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Corporate pension plans fly friendlier skies

Last year was a breather for deficit-addled pension plans. Strong equity markets lifted the value of stocks held in their plans, while rising interest rates substantially reduced their deficits. An added bonus for Canadian plans was the positive effect of a declining Canadian dollar on the value of their foreign holdings. Many plans entered this year with the slate wiped clean of deficits that have been a chronic fact of life since the start of the millennium.

The question for plans and the employers that largely fund them is, now what? The model of the past 20 years of relying on equity markets to produce above-average returns and thus lower the amount employers needed to fund plans (compared with the old strategy of just buying bonds) had clear shortcomings for pension funds when markets were volatile and interest rates were low. As a result, many employers had to make ruinously expensive payments in the short term to bring their deficits into balance. Clearly the way forward for plans fortunate enough to now be out of deficit, or nearly there, is something different.

That brings us to Air Canada, which revealed Wednesday that is has joined the Pension Deficit-Free club. It got there due to rising rates and strong equity returns last year, but also thanks to funding relief from the federal government and some hard-won changes to its benefits arrangements with unionized employees, including a move to hybrid defined-benefit/defined-contribution plans.

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The way forward is a flight from risk: Four years ago, Air Canada adopted an investment strategy that aimed to match its liabilities by focusing on interest-bearing investments, removing the risk of interest-rate fluctuations. The company says its liabilities and assets are now 70 per cent matched; the intention is to get all the way up to 100 per cent and neutralize all capital markets risks, although the company hasn't shared many details about that strategy or whether than means it will eschew equities altogether. But clearly the intention is to cut out the risk. Another option for risk-averse, deficit-free plans is to buy annuities from insurance companies (rather than manage the pension assets themselves). It's an expensive move but it has bought peace of mind to those that have taken the plunge, including General Motors and Verizon Communications.

There are benefits and costs to the de-risking approach. On the plus side, employers can fund pensions steadily while flying above the turbulence of markets. The downside is that by ditching the old way of managing pensions, Air Canada and other plan sponsors will, over time, miss out on the historically higher returns from stocks and interest-bearing investments, and thus the lower contributions they could make when the plans go into surplus. Another option is a shared-risk plan, like public pension plans in New Brunswick and Newfoundland have tried, where employees share the burden of underfunding with the employer when poor markets create deficits.

What these higher-ground options have in common is a tradeoff: higher pension funding costs upfront in exchange for greater stability and more predictable costs down the road. Given what has happened in the past 14 years – where the upside opportunities were obliterated by the downside risks that materialized in two market meltdowns – and the continuing angst about the affordability of retirement as the baby boomers leave the work force en masse, it's a tradeoff more employers are likely to make.

Jacquie McNish is the co-author of The Third Rail: Confronting Our Pension Failures.

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