Defined Benefit Plan De-Risking

In 2008, Sibson Consulting (a member of The Segal Group) hosted a Breakfast Briefing in Toronto that first introduced many of the pension risk management concepts that have made headlines in the years since then. Alternatives to conventional annuitization like buyouts/buy-ins, longevity swaps and synthetic annuities are all part of the continuum of defined benefit (DB) pension plan de-risking strategies; but, before our 2008 Breakfast Briefing, “de-risking” was synonymous with “liability-driven investing.”  

We first introduced the concept of a Target Benefit Pension Plan as being “a multi-employer plan for the single employer,” leveraging our 75 years of experience. These plans that de-couple costly employer guarantees from desirable risk pooling have proved successful for millions of North American workers. In many respects, our 2008 Breakfast Briefing was a watershed for single-employer pension risk management in Canada.

Continuing today, the inherent volatility of global capital markets is causing sponsors of defined benefit pension plans to consider strategies for managing pension risk.

Corporate pension plan sponsors have shifted from a long-term approach to a "marking to market bond yields" approach for both the funding (solvency) and accounting of their pension obligations. So today's lower bond yields, driven by global capital markets, are now important both in terms of a corporation's capital structure and as the key driver of pension plan funding and accounting. Because all markets are turbulent, risky and inherently uncertain, DB de-risking is imperative. But how to de-risk?

Sibson considers there to be a variety of choices on a spectrum of de-risking solutions that are broadly categorized as follows:

  • Partial Annuitization: This involves transferring risk to a third party (such as an insurance company) by purchasing annuities or, in the U.K. model, buyouts or buy-ins. As part of the world’s leading network experienced at negotiating annuity contracts with insurers for our clients, Sibson Consulting can encourage insurers to be more innovative in plan design, risk-sharing and pricing.
  • Plan Redesign: Plans may consider migrating from a single employer pension plan (SEPP) to a risk-shared, jointly sponsored pension plan. Sibson’s parent organization pioneered and is the world’s largest consultancy for jointly sponsored pension plans.
  • Liability Driven Investing: Liability Driven Investing (LDI) is a framework for managing the pension plan’s asset allocation. Our industry leading LDI takes a holistic approach and views the fundamental role of the asset portfolio as supporting the liability. De-risking through risk mitigation in an LDI framework includes:
    • Determining the current position of the plan and return/risk objectives
    • Understanding the current plan’s sources and magnitude of risks
    • Evaluating the tradeoffs of the various risks and adjusting appropriately

Continuum of Strategies for Managing DB Pension Risk

Continuum of Strategies for Managing DB Pension Risk

 

As a plan sponsor, your focus is on contribution risk, not just asset volatility (i.e., asset-only risk). Contribution risk has to also take into account liability volatility (i.e., balance sheet risk), and these liabilities are measured using volatile global markets. The graphs below show the importance of interest rate risk when the risk framework is asset-only as opposed to balance sheet.

Graph – Asset-only Risk Analysis vs. Balance Sheet Risk Analysis

Global capital market volatility now highlights the need for single-employer defined benefit pension plan sponsors to change their frame of reference from the traditional Asset-only Risk Analysis to Balance Sheet Risk Analysis, with a focus on interest rate risk.

Determining the current position of the plan and plan sponsor’s return/risk objectives is essential to determine the appropriate de-risking strategy:

  • Is the plan underfunded or overfunded?
  • Is the plan young and growing quickly with benefit accruals?
  • Is the plan mature or frozen?
  • What is the level of risk-taking among the plan’s stakeholders?
  • What is the market value of assets relative to the market capitalization of the sponsor?

The particular de-risking solution, or combination of solutions, is depicted below, where the vertical axis is economic cost and the horizontal axis shows increased retention of risk for solutions that are further to the right (the riskiest being the traditional asset-only approach). The median cost, as indicated by the blue lines, rises as volatility is reduced, as indicated by a shorter bar. The red dots represent the "tail risk" of each solution.

Continuum of De-Risking Strategies

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