Canadian Pension Risk Management

Transcription

1 Canadian Pension Risk Management Proactively managing the health of retirement plans

2 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 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 CALGARY TORONTO MONTREAL 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., IC

3 Sponsors BlackRock Asset Management Canada Limited 161 Bay Street, Unit 2500 Toronto, ON, M5J 2S1 Eric Leveille Managing Director, Head of Canadian Institutional Business Phillips, Hager & North Investment Management Waterfront Centre, 200 Burrard St., 20th Floor Vancouver, BC, V6C 3N5 John Skeans Vice President Pyramis Global Advisors (A Fidelity Investments Company) 483 Bay Street, North Tower, 3rd floor Toronto, ON, M5G 2N7 Michael Barnett Executive VP Institutional Distribution Sun Life Financial 225 King St. West Toronto, ON, M5V 3C5 Heather Wolfe Managing Director, Client Relationships, Defined Benefit Solutions TD Asset Management, Inc. 161 Bay St., 34th Floor TD Canada Trust Tower Toronto, ON, M5J 2T2 Mark Cestnik, CFA Managing Director 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

4 Facing Down the Risk Challenge Canada 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 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 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 4 Canadian Pension Risk Management

5 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

6 depending on the answer. In the past, Canadian accounting rules allowed plans to use amortization of gains and losses and discoun t 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. 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 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 6 Canadian Pension Risk Management

7 Over 40 Years Of Experience Serving Institutional Fixed Income Clients Worldwide FIXED INCOME EQUITY ASSET ALLOCATION ALTERNATIVES One of the largest and most successful fixed income franchises in the world, with more than $1.7 trillion in assets Fully independent and proprietary research across the capital structure with over 200 fixed-income investment professionals globally A robust risk-management process that combines in-depth fundamental research and proprietary quantitative analysis A wide range of investment strategies and global capabilities with over 25 disciplines across diversified, single sector, custom and passive strategies For more information about Pyramis investment solutions, including our fixed income strategies, please visit pyramis.ca or call your Pyramis representative at Figures as of December 31,2013 and include the resources of Pyramis and Fidelity Investments. Resources described reflect the combined resources of Pyramis and Fidelity Investments. FOR INSTITUTIONAL USE ONLY

8 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, 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 Letters of Credit: A Funding Alternative 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. 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 It would not be able to recover the premium, however. 8 Canadian Pension Risk Management

9 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 themselves 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 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 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 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

10 With many Canadian plans close to full funding, plan sponsors are considering more robust risk management measures Finding the Right Investment Approach Risk 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 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 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 Canadian Pension Risk Management

11 MANAGING PENSION RISK IS CORE TO OUR BUSINESS RISK TRANSFER SOLUTIONS Sun Life Financial has been in the risk transfer ANNUITY BUY-OUTS business ARE for CORE more than TO 140 OUR years, BUSINESS starting with underwriting individual risk through to our solutions ANNUITY BUY-INS today Sun for Life Defined Financial Benefit has been (DB) in the Pension risk transfer Plans. business for more than 140 years, starting with underwriting individual risk through to today s solutions for defined Benefit (DB) Pension Plans. Our solutions are backed by deep investment L ONGEVITY INSURANCE experience Our solutions and are expertise backed by in deep matching investment assets experience and knowhow in matching assets to liabilities, to liabilities, brought together combined with highly with developed highly developed processes and risk management. LIABILITY DRIVEN INVESTING processes and risk management. From annuity buy-outs and annuity buy-ins, to longevity insurance and liability driven investing, we design innovative strategies to help employers manage their DB pension plan transferrisk. solutions are provided by Sun Life Assurance Company of Canada, From annuity buy-outs and annuity buy-ins, to longevity insurance and liability driven investing, we design innovative strategies to help employers manage OUR their SOLUTIONS: DB pension plan risk. a member of the Sun Life Financial group of companies. TO LIABILITY LEARN MORE: DRIVEN INVESTING Heather Wolfe Managing Director, Client Relationships Defined LONGEVITY Benefit Solutions INSURANCE heather.wolfe@sunlife.com ANNUITY BUY-OUT / BUY-IN TO LEARN MORE: Heather Wolfe Managing Director, Client Relationships Defined Benefit Solutions heather.wolfe@sunlife.com Risk Transfer solutions are provided by Sun Life Assurance Company of Canada, a member of the Sun Life Financial group of companies.

12 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. Reporting 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 f ull 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, 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. 12 Canadian Pension Risk Management

13 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 or visit 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.

14 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 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. 14 Canadian Pension Risk Management

15 June 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 14pi0123.pdf RunDate: 03/31/14 pi supp 8 x VIEW COMPLETE INFOGRAPHIC ONLINE Color: 4/C

16 and present REGISTER NOW 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 sponsored by: Questions? For more details please contact Elayne Glick at (212) or pi-registration@pionline.com *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.