Defined Benefit Plans Amid Market Volatility

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For a finance executive confronting volatile market conditions, what's the right balance of risk and return in a defined benefit (DB) pension plan? If you're committed to a DB plan, what strategies …

For a finance executive confronting volatile market conditions, what's the right balance of risk and return in a defined benefit (DB) pension plan? If you're committed to a DB plan, what strategies can remove excessive risk? Or is it time to refresh your exit strategy?

Towers Perrin and CFO Research Services have completed a study that examines the risk management approaches that finance executives have already taken for their defined benefit pension programs in the United States and Canada. Risk management is clearly "top of mind" for corporate finance executives throughout North America, though risk management solutions may vary widely.

Learn more about the findings and implications of this survey and its relevance to your pension plan as Sylvia Pozezanac, practice leader for Towers Perrin Retirement Risk Solutions, Monica McIntosh, business leader for Towers Perrin Asset Consulting in Canada, and Sam Knox, VP of CFO Research, discuss the findings with a panel.

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  • 1. Defined Benefit Plans amid Market Volatility Highlights of the 2nd Annual Towers Perrin — CFO Research Services Pension Plan Study September 18, 2008 Sylvia Pozezanac Sam Knox Monica McIntosh Managing Principal VP and Director of Research Managing Principal Retirement Risk Solutions CFO Research Services Asset Consulting Towers Perrin Boston, MA Towers Perrin New York, NY Toronto, Canada © 2008 Towers Perrin
  • 2. Today’s agenda Review findings from the report, Defined Benefit Plans amid Market Volatility Towers Perrin’s point of view on the research and the broader business challenge of pension risk Open dialogue with our panel, including audience Q&A © 2008 Towers Perrin 1
  • 3. Research methodology The Survey: 214 senior finance executives in U.S. and Canada All respondents have defined benefit (DB) plans Broad industry representation with more than half of respondents from $1B+ companies The Interviews: 12 senior finance executives Explore the broader business context for pension decision- making The opinion/performance analysis: Linked data on respondents’ opinions to their companies’ financial and pension performance Publicly available data collected from filings of 65 public companies that participated in the survey © 2008 Towers Perrin 2
  • 4. A solid majority of companies focus on eradicating risk from their pension portfolios, as opposed to increasing returns In your opinion, is your company more likely to focus on increasing the return on, or managing the risk in, its pension portfolios in the next several years? Asset intensive: 85% 24% Labor intensive: 67% Asset intensive: 15% Equity %: Hi 83% Low 68% Labor intensive: 33% Assets/cap: Hi 85% Low 68% 76% Percentage of all respondents Company will reduce risk more than seek higher returns in its pension portfolios Company will seek higher returns more than reduce risk in its pension portfolios Source: CFO Research Services. © 2008 Towers Perrin 3
  • 5. Why? Concerns about cash and compliance top the list of reasons What aspects of your DB plan do you expect senior management to be most concerned about over the next 24 months? Cash & Compliance Impact on our cash flow 38% Plan sponsors must be sure they have the Conforming to regulatory requirements 35% cash they need to run their business — Impact on our income statement 27% especially at a time when credit is not Impact on our current employees 21% always readily available. A return- Impact on our balance sheet 20% focused investment Impact on recruitment and retention 12% strategy could result in needing to make Impact on our credit rating 8% contributions at a time when they can least Impact on public perception of our company 6% afford it Other 3% 0% 10% 20% 30% 40% Percentage of all respondents Source: CFO Research Services. Note: Respondents were asked to select up to two. © 2008 Towers Perrin 4
  • 6. While a sizeable number of respondents have closed or frozen their plans, very few have terminated them In what ways, if any, has your company How likely is your company to take any changed its DB plan design or offerings of the following actions over the next 24 since 2000? months with respect to your DB plan? We closed existing DB plans to new employees while continuing 36% benefit accruals for current employees Replace DB plans with defined We replaced DB plans with contribution (DC) plans, cash- 31% 20% defined-contribution (DC) plans outs or other alternatives 28% or shifted contributions from DB to DC plans Close plans to new employees, We offered new DB plans to 22% but continue benefit accruals for 23% 20% current employees current employees We closed existing DB plans for all employees and froze benefit 19% Convert to hybrid plans (e.g., accruals 24% 9% cash balance) We converted DB plans to hybrid 15% plans such as cash balance plans Close plans and cease benefit 20% 11% accruals for all employees We terminated DB plans for an 4% ongoing line of business Terminate some or all plans 18% 10% None of the above 22% 0% 20% 40% 0% 20% 40% 60% Percentage of all respondents Note: Respondents were asked to select all that apply. Somewhat likely Very likely Source: CFO Research Services. © 2008 Towers Perrin 5
