The DB pension plan business model has failed – and everyone is paying the price

The DB pension plan business model has failed – and everyone is paying the price

Brent Simmons Contributed to The Globe and Mail Published September 10, 2019

Brent Simmons is Senior Managing Director & Head, Defined Benefit Solutions at Sun Life

For the past 20 years, many private-sector companies across Canada followed the same risky strategies for their defined-benefit (DB) pension plans as they did in previous decades. Unfortunately, over this time these strategies cost stakeholders almost $158-billion and jeopardized the retirement security of millions of Canadians.

As a result, many companies have abandoned these perilous approaches, but a surprising number have not. To better understand why new strategies are needed, think of the DB pension plan as a division of the company – the DB Pension Division.

A company’s employees lend the DB Pension Division money in the form of deferred wages. In return, the company promises to provide a pension to those employees when they retire. Until then, the DB Pension Division invests this money with the goal of being able to pay these promised pensions.

However, many DB Pension Divisions are investing this money in a way that’s mismatched from the bond-like promises they made to employees. They make bets on equity markets and interest rates in the hopes of generating excess returns that will make it cheaper to pay these promised pensions.

Imagine – what do you think would happen if you went to your CFO and told her that you had a great idea for a new business. You want to borrow money and invest it in the equity markets to generate excess returns for shareholders. I suspect you’d find that it would be a pretty short and career-limiting conversation!

So why would this idea work for a DB pension plan? What’s clear is that for the past 20 years, it has not.

After a lot of ups and downs, the average DB Pension Division is essentially in the same place that it was 20 years ago from a funded-status perspective.

In fact, the typical company contributed significant dollars to its DB Pension Division during this period. According to Statistics Canada, companies in Canada contributed almost $158-billion between 1999 and 2018 to shore up deficits in their pension plans. This means that a typical DB Pension Division earned a negative return – destroying value for shareholders who invested in the company.

If the business model had been successful, the typical DB Pension Division would be well over 100-per-cent funded by now and these $158-billion of contributions wouldn’t have been required.

It’s not surprising that some DB Pension Divisions stuck with their historical business models over the past 20 years. After all, interest rates were at historic lows and were widely expected to rise and equity markets had a long history of providing excess returns.

So why didn’t things turn out as expected? The business model involves making multiple bets on equity markets, interest rates, credit conditions, foreign exchange rates and life expectancy. Companies need to win all these bets consistently as the gains from good bets can be wiped out by the losses from bad bets.

Making multiple successful bets with the DB Pension Division is very hard to do – especially given the increased unpredictability of the markets over the past 20 years. In addition, most companies rely on the same investment managers as their competitors, which doesn’t create a competitive advantage for their shareholders.

Given these challenges, many forward-thinking companies are concluding that the DB Pension Division’s business model no longer works – an appropriate conclusion for a division that’s been losing money for 20 years.

The first step these companies take is realizing it’s better to take risk in their core business rather than in the DB Pension Division. General Motors was one of the first companies to articulate this strategy. In 2012 Jim Davlin, vice-president of finance and treasurer at General Motors, said: “We’re in the business of making great cars – that’s our core competency. It’s not managing pension investments to provide a lifetime income to folks.”

The second step these companies take is changing the business model of their DB pension plan to embrace better risk management. These companies are investing plan assets to match liabilities and/or transferring portions of their plans to insurers through the purchase of annuities.

The bottom line? Everybody pays the price for a failed DB Pension Division. Let’s not lose track of why we created pension plans in the first place – to help Canadians be ready for retirement. Isn’t it time to adopt better risk management and switch to a business model that works?

As posted on The Globe and Mail