The Observer

GUEST COLUMNIST

Do you have the right umbrella? Pension Funding needs to consider Risk Tolerances

by Derek Dobson, CAAT Pension Plan

Every Canadian considers risks and rewards when they leave home in cloudy weather. If we think it will be windy and pour buckets, we may invest in a sturdy and large golf umbrella. If we only anticipate clouds, we may take our chances without any rain protection. There are a range of alternatives in between.

This analogy becomes more complicated when you have a fiduciary duty to members of a defined benefit pension plan. If the sun is always shining, as is the case during bull markets, many will question why we carry an expensive umbrella. However, if there is an unexpected rainfall and we all get wet (i.e., a bear market), many will expect us to have forecast that probability and to have taken appropriate action to stay protected.

This weighing of protection against potential outcomes is one way to explain risk tolerance to our members. Assessing changing tolerances in various environments is a regular exercise that defines what risks we can accept, both now and in the future, in pursuit of our funding and other key goals.

At the CAAT Plan, we regularly review our risk tolerances with Plan governors to ensure they remain appropriate as conditions change. Our key goals are benefit security, appropriate and stable contribution rates, and intergenerational equity.

Ultimately, our risk tolerance defines what we think is appropriate protection from the unpredictable, at a cost that is acceptable to our stakeholders. 

Pension funding must consider risk tolerances

If the pension and investment market changes suddenly, we can’t just grab an umbrella on our way out the door. We need to be thinking about how the pension and investment environment may evolve over the next 20 years. To do this, we use sophisticated modelling tools and test our sustainability against myriad economic, demographic, and pension policy scenarios.

However, like long-range weather forecasts, the future is not guaranteed. As a result, pension plan administrators must use their specific risk tolerances to decide how to fund promised future benefits, while guarding against economic and demographic shocks, managing current cost pressures, and addressing the desire for equity across member groups.

In all scenarios, being fully funded will mean being able to better weather storms. At the CAAT Plan, our top priority is benefit security. Keeping the Plan properly funded, especially because we’re a jointly sponsored pension, is the foundation of benefit security. To ensure we keep the Plan healthy for decades to come, our members and employers are making supplementary contributions to build reserves by design. We are 118% funded and our goal is to build additional reserves based on our risk tolerances.

Contrary to popular belief, jointly sponsored pension plans cannot reduce benefits as an ongoing entity.  Employer obligations are simply to match member contributions. If a deficit emerges, employers are not obliged to make up a funding shortfall. In this context, it is clear why a strong funding policy with a focus of reserve building is essential.

Finding the appropriate balance between potential risks and the right level of protection needed to fund a pension plan is different for each plan; however, there are four cornerstones every plan needs for a solid foundation.

A robust funding policy

A funding policy is essential. It guides decision-making within the context of a pension plan’s goals and focuses conversations about risk tolerance. A robust funding policy makes decision-making easier and communicates the goals of the plan so there are fewer surprises when the unforeseen inevitably occurs.

The CAAT Pension Plan Funding Policy was established in 2006. It took a long time to develop and it was worth the investment. Trustees and Sponsors’ Committee members have relied on the Funding Policy to guide them in making decisions, many times in many different circumstances, from the Global Financial Crisis to our well-funded position of today.  Having a plan of action set in advance is highly recommended.

The CAAT Plan’s Funding Policy uses three funding controls:

 
  • reserves,
  • contributions, and
  • conditional benefits (inflation protection that is conditional on the Plan being fully funded).
The policy sets guidelines for the use of these controls within six funding levels. Multiple options exist within some funding levels and the CAAT Plan’s governors decide how to balance the timing of possible changes to ensure ongoing benefit security considering the conditions that exist at the time. This structure allows decisions to reflect the evolving needs of the Plan or emerging risks.

Strategic alignment between funding assumptions and asset mix

An investment program should generate sufficient long-term returns through a well-diversified portfolio with a level of risk that is appropriate for the pension plan to meet its goals. The challenge for most plan administrators is not performing asset-liability modelling (ALM) studies, but rather it is defining the primary funding goal of the plan.

