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Current pension issues and possible actions
Challenges in finding a sustainable solution
Presentation to ACPAU
June 16, 2012
Michel St-Germain, FSA, FCIA
Partner
Agenda
• Why are pension plans in trouble?
• Why are university plans different?
• What is a sustainable pension plan for a university?
• Could a DC plan be the solution?
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Jan. 2012
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Pension plans are in trouble
Last 12 years have been difficult
Mercer Solvency Index
120%
110%
100%
90%
80%
70%
60%
50%
2
94% of plans are in deficit
Solvency ratios
80%
2010-01-01
% of plans
70%
2011-01-01
2012-01-01
60%
50%
40%
30%
20%
10%
0%
<70%
70%-80%
80%-90%
90%-100%
100%110%
110%120%
>120%
Solvency ratios
2010
2011
2012
% of plans in deficit
91%
83%
94%
Average solvency ratios
87%
93%
79%
© 2012 Mercer (Canada) limited
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Yield %
The 1990s
Interest rate – Long-term federal bonds
12
10
8
6
4
2
0
4
The 1990s
• Annual returns - Equities
–
11%
–
19%
• Benefit improvements
• Contribution holidays
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The 2000s
Annual returns on equities
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1990 – 1999
2000 – 2011
11%
7%
19%
- 2%
6
Dec-99
2%
2%
1%
1%
0%
0%
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2012 Mercer (Canada) Limited.
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Dec-00
Aug-00
April-00
Yield %
The 2000s
Lower interest rates
7%
7%
6%
6%
5%
5%
4%
4%
3%
Long-term federal bonds
3%
Real return bonds
7
Success in containing the financial crisis has not helped pension plans
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In private sector, accounting rules require disclosure of financial situation
and regulators require funding of solvency deficit
What is the typical private sector solution?
• Design
– Close DB plan to new non-unionized employees and replace by less
costly DC plan
- Some will wait for right time to terminate plan
– Consider whether DC plan can be negotiated with unions
• Funding
– Accept to make higher contribution to fund solvency deficit
– Benefit from possible relief measures
– Consider letter of credit
• Investments
– Wait for higher interest rate, but plan to sell equities and buy bonds as
financial situation improves
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Public sector plans not subject to funding regulations, and accounting
rules are mysterious
What is the typical public sector solution?
• Acknowledge that DB plans are more expensive because:
– Lower interest rate
– Longer life expectancy
• Confirm cost sharing with employees and increase employee contribution
• Reduce early retirement incentives
• Prepare to justify generous DB plan to taxpayers
– Attract and retain tool
– Realistic cost estimate
– Inclusion in total compensation
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Universities have unique challenges in finding a sustainable solution
• Difficult access to funding for increase in cost and deficit
• Ambiguous role of sponsor and administrator
• Benchmarking for attracting talent?
– Public sector with generous DB plan, or
– Private sector with low DC cost
• Diversity of employee needs in same plan
– Do professors need early retirement incentives?
– Can lower-income employees afford higher contributions?
– Are new professors attracted by DB plan?
– Should new employees fund current deficit?
• Are pension changes subject to union negotiations?
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Quebec and Ontario addressing the problems differently
• Quebec
– Solvency exemption
– Relief on amortization of deficit
– Wait for better times
• Ontario
– Framework for jointly sponsored pension plans
– Solvency requirements except indexation
– Sustainability to be addressed for access to relief
– Move to 50/50 cost sharing
– Deficit to be funded by lower benefits
• Both are looking at similar long-term solutions
– Increase in employee contribution
– Replace DB plan by DC plan
– Reduce early retirement incentives
• Solvency exemptions in other provinces
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What is a sustainable pension plan for a university?
• Acknowledge that pensions are more expensive and require increase in
employee contribution
• Target stable contribution rate equal to expected value of benefits, taking
into account some of expected value added from investments
• Amortize current deficit over reasonable period; part may be funded by
higher employee contribution, including new employees
• Share risk with members, including target benefit for active employees and
indexation for pensioners
• Monitor risk that contributions exceed a threshold
• Adjust investment policy to reflect risk tolerance
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How can a funding policy contribute to a sustainable solution?
• Contributions cannot be stable with solvency requirements and investment
policy that includes equities
• Funding policy providing for:
– Selection of margins and assumptions
– Reserve accounts
– Amortization of going-concern surplus and deficit
can result in stable contribution in short term, but not in long term
• Cost sharing with employees may result in intergenerational transfers, if
new employees are expected to fund current deficit
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How can the investment policy contribute to a sustainable solution?
• Investment policies formulate trade-off between risk and return
• Possible to reduce investment risk by investing in selected portfolio of
fixed-income securities
• But most prefer to seek higher returns with equities and alternative
investments and expect returns to reduce cost
• Better risk/return trade-off can be obtained
– Reduce interest rate risk
– Reduce volatility through better diversification with alternative
investments
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Pension investments - Is bigger better?
• Ontario budget
– Appoints advisor to facilitate pooling of public sector pension fund assets
• The bigger the better
– Lower fees
– Access to alternative strategies
– Access to professional managers
– Better use of management time
• But:
– Loss of control by stakeholders
– How to reflect varying risk/reward preferences?
– Governance issues - Who is responsible?
– Is fiduciary responsibility fully transferred?
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How can the design policy contribute to a sustainable solution?
• Benefit reduction
– Early retirement incentives
– Indexation of pensions
• Risk reduction – Transfer risk to members
– Conditional improvements
– Target benefit plan
– Hybrid plan
– Defined contribution plan
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Main features of target benefit plan
The best of DB and DC plans
• DB features
– Future benefits determined using set formula
– No change to past-service benefits
– Assets invested on aggregate basis
– Longevity risk is pooled
– Retirement subsidies can be offered
• DC features
– Employer and employee contributions are fixed, but include significant
margin
– Level of benefits ultimately tied to plan experience
– May be easier for members to understand value of their benefit given
stable contribution rates
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Plan governance
• Administration by Board of Trustees, composed of employer,
member/union representatives, retirees, and third-party members
• Board’s mandate:
– Administer benefits
– Invest plan assets
– Reduce or improve benefits when necessary
• Fiduciary risk is high
– Who will represent retirees?
– Who will represent non-unionized employees?
– Do employees and retirees have same risk tolerance?
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Different ways to implement DC component
• New employees are required to join DC plan
• Current employees can stay in DB plan, or are offered option of joining
DC plan for future service
• Current employees are offered option of converting accrued DB benefits
to DC benefits
• Current employees must join DC plan for future service
– No change in accrued pensions
– Some protection for older employees
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Pros and cons of DC plan
Pros
• Sustainability
• No future risk to employer
• No early retirement incentives
• Reflects value of new employees; no single-employer career
Cons
• No immediate reduction of risk for accrued benefits
• Union concerns
• Lack attraction vs. public sector DB plans
• Can employees manage DC risk?
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Shortcomings of DC plans
• Retirement planning responsibilities are transferred to employees. Can
they assume responsibility of determining:
– How much to contribute?
– Where to invest?
– How to use capital at retirement?
• How can employer assist employees without assuming responsibilities?
– Educate without recommend
– Default options
– Access to advice
– New products on retirement
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Conclusions
• Changes will be driven by interest rates
• Pensions will cost more
– Contributions will increase or benefits will decrease
• Risk should be shared with members
• Early retirement subsidies should be reduced
• You need to justify why you are keeping a DB plan
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