Pension Index Tracks Impact of Stock Markets and Interest Rates on Financial Health of Defined Benefit Pension Plans
TORONTO, July 4, 2012 /CNW/ - Following a difficult 2011, defined benefit (DB) pension plans - those that promise a guaranteed level of pension for the retiree's lifetime - continued to face the dual challenges of low long-term interest rates and volatile equity markets through the first half of 2012. Not surprisingly, as the costs of the defined benefit promise continue to weigh heavily on the financial performance of the organizations that sponsor such plans, many such organizations, especially in the private sector, continue to seek ways to mitigate the risks associated with these commitments.
"The solutions currently being explored and implemented are wide-ranging - from investment strategy shifts to plan design changes to a complete sell-off of the risk. But the catalyst for change in all cases is the desire to reduce financial risk" said Ian Markham, Canadian Retirement Innovation Leader at Towers Watson.
The Towers Watson DB Pension Index has been tracking the performance of a hypothetical fully-funded defined benefit plan started in 2001. The health of the plan is tied to two important measures - investment returns, which boost the amount of assets held in the pension fund, and the level of long-term interest rates, which determines the amount of assets that are theoretically needed today to pay the future benefit promises made to current plan members and retirees.
While stock markets started 2012 on a positive note, investment returns in the 2nd quarter of the year were negative, and as a result, the typical Canadian DB pension plan invested 60% in equities and 40% in fixed income would have earned only 2.3% on its investments for the six months ending June 30, 2012. The combined effects of poor investment returns and decreasing interest rates caused the DB Pension Index to fall 1.4%. (See chart here). Based on other data collected by Towers Watson on the funded status of Canadian DB plans, this would mean that the typical plan, which was roughly 85% funded at the start of 2012, is likely in no better shape at mid-year.
Particularly challenging for pension plan sponsors is the dual effect of the fear and uncertainty currently pervading financial markets. Not only does risk aversion cause instability in stock prices, but for the most part, the "safe" money is shifting to bonds, keeping interest rates low and inflating pension liabilities and costs.
"With interest rates seemingly stuck at such low levels," said David Service, Director of Investment Consulting at Towers Watson, "DB plan sponsors have by necessity started to assess more critically the investment tools they've historically used to boost returns and reduce risk. Led by some of the larger, more sophisticated plans, Canadian pension funds are accelerating a trend toward alternative assets such as real estate, private equity and infrastructure."
As the markets evolve, some plan sponsors are also starting to explore ways of using traditional tools in non-traditional ways. For example, alternative approaches to equities market investing can help sponsors boost returns while at the same time reduce volatility. As Service observes, "Some pension fund sponsors are putting shiny new tools in the toolbox. Others are simply sharpening the tools they already have. There are many ways to manage risk, and plan sponsors would be wise to explore them all."
About The Towers Watson DB Pension Index
The Towers Watson DB Pension Index tracks the performance of a hypothetical fully-funded defined benefit plan started in 2001. The health of the plan is tied to two important measures - investment returns, which assumes a balanced investment portfolio consisting of a 60% allocation to Canadian and foreign stocks, and a 40% allocation to bonds, and the level of long-term interest rates, which determines the amount of assets that are needed today to pay the future benefit promises that have been made to the current plan members. The liability measure is based on long-term corporate bond yields, which is consistent with the way corporations would be required to measure the liability on their year-end corporate financial statements. To isolate the effects of market forces, the index assumes that no net cash is added to or taken out of the fund. In other words, the assumption is that contributions to the fund are always equal to benefits paid out of the fund.
About Towers Watson
Towers Watson (NYSE, NASDAQ: TW) is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. The company offers solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Towers Watson has 14,000 associates around the world and is located on the web at towerswatson.com.
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