It is January 2nd, 2013 – How Bad Is It?

2013-01-02 It is January 2, 2013 - How bad is it

It is January 2, 2013….many are focused on New Year’s resolutions, others on their long to-do list for 2013, and for a few – just on recovering from 2012.  For us, our focus is on the financial position at the end of 2012 of the pension plans sponsored by our clients.

Although the process of preparing actuarial valuations has gotten faster in the last 25 years, it still takes time to collect membership data and plan asset information in order to create a customized valuation that reflects the liabilities of each plan.  It would be nice to provide clients with helpful estimates in January, but with so many moving pieces including membership changes, pension fund performance, changes in bond yields, and actual plan cash flows (in particular special payments), any simple estimate could be materially different from the final result.

We know that the TSX closed on December 31st up modestly for the year and that bond yields on Government of Canada bonds have declined modestly through 2012.  This information suggests that an average underfunded pension plan invested in a balanced fund is not likely to make up a lot of ground but likewise should not see crushing losses for the year either.

Amidst the waiting for final results for each pension plan, what is interesting to us is the continued discussion regarding “liability driven investing” our industry has been having for as long as I have been around, but in great seriousness for a decade now.

Although Actuarial Solutions Inc. does not give investment advice, by necessity we keep abreast of the investment decisions of our clients and the investment philosophy that underlies those decisions.  While there are a wide variety of approaches to pension fund investments, our clients tend to land in two distinct camps.

The first camp is for clients that believe that over the long-term that equities will outperform bonds and/or that bonds yields have bottomed out.  For these clients, a balanced fund approach or one titled even farther towards equity is common.  These sponsors are consciously taking the annual ups and downs in the equity markets in exchange for what they perceive will be a superior fund return over the long-term.

The second camp is for clients that have to some degree bought into the idea of liability driven investing, which in a nutshell seeks to invest the pension fund in assets (often bonds) that will react to changes in interest rates in a manner that matches changes in liabilities.  This methodology is also is referred to as “de-risking” or “immunization”.  The degree to which clients wish to lower the volatility of their funding contributions determines how far away from equities and towards bonds they move their portfolio.  The purchase of annuities in an ongoing plan is another way to de-risk.

At this stage, we don’t have clients in the third camp, which would be 100% immunized.  However, at two recent pension committee meetings I saw two different clients focus more on this choice, in one case agreeing to make a partial shift away from equities towards bonds, and in a second case agreeing to meet again in early 2013 to discuss making a complete shift in one shot.

With interest rates at arguably historically low levels, why are plan sponsors choosing to get out of equities and move toward bonds?  The answer lies in the question of what they are trying to accomplish.

In the 1990s, most sponsors of defined benefit pension plans found it relatively easy to generate a fund return well in excess of the discount rate at which liabilities were set.  In this environment, the pension plan became a profit centre.  The volatility of returns didn’t bother many when they were bouncing from small surplus to large surplus and back again to small surplus (who misses the good old days??).  The 2000s ushered in an ugly decade where most plans have run into deficit, and with each year, it generally seems that new deficits arise and they rarely abate – except through the continued injection of cash from the sponsor.  This “volatility” has been much less enjoyable for sponsors than the volatility they enjoyed in the 1990s.

After years of waiting for “friendly volatility”, sponsors are now rethinking the purpose and benefits of accepting significant volatility in the status of their pension funding.  Sponsors are more willing today to “de-risk” in order to avoid having pension funding outcomes drive the financial results of their businesses.    Of course, this option is only available to those sponsors that can “afford” to recognize the cost of de-risking, which is the cost of no longer relying on equities to out-perform bonds in the long run.

As mentioned, ASI does not give investment advice – but we do think that all plan sponsors should be talking to their investment advisors about de-risking and consciously choosing to stay “risk on” or to move gradually or suddenly along the de-risking scale to match a clear understanding of their pension funding strategy.  Don’t get me wrong – I am not trying to lead sponsors to the “right” answer, because there isn’t one.  There are two right answers that match two different goals.  What I am trying to do is to lead sponsors to setting goals that work for them – that will tell them their right answer.

 

 

Joe Nunes
Joe Nunes
Joseph Nunes, Co-founder and Executive Chairman of Actuarial Solutions Inc, has practiced in the area of pensions and retiree health plans for over 30 years. He has experience with many types of plans including single-employer, multi-employer, private sector, government, unionized, non-unionized, as well as registered and non-registered executive plans.

3 Comments

  1. Avatar John Platt says:

    Good post Joe:

    It’s good to know that there is a growing camp of pension sponsors that are using a liability matching approach (the second camp). Investing solely in hopes of the long term outperformance of equities may prove to be successfull IN THE LONG TERM. However, as asset managers, it has been our experience that plan sponsors that pursue this approach continue to struggle with very real short term (year to year) funding requirements.

  2. You raise some very good points and I agree that thinking within a liability driven investment framework is a healthy approach. I do believe, however, that the long-term investor has a clear advantage over those that are obliged to focus on the short-term due to regulatory and funding requirements. Why are long-term investors focusing on short-term solutions and foregoing premiums that are available with equities and various other investments?

    I would argue that the regulatory regime needs to change in order to accommodate the realities of the market.

    The low yield, high volatility environment has created a dilemma and is forcing investors into making some difficult choices. I would be very cautious with de-risking given where we are in the economic cycle.

  3. Avatar Dan Hallett says:

    While LDI traditionally would have a portfolio with long-duration liabilities invested significantly in long bonds, you can make a good case for shifting more toward stocks or income-producing alternatives.

    You can calculate duration for investments like dividend-paying stocks or even income-producing real estate simply by dividing 1 by the yield (assuming no maturity or embedded option).

    A stock market dividend yield of about 3% implies a duration of 33 years. This could support the view that even a move to stocks can be done in compliance with a LDI approach – particularly if it boosts the portfolio’s potential to achieve real return targets.

    That said, I’m not sure if pension committees would buy this line of reasoning.

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