  • 7. It’s portfolio management — not settlement or risk transfer—that proves the most common approach to managing risk In your opinion, how likely is your company to adopt the following methods for managing pension risk? Likely Ongoing Liability-based asset 15% 30% 20% 28% 7% management Management Respondents have a Decrease equity clear preference today exposure in pension 12% 30% 32% 20% 7% for managing the risk portfolio as opposed to transferring or settling Transfer of plan to the risk third party 7% 21% 22% 45% 6% Settlement with life 7% 20% 20% 46% 7% insurer Captive insurance 8% solutions 6% 17% 18% 52% 0% 25% 50% 75% 100% Percentage of all respondents Very likely Somewhat likely Somewhat unlikely Very unlikely Don't know Source: CFO Research Services. © 2008 Towers Perrin 6
  • 8. Market/economic performance, competitors and regulation have driven change in plan design Which of the following external events contributed most materially to the decisions your company has made in DB plan design since 2000? Performance of the economy or 45% financial markets Competitors' pension 40% policies and offerings Changes in retirement 37% program regulations Increased investor demand for 18% profits and financial strength Increased scrutiny of risk 17% management practices Other 11% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Percentage of all respondents Source: CFO Research Services. Note: Respondents were asked to select up to three. © 2008 Towers Perrin 7
  • 9. Some takeaways and insights Companies intend to focus more on risk reduction than on higher return generation over the next few years Most companies have adopted an incremental approach to pension plan design. However, the next step for a plan that is completely frozen is a full termination, which respondents say is not in the cards Companies indicate they are trying to coordinate their pension risk strategy with a broader enterprise framework — but find this a challenge There is strong interest in LDI — which is in line with companies having stated a clear preference for risk management over generating return Agreeing on a pension risk management strategy is often difficult because it involves trade-offs © 2008 Towers Perrin 8
  • 10. On the issue of risk — key risks in a defined benefit program Type of Risk Source Market risk posed by investments held in pension trust (equity volatility, credit risk, currency risk, etc.) Market risk Market risk can be compensated: Greater returns are expected in the long run for greater risk undertaken Risk posed by inflation rate changes, changes in spreads and yield Interest rate curve shapes, pension asset/liability mismatch risk Interest rate risk is not compensated: Greater returns are generally NOT expected from interest sensitivity mismatches Demographic Risk posed by participant longevity and embedded design options risk (e.g., lump sums, early retirement subsidies) Regulatory Risk from regulatory changes risk Asymmetric risk of surplus rules Operational Plan governance risk Plan administration These risks can be managed! © 2008 Towers Perrin 9
  • 11. Plans are taking an incremental approach to plan design change Ongoing Soft Freeze for Hard Freeze DB Plan New Entrants + DC Plan Ongoing Hybrid DB Hard Freeze DB Plan for All + DC Plan Once a plan is in a hard freeze, the decision to exit has been made — it’s only a question of when, at what pace, and through what tactics © 2008 Towers Perrin 10
  • 12. Managing pension risk within an enterprise context means assessing both pension plan and company performance under a range of economic scenarios High Growth Good times Overdrive Pension ? + Pension Business + + Business Low inflation / High inflation / Low interest rates High interest rates Pension - ? Pension Business - - Business Perfect Storm Stagflation Low Growth © 2008 Towers Perrin 11
  • 13. What do market and interest rate risk really mean? A typical defined benefit plan has: Assets. An asset allocation of 60% equities/40% fixed income Liability. 60% of its liability is for “inactive” participants; liability duration of 12 years $1,120M $1,120M 3 Ways to Decrease Interest Rate Risk $1,018M $1,000M Increase fixed $1,000M $940M income allocation Increase fixed income duration Use derivatives Invest in portfolio whose 10% 1% decrease movements decrease in in discount mirror those of Equities rates the liabilities Assets Liabilities Fully Funded $60M Deficit $102M Deficit Fully Funded © 2008 Towers Perrin 12
  • 14. With the risks identified and objectives set, the strategy starts to fall into place © 2008 Towers Perrin 13
  • 15. Panel discussion Q&A Our Panelists Sylvia Pozezanac Sam Knox Monica McIntosh Managing Principal VP and Director of Managing Principal Retirement Risk Solutions Research Asset Consulting Towers Perrin CFO Research Services Towers Perrin New York, NY Boston, MA Toronto, Canada (212) 309-3663 (617) 345-9700, Ext. 243 (416) 960-2674 sylvia.pozezanac@towersperrin.com samknox@cfo.com monica.mcintosh@towersperrin.com © 2008 Towers Perrin 14