Reducing Risk For Multi-Employer Plans
By: Stephen Johnson & Joan Johannson
Multi-employer pension plans (MEPPs) have unique characteristics, quite different from traditional corporate plans, which require them to be more cautious. However, a properly invested plan can help protect the pension benefit by making use of strategies already adopted by some of the largest plans in Canada.
In striving to meet this promise, the trustees of these plans need to understand the risks and attendant consequences. Most trustees think of risk in terms of losing money due to the performance of an investment. For example, investments in Canadian stocks will drop in value when the Toronto Stock Exchange declines.
A further risk lies with interest-bearing investments such as bonds. As interest rates increase, the value of bonds decrease. Whereas, as interest rates fall, the value of bonds increase, but it then becomes increasingly difficult to find bonds that will generate sufficient interest to match the outflow of cash needed to fund the pension promise.
It all comes down to investment decisions and therein lies an interesting history as to how we reached where we are today. In the early years of pensions, starting in the 1950s, plans were largely invested in long bonds, most via annuity contracts provided by insurers. The assets in the plan always equaled the liabilities (the pension promise) as they were matched with the annuity contracts. The insurance companies simply matched the liabilities with long bonds and made a profit for taking on this ʻrisk.ʼ Eventually, however, trustees began to take on control of their investments, realizing that they were paying a premium for purchasing long bonds via annuities. This trend away from annuity funding began in the 1960s. With this new level of control came changes to policy allowing for a broader array of investment alternatives. The trustees began investing in the stock markets understanding that, over time, stocks were proven to outperform bonds. By the early 1970s, stocks represented about 30 per cent of plan assets with long bonds at 70 per cent.
How We Strayed
During the 1980s and through much of the 1990s, we enjoyed a period of incredible growth, and falling interest rates, during which stocks performed so well that trustees began to move investments away from under-performing bonds and into the stock markets. The benchmark for success became how well one fund performed against its peers in the marketplace. In effect, we began chasing returns and investment management opportunities were won based on which horse had been near the front of the pack the longest. At this same time, although the general population was now living longer than in the 1950s when pensions first became popular, investments in bonds were for shorter durations, usually in mid-term bonds, as the return on long bonds was simply too low. Pensions developed more and more of a mismatch between the duration of their liabilities and the duration of their fixed income investments.
Reality set in when the markets experienced a major adjustment in the early 2000s and the ʻtech bubble burst.ʼ Unfortunately, not all plans were in a position to weather this storm. In pursing returns, the trustees had forgotten their primary concern: Can we pay the promised pension to our retired members?
This mismatch is reflected in the misnamed ʻasset and liabilityʼ studies, often undertaken by pension plans. The name is backwards. To properly answer the question of whether we can pay the promised pension to our plan members, we need to first look at the liabilities inherent in this promise and then at the assets which are needed to fund those liabilities.
Only by assessing the liabilities first, can we determine how much of a mismatch we can withstand. What is the duration of the liabilities and do the assets, then, match that duration?
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