination process is underway or complete 2014 SEI 2

3 Asset allocation and drivers of change in 2014 Asset mix strategies in place for 2014 indicate that surprisingly, most plan sponsors are not taking advantage of the opportunity to hedge pension liabilities afforded by improvements in funded status. Figure 4 shows plan sponsors intend to keep asset allocation strategies relatively static this year, with more than half (57%) maintaining their current weight to domestic equities, and almost two-thirds (65%) maintaining their weight to international equities. This finding is consistent with a separate study conducted earlier this year (refer to SEI s paper De-risking Considerations for Pension Plan Sponsors: Pension Funding is Up but Investment Strategies Remain Unchanged ). In this study, SEI evaluated data from 820 public company pension plans in Canada and the U.S. The sample showed the funded status of the average defined benefit plan increased from a median of 74% in 2012 to 84% in Again, despite the improvement, asset mix strategies stayed somewhat static at the end of 2013 with the median allocation to equity at 52%, relatively unchanged from FIGURE 4: WHAT ASSET ALLOCATION CHANGES ARE PLANNED FOR 2014? Domestic Equity 37% 57% Fixed Income 9% 5 International Equity 27% 65% Alternatives 22% 72% Cash 8 100% Increase weight Decrease weight No change Of the poll participants that intend to change their asset mix strategy, a small percentage will continue to pursue returns in the equity markets in order to reduce long-term funding ( will increase domestic equities, will increase international equities). Plan sponsors reducing their equity exposure are moving into fixed income and alternative securities. Of the of poll participants planning to increase their fixed income holdings, 84% will do so to better match liabilities and 72% to reduce risk. Figure 5 shows the overall primary goals for making asset allocation changes. FIGURE 5: WHAT ARE THE PRIMARY GOALS FOR MAKING ASSET ALLOCATION CHANGES? Reduce risk 41% 7 Better match liabilities 4 47% Diversify portfolio 19% Increase returns 2 Rebalance 15% Canada U.S SEI 3

4 While almost one-quarter (22%) of poll participants will increase their allocation to alternatives, within this group 65% do so to reduce risk, 50% seek to increase returns and 34% seek to diversify the portfolio (poll participants were able to select multiple goals). Alternative investments continue to garner attraction from pension committees seeking to build more efficient portfolios. As an asset class, alternatives offer unique benefits: Liability Matching: The regular income stream offered by alternatives such as real estate and infrastructure investments typically mimic the liability matching characteristics of long bonds without the interest rate sensitivity tied to bonds. Figure 6 shows the majority (7) of Canadian plan sponsors invest in real estate. Providing exposure to real, tangible assets, real estate has historically produced consistent income throughout the economic cycle. Inflation Hedging: Alternative investments that are linked to real economic growth can provide a hedge against pension liabilities which grow with inflation. Return Enhancing & Diversification: Alternatives offer an opportunity for increased uncorrelated riskadjusted returns and a means to reduce portfolio volatility. The level of volatility associated with alternatives typically falls between that of equities and bonds. FIGURE 6: WHICH ALTERNATIVE ASSET CLASSES DOES YOUR DB PLAN INVEST IN?* Real Estate 7 Private Equity Hedge Funds Infrastructure 39% 44% 44% Structured Products 11% Commodities / Managed Futures Timberlands / Forestry Investing in alternatives continues to be accompanied with challenges. While the high level of necessary due diligence is the top concern expressed by Canadian poll participants (refer to Figure 7), other pressing concerns related to alternative investing involve the lack of liquidity, higher fees, and lack of transparency. FIGURE 7: WHAT ARE YOUR CONCERNS AND CHALLENGES AROUND INVESTING IN ALTERNATIVES?* Increased level of necessary due diligence 7 Lack of liquidity Higher fees Lack of transparency 65% 65% 70% Level of risk involved 39% Higher minimums required 2 *Results include Canadian poll participants only SEI 4