Is the goal to manage accounting volatility, address going-concern or solvency targets, minimize costs or maximize benefit security? Unfortunately, there is no single asset mix that can accomplish all of these goals. Hence, understanding your risk tolerance is essential. Further, as financial, demographic, or environmental conditions change, your risk tolerances and asset mix should also adjust. 

Asset-liability modelling is a key tool to test for strategic alignment. It tests future potential investment performance of various asset mixes and funded status under a range of economic and demographic scenarios. It helps administrators understand whether the current asset mix is aligned with the plan goals and risk tolerance or whether it needs to be adjusted. With the pace of change accelerating, the CAAT Plan has moved from conducting an ALM study every three years to performing them several times each year.

Transparent stakeholder communications

The path to pension sustainability is not straight. There will be many twists and turns over time. When something unexpected happens, administrators need to have a long history of sharing information in good times and bad. Put another way, ongoing transparency builds trust.

A funding policy helps establish trust when it is communicated routinely and widely to plan stakeholders. This ensures people understand the reasoning driving decisions. When stakeholders understand the goals and value of their pension, they can champion your approach and become effective advocates of the plan. There are no surprises.

Staying relevant in a changing world

Finally, plan administrators should regularly assess how their plan meets the needs of its members. Our plan was established in 1967, on Canada’s 100th birthday. Many other DB pension plans have a similar longevity. Of course, the needs of our members and employers have evolved over the past 50 years and our plans must adapt with them. For example, part-time employment was not pension eligible in 1967, yet today members who work part-time outnumber those who work full-time by a significant margin. 

The CAAT Plan has undergone detailed and substantive reviews many times over the last decade. Stemming from these reviews, our Plan governors will introduce a second plan design on June 1, 2018 to ensure the CAAT Plan remains relevant for a wider group of employees and employers for years to come.

The emerging needs of members are not too different from the needs of prior generations. All want secure, predictable, lifetime retirement income that’s protected from inflation. Recognizing this, both our plan designs will continue to be defined benefit.

Our Plan governors also believe that expanding defined benefit coverage is beneficial to the Plan and to Canadian employees and employers. This second plan design will be available to Canadian employers and employees across all sectors: private, public, and not-for-profit.

Consolidation and efficiently expanding defined benefit coverage is also consistent with our objective of growing active membership to better manage plan maturity risk and further strengthening benefit security.
 
We don’t want anyone to get caught out in the rain. Improperly funded pension plans can affect everyone – through perceptions of pension plan sustainability, increased Pension Benefit Guarantee Fund premiums, increased reliance on social programs, or the need to help a struggling family member.

Therefore, it is important that we work together to build a properly funded pension system. As plans look to adapt to evolving needs they can use their established risk tolerances to find balance between costs and risk protection to ensure they are adequately funding future benefits. They can establish and communicate their funding policy, and they can regularly check that their assumptions and asset mix are aligned with their strategic objectives.

While no forecast can be fully relied upon, we should all work to prepare for the stormy days ahead while the sun is still shining.

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  Derek Dobson
  Chief Executive Officer and Plan Manager
  CAAT Pension Plan







Derek is a tireless advocate for shared-risk, multi-employer defined benefit (DB) pension plans. During the past few years, the Plan has been in discussions with employers from the public and private sectors interested in joining CAAT.  Notable new employers are the Youth Services Bureau (YSB) of Ottawa and the Royal Ontario Museum (ROM). Both have merged their single-employer DB plans with the CAAT Plan.

Derek has an undergraduate degree in mathematics from the University of Waterloo, and is an Associate of the Society of Actuaries. He is Co-Chair of the Canadian Public Pension Leadership Council (CPPLC) and a member on the ACPM (Association   of Canadian Pension Management) Board of Directors.

The CAAT Plan has assets of $10.8 billion and serves 46,000 members and 41 employers, including all of Ontario’s colleges. In its valuation as at January 1, 2018, the CAAT Plan is 118% funded on a going-concern basis with a funding reserve of $2.3 billion. The CAAT Plan’s well-diversified investment portfolio has earned a 5-year average annual rate of return of 11.4%, net of investment management fees.