The DB Pension Plan Model Has Failed?

Brent Simmons, Senior Managing Director & Head, Defined Benefit Solutions at Sun Life, wrote an op-ed for the Globe & Mail on why the DB pension plan business model has failed – and everyone is paying the price:

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?

Let me first thank Steve Martyn for sending me this article.

My first impression after reading this article is it's well written but superficial. To be fair, I wouldn't expect much more from the Head of Defined Benefit Solutions at Sun Life who is peddling his team's products and services.

Mr. Simmons and his team are into the de-risking business, meaning convincing companies to do away with their defined benefit plans altogether and "focus on their core business".

For a nice hefty fee, Sun Life and other large insurers will take on the risk of a company's existing DB plan and de-risk it through an annuity buy-out, buy-in, longevity insurance and liability driven investments all designed to make pensions boring again.

I'm being facetious and highly cynical but if I had a dollar for every time I heard these large insurers discuss their de-risking schemes solutions.

Let me get to the point. Simmons isn't telling me anything new. I started this blog in 2008 and have long warned my readers that private defined benefit plans are in big trouble and many of them would go the way of the dinosaurs.

But unlike Mr. Simmons who has a vested interest in peddling his 'defined benefit solutions' (a bit of an oxymoron when you think about it since they want to do away with these plans), I just tell it like it is and see this as part of a bigger problem, the global pension crisis which is deflationary.

The real cost to society isn't the failure of corporate DB plans the way Simmons portrays it, it's the shift out of defined benefit plans into defined contribution (DC) plans (benefiting large insurance companies and big banks) which exacerbates pension poverty down the road.

You see, Simmons is right, most companies have made a mess of their defined benefit plan and they shouldn't be running a DB plan, they should be focusing on their core business, whatever that is.

However, there are important exceptions to the rule. For example, CN Investment Division (CNID) managing the pensions of CN workers:

Established in 1968, the CN Investment Division (the Division), based in Montreal, manages one of the largest single-employer defined benefit pension funds in Canada and holds a long track record of solid performance.

Approximately C$16.4 billion is actively managed in-house by about 80 employees for the CN Pension Plan’s approximately 50,300 pensioners and pension plan members. The Division also manages the assets of the CN Pension Plan for Senior Management and the BC Rail Pension Plan.

The Division’s culture is nimble, innovative, collaborative and risk-aware. Pensioners are always at the heart of what we do. 

Marlene Puffer is the president and CEO of the CN Investment Division and she has done a great job just like her predecessors, Russell Hiscock and Tullio Cedraschi.

I last met Marlene at the Toronto annual spring pension conference which I covered in-depth here. To recall:

Marlene said she oversees a very mature $18 billion pension plan at CN where there are 3 retired workers for every active member and she needs to make sure they have the $1 billion a year they need to make payouts every year.

She said she was balancing out liability hedging component with return seeking component. They hedge a lot of interest rate risk and they have their board's approval to prudently leverage their balance sheet (her experience sitting on HOOPP's ALM committee for years came in handy there).

She stated they are trying to generate the same return using less risk using all the tools available and are investing across public and private markets and anything that falls in between but are managing their liquidity very tightly.

And just so you know, Peter Letko and Daniel Brosseau of Letko, Brosseau & Associates, one of the most successful money managers in Canada with a very long track record met at CN Investment Division before starting their own firm (read my comment on resilience according to Boivin and Letko).

Another very successful corporate DB plan is the Air Canada Pension Plan. Air Canada went from a $4.2 billion pension solvency deficit in 2012 that threatened the company’s future, raising concerns about another trip to bankruptcy court, to a $1.2 billion surplus three years later (read this article).

At that time, Air Canada said 75% of its plan’s assets — $12 billion out of $16 billion (at that time) –— were “immunized,” in fixed income investments. That means buying bonds where the cash flows from the bonds, more or less match the duration of the plan’s obligations, reducing overall risk.

The architect of that turnaround was Jean Michel, IMCO's current CIO. His successor, Vincent Morin, continued the same approach and retooled the now $20 billion Air Canada pension plan for better returns and lower risk. Chief Investment Officer had a profile on him which you should all read here.

Last I heard, Vincent Morin and his team are branching out, providing real DB solutions to corporations looking to maintain their DB plan intact but needing professional pension fund managers to properly manage it.

Another corporate pension plan I like a lot in Montreal is the Kruger plan. Greg Doyle is the Vice President of Investments and don't let his Scottish accent fool you, he really knows his stuff as does Mr. Kruger who I had the pleasure of meeting once and think highly of because he's a very hard worker who really understands finance and investments.

Why am I bringing this up? Because we need to focus on the success stories, not the corporate DB plans that fail which there are plenty of.

Some plans are better managed than others and if it were up to me, I'd create a new federal pension fund which absorbs all of Canada's existing corporate DB plans and also offers a new pension plan to the BDC and EDC's clients (small and medium sized businesses) at a reasonable cost.

This new federal entity would be backstopped by the federal government, it would be based here in Montreal and have legislation and independent and qualified board like CPPIB and PSP Investments.

This is why I fundamentally believe we can offer Canada's corporations real, long-term solutions to their workers' pension needs and it's not by de-risking them and doing away with them, it's by bolstering them and creating a national plan that covers all workers properly just like CPPIB covers all Canadians properly (especially enhanced CPP).

In closing, I have nothing against Brent Simmons and the Defined Benefit Solutions at Sun Life. I just like to think bigger and better and realize the severe limitations of the solutions they are offering.

If we want to improve corporate DB plans, all we need to do is look at the success of Canada's large public DB plans and model something based on their governance and investment approach.

Lastly, I read an article today on how Canadian pension assets enjoyed healthy gains in the first quarter of 2019, according to new data from Statistics Canada:

The national statistical agency reported that the market value of Canadian pension assets rose by 5.0% in the first quarter to $1.97 trillion.

The increase was powered by short-term investments, such as corporate bonds, banker’s acceptances, treasury bills and commercial paper, which increased by 10.2% in the first quarter, StatsCan said.

Additionally, mortgage investments rose by 6.3% and bond investments grew by 6.0% in the quarter.

StatsCan said that real estate investments were the only asset class to decline in the first quarter, and they only slipped by 0.2%.

Pension funds also recorded a 52.6% jump in net income in the first quarter, StatsCan reported.

Securities sales drove the increase in pension income, the agency noted, as profits on securities sales jumped 58.2% in the quarter to $20.0 billion.

While this is encouraging, as I keep repeating, pensions are all about managing assets AND liabilities. The recent plunge in long bond yields all over the world is bad news for Canadian and global pensions because liabilities soared disproportionately more than assets (as duration of liabilities is a lot bigger than duration of assets).

Below, Gina Klein, Managing Director at PwC, discusses the types of risks pensions are facing, the actions companies are taking and the related accounting impacts.

Update: There was excellent and extensive feedback on this comment that required me to write a follow-up revisiting the failure of the DB pension plan model. Take the time to read it here.