5 Focus on risk reduction and liability matching Figure 5 shows the predominant reasons for making an asset allocation change is to reduce risk and better match liabilities. With the majority of Canadian poll participants committed to are particularly focused on risk reduction. These findings comes as no surprise since after the 2008 crisis, the reality that the funded status of a DB plan could impact the viability of the sponsoring organization became a harsh one. Having experienced a significant fall in funded status, many organizations faced unwanted cash injections and a dent in profits. Sustaining the improved state of financial health enjoyed today requires vigilance over managing pension risk exposure, and understanding sources of pension risk. Roughly 90% of pension risk stems from: Investment Risk = The risk of investment returns falling below expectations. Plans with an overweight to equities can expect to see roughly two-thirds of their total risk budget consumed by investment risk. The uncorrelated relationship between equities and pension liabilities can potentially cause a significant asset/liability mismatch if not properly managed. Interest Rate Risk = The risk that an increase in the value of liabilities outpaces an increase in assets. Liabilities are determined using interest rates. As such, fluctuating interest rates increases the risk that the value of liabilities will increase faster than assets. Inflation Risk = The risk that salary increases and indexation are higher than anticipated. Where pension payments are indexed to consumer price or wage level indexes, inflation uncertainty increases the need to hedge against unexpected changes in price levels. Inflation-linked securities are widely available but typically provide low real returns. The remaining or so of pension risk stems mainly from: Longevity Risk = The risk that retired DB participants live longer than expected, or active participants retire earlier than expected. Manager Risk = The risk that active management performance returns fall under benchmark. Currency Risk = The risk that foreign investment returns fall due to a decrease in the value of foreign currency relative to the local currency. Poll participants shared the risk reduction strategies that play a role in their organization (refer to Figure 8). While the funded status of the pension plan will largely dictate which strategy is most appropriate, overall implementing a glidepath and/or liability driven investing (LDI) is most widely used. FIGURE 8: TO REDUCE RISK, WHICH HAVE YOU IMPLEMENTED OR ARE CONSIDERING IMPLEMENTING? Implement a glidepath and/or LDI Close the plan to new entrants Freeze accruals for participants Purchase an annuity buy-out or buy-in Terminate the pension plan <79% Funded 80-89% Funded 90-99% Funded 100%+ Funded 2014 SEI 5

6 Implement a Glidepath and/or LDI The majority of poll participants (57% in the U.S., 63% in Canada) utilize a glidepath and/or LDI to reduce risk. Overall, LDI keeps pension committees focused on managing assets to liabilities, setting the framework for holistic decision-making. While some firms may use LDI to progress the plan towards termination, others may implement LDI to control the funded status volatility of an open and viable plan. The ultimate goal will depend on plan objectives. A glidepath is essentially an active approach to asset allocation. With acceptable levels of risk established within a portfolio, key trigger points are used to dictate asset mix adjustments with the goal to shed risk. While changes in the funded status serve as the most commonly used trigger point, interest rates and market outlook must also be considered. Because the markets will inevitably move in unexpected directions, glidepath strategies need to be periodically reviewed. Plan sponsors should consider not only derisking, but re-risking when appropriate, as part of an active glidepath strategy. Close the plan to new entrants Over half (57%) of U.S. poll participants, and almost a third (32%) of Canadian participants will close the DB offering to new entrants as a step to exit the defined benefit pension game. While the strategy will help to reduce future risk and costs, the remaining assets and liability sensitivities will need to be managed with the same level of fiduciary care as was afforded prior to the close. Typically, the investment policy will be revised to a more conservative investment approach to reflect the ageing workforce in the remaining plan. Freeze Accruals for Participants While almost half (41%) of U.S. poll participants will freeze accruals, only 5% of Canadian poll participants will follow. As with plan closures, sponsors electing to freeze their DB plans typically do so because the plan no longer offers a competitive benefit for the organization, and freezing the plan will help to reduce costs and liability growth. The need for dynamic ongoing management is also required, otherwise the frozen plan could experience a higher level of volatility relative to when it was active. Purchase an Annuity Buy-Out or Buy-In Over a third (37%) of Canadian poll participants suggest a desire to purchase an annuity to shed liability risk versus 17% in the U.S. A buy-out allows the plan sponsor to offload the obligation to pay pension benefits to an insurance provider, as well as offload the associated risks of those payments. Conversely, in an annuity buy-in, the plan sponsor retains the obligation to pay benefits but receives guaranteed liability cash flows from the insurance company. A buy-in aims to limit the pension plan s exposure to various risks including investment and longevity risk. The price to purchase an annuity typically includes 100% of the value of the liability being annuitized, plus an additional premium for factors related to mortality risk, the interest rate environment, re-investment risk, and administrative costs. It is possible to see premiums of up to 15-20% over the liability value, depending on the membership and other considerations. Cost is an important consideration when evaluating the benefits derived from an annuity purchase. Terminate the Pension Plan As the ultimate end game, plan termination relieves the sponsor from all risks and costs associated with the pension plan. In a voluntary standard termination, the DB plan must be fully funded and all required benefit payments must be disbursed either through lump sum payments or purchased annuities. With continuing deficits, the termination process can be costly and extremely complex to administer, and most plan sponsors view freezing the pension plan as a more advantageous option, hence only 13% opted for this strategy, all residing in the U.S SEI 6

