Risks and rewards

The environment for defined benefit (DB) pension plans is changing. Are plan sponsors ready to adapt?

The threats of geopolitical instability, inflation and volatility that loomed large at the beginning of 2022 have become reality in 2023. From the war in Ukraine and the energy crisis in Europe to rollercoaster public global markets, a shifting policy environment in Canada with Bill C-228, and the ending of new real return bond issuance, the only constant is change. 

But here’s the good news: Pension funds are generally in an enviable funded position. Now is the time to take stock, reassess risk exposures and search for opportunities.

Here are some key actions plan sponsors should be looking to take in 2023:

Making sure the investment strategy is in shape

Many DB plans are in a strong financial position — but markets are shifting. The investment industry has had to navigate a substantial amount of short-term volatility. 

In this environment, all investors — but especially sponsors of DB plans — should review their investment strategies, assessing their exposure to market risk against their objectives and tolerances. Investors could look, for instance, to capitalize on higher long-term yields on fixed income investments while they are available.

Diversification is also always important, but in the current environment, investors should sharpen their focus. We do not know what will happen in the medium or long term. A properly diversified investor can better build resilience into their portfolio. This will be necessary, as more volatility may lie ahead.

Taking stock of surplus

Although the strong financial position of many DB plans may be counterintuitive given the decrease in asset values, this is the result of liability tailwinds from higher interest rates.

If a plan has a surplus, the plan sponsor may wish to simply retain it. A surplus buffer can be an effective safeguard against uncertainty and will allow a degree of flexibility should unexpected events occur. The sponsor may also wish to engage in an off-cycle valuation, which would allow the surplus position in the plan to be locked in for the next three years.

If the plan sponsor wants to spend some surplus, then, with careful deliberation, it could be used for an employer or employee contribution holiday or, in Ontario, for reduced Pension Benefits Guarantee Fund premiums. Sponsors could also consider benefit improvements, such as an increase in retirees’ pensions, given the inflationary environment.

“Due to geopolitical tensions, globalization may be slowing, thus negatively affecting economic growth.”

Inflation may continue — but uncertainty is certain

While inflation has been one of the defining themes underlying financial markets around the world in 2022, it is not the only source of uncertainty. 

Due to geopolitical tensions, globalization may be slowing, thus negatively affecting economic growth. 

Significant challenges with respect to energy infrastructure exist — particularly in Europe, which is undergoing a significant energy crisis due to conflict-driven sanctions.

All of this means that inflationary forces may be around for a few more years. Portfolios should be structured to handle more than just the “base case.” It should be able to navigate different inflationary regimes. An examination of the lessons of the 1970s may be in order, along with selecting investments that provide long-term, inflation-sensitive revenues.

Finding operational alpha

In an environment where predictable returns are difficult to come by, plan sponsors must look for them in every possible place — including within their own processes. 

Finding the right partner to manage investments can be an important source of efficiency as this allows to rededicate resources to managing the business — and a partner can ensure that the portfolio is performing at its peak. 

Positioning to transition

Climate-driven weather events have made headlines in Canada, and these show no signs of abating. Climate change is now an economic fact and presents a systemic risk to investors’ portfolios. Though all investors will be at different points in their transitions, they must have plans.

This means integrating ESG factors into portfolio management — to both reduce climate risk and identify potential opportunities that may arise as the world transitions away from fossil fuels.

“Climate change is now an economic fact and presents a systemic risk to investors’ portfolios.”

Considering an alternative approach

Interest rates may no longer be at their historical lows, but there is still a strong case for investment in alternative assets and private markets. 

In a volatile market, private assets are better positioned to capture the long-term opportunities that exist — such as innovation. 

Certain alternative investments, such as private real assets or infrastructure, could also provide some protection against inflation and volatility — either through the nature of their business model or the fact that they provide a welcome relief from the high volatility of public markets. 

Sponsors need to be aware of the investment environment. Where there are opportunities, private markets may be a way to profit. Options are available that can help assess risks and choose the right option.

Updating assumptions

It may also be a good time to ensure the plan’s assumptions reflect the world we live in. Do demographic factors such as mortality, average retirement age and years worked still hold? 

Consider an experience study to ensure assumptions are up to date and that the plan sponsor is ready for whatever comes next.

Plan governance

Many Canadian regulators — among them the Financial Services Regulatory Authority of Ontario and the Canadian Association of Pension Supervisory Authorities — have signaled that governance expectations are increasing for plan sponsors. Plan sponsors may be expected to establish a governance framework and document it in a formal policy. 

Development of these policies isn’t just for the purpose of checking a box. These ensure that roles and responsibilities are well understood, that there are processes in place to manage risk and enhance outcomes, and that plan members will be able to receive the benefits to which they’re entitled.

Now isn’t the time to fall behind. It’s time to review plan governance, and ensure that the plan is positioned to succeed despite new headwinds and future uncertainty.

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