Dwindling returns

By Gérard Bérubé

The 2000-2002 market correction dealt a severe blow to pension plans. Since then, actuaries and pension fund managers have been trying,  without much success, to initiate a debate on the chances of survival of defined-benefit plans and the needed changes. If the issue is still not debated, it may be because they haven't been able to convince stakeholders that the crisis is more structural than cyclical. Also, could this crisis be revealing of managers' inability to generate adequate returns?

The issue is important as it concerns the country's largest pension funds and affects five times more employees than de- fined-contribution plans. But people are shell-shocked by the damage caused by only two years of market corrections. Although Toronto's S&P/TSX rebounded by 24% in 2003, almost nothing has changed. At the end of 2003, 60% of defined-benefit pension plans were still playing catch-up, as opposed to 67% a year earlier, with a cumulative actuarial deficit of $160 billion in Canada according to a solvency-based evaluation. Based on this method, employers have five years to remedy the situation and erase the deficits. Imagine the pressure the imbalance puts on corporate cash flows.

Not surprisingly then, in a Watson Wyatt survey conducted in May, 18% of defined-benefit plan participants indicated their organizations had terminated at least one plan or converted it into defined-contribution. And 11% reported such changes are underway. The survey showed of the 71% who intend to stay with defined-benefit plans, one in five has added defined-contribution elements or cut back future benefit levels or early retirement provisions.

The cause of the damage, therefore, isn't limited to the market correction. In addition to two years of negative returns, the decline in long-term interest rates has sapped pension plan funding by increasing estimates of pension plan actuarial liabilities, explained a June Bank of Canada's Financial System Review report. Compounding the funding problem is the fact that many plan sponsors took contribution holidays in the late '90s when their plans posted a surplus thanks to robust equity markets.

As for what happens next, large pension plan managers say we will have to cope with demographic pressures and an era of poor returns. They be-lieve the period between 1982 and 2000 was a golden age for fund managers but that two-digit returns are a thing of the past. One such manager, Henri-Paul Rousseau, chairman and CEO of the Caisse de dépôt et placement du Québec, backs this claim by pointing out that a US government bond maturing in 10 years yielded an effective interest rate of 10% at the end of the 1980-'82 recession. This effective rate, net of inflation, gradually dropped in the 1980s to hover at 4% throughout the 1990s and has fallen to 2% since early 2000. According to Rous- seau, people will have to work longer and lower their standard of living expectations. Human resource consultants Towers Perrin say the rules will have to be relaxed by allowing a combination of salary and pension benefits or by letting employees contribute to plans for as long as they work, regardless of their age.

Towers Perrin suggests surplus ownership be tackled head on. The firm believes by rec-ognizing employer ownership of the surplus and acknowledging that defined-benefit plans amount to a promise to pay a pension based on a minimum funding standard, plan sponsors could be encouraged to contribute more than the required minimum during a strong business cycle. But was there not there widespread use of contribution holidays when surpluses occurred? Towers Perrin attributes this to a regulatory imperative under the Income Tax Act rather than to any response by employers.

And there's the issue of equity returns, which should be of primary concern to managers. According to a simulation conducted by Mercer for 2003 to 2008, the baseline scenario for this five-year horizon is an average annual return of 6%. Based on this and despite special employer funding, the pension situation will improve little since the return on assets will not cover the growth in liabilities. However, a projected return of 8.6% would turn the 5% deficit into a 5% surplus in five years, boosting the solvency ratio to 107% from 89%. Is this so difficult to attain? According to an Aon Group survey, the average annual return on diversified funds was 9.2% for the 10-year period ended March 31 (including the period from 2000 to 2002).

Gérard Bérubé is editor of the Économie et finance section of Le Devoir in Montreal