7 Confidence implementing effective plan management varies With pension management becoming increasingly complex and time-consuming, many plan sponsors are evaluating their current governance structures to ensure optimal plan management can be achieved. Poll participants shared their confidence in the organization s ability to successfully accomplish various tasks required for effective plan management. Figure 9 shows plan sponsors are most confident in the organization s ability to align pension strategy with long-term organizational goals (20% state they are extremely confident, 20% are confident). Likewise, the majority of poll participants believe they have a good handle on making manager changes, controlling contribution volatility, and managing the impact of pension expense on the bottom line. FIGURE 9: HOW CONFIDENT ARE YOU IN YOUR ORGANIZATION S ABILITY TO SUCCESSFULLY ACCOMPLISH THE FOLLOWING?: Align pension strategy with longterm organizational goals 20% 62% 14% 3% Implement investment manager changes in a timely and efficient manner 19% 59% 1 3% Control volatility in plan funding contributions 12% 53% 30% 5% Manage the impact of pension expense on corporate finance 53% 29% Take advantage of market inefficiencies in order to increase return and/or mitigate risk 7% 3 37% 19% Extremely confident Confident Somewhat confident Not confident Plan sponsors are least confident in the organization s ability to take advantage of market inefficiencies in order to increase returns and/or mitigate risk. While 37% are only somewhat confident, 19% have no confidence. The ability to capitalize on short or medium-term market inefficiencies requires resources, an informed point of view, and nimbleness to implement that view. As such, confidence tends to correlate with staff size. Figure 10 shows a general decrease in confidence as staff size decreases, (where staff size refers to the number of individuals who dedicate the majority of their time to the investment management of the DB plan.) FIGURE 10: HOW CONFIDENT ARE YOU IN YOUR ORGANIZATION S ABILITY TO TAKE ADVANTAGE OF MARKET INEFFICIENCIES IN ORDER TO INCREASE RETURN AND/OR MITIGATE RISK? 4+ staff 14% 3 43% 7% 3 staff 22% 67% 11% 2 staff 7% 37% 41% 15% 1 staff 29% 37% 24% 0 staff 4% % 100% Extremely Confident Confident Somewhat confident Not confident 2014 SEI 7

8 Plan governance Overall, the majority of poll participants are confident effective plan management is being successfully implemented, according to Figure 9. However, there exists a population of organizations who are not sufficiently confident and may be struggling. For many firms today, the onerous demands placed on already constrained pension committee members can leave little time to proactively focus on strategic pension matters. Many organizations in this situation are now adopting delegated solution models which allow for dedicated resources and sound governance structures to be built. Poll participants were asked what types of services they delegate, or would consider delegating, with the majority (74%) seeking assistance in advisory services including LDI. FIGURE 12: WHAT FUNCTIONS DO YOU CURRENTLY OUTSOURCE OR WOULD CONSIDER OUTSOURCING FOR YOUR PENSION PORTFOLIO? Advisory services including liability driven investing strategy 74% Asset allocation changes within bands established in the IPS 50% Manager changes for all assets classes 4 Manager changes within a single asset class Additionally, when poll participants were asked what strategies are being used to help control the impact of the pension plan on organizational finances, the majority (73%) are adopting delegated solutions to complement their internal teams with external resources. FIGURE 11: WHAT STRATEGIES ARE CURRENTLY BEING USED TO CONTROL THE PENSION PLAN S IMPACT ON ORGANIZATIONAL FINANCES? (CHECK ALL THAT APPLY) Use of external resources in making pension-related decisions (in addition to internal resources) Consideration of assets, liabilities and organizational financials when making portfolio decisions 73% 71% Analytical stress-testing and projections across entire pension portfolio 39% Daily monitoring of performance/funded levels 1 0% 20% 40% 60% 2014 SEI 8

9 The Pension Management Research Panel, sponsored by SEI s Institutional Group, conducts industry research in an effort to provide members with current best practices and strategies for the investment management of pension plans. For more information, please contact SEI at SEICanadaResearch@seic.com Information provided by SEI Investments Canada Company, a wholly owned subsidiary of SEI Investments Company. This information is for educational purposes only. Not intended to be investment, legal and/or tax advice. Please consult your financial/tax advisor for more information SEI 9