Pension funds not immune to volatility

By Bryan Borzykowski | July 10, 2008 | Last updated on July 10, 2008
3 min read

Almost no one has been spared during the past year’s market meltdown, including pension plan sponsors. A Watson Wyatt report finds that in the past six months, pension funded ratios have been careering wildly due to extreme market volatility.

In the first two months of the year, pension funded ratios dropped three points to 103%, then spiked eight percentage points from March to May, before falling four percentage points, to 107%, in June.

“If you look at the starting point at the beginning of this year and then in June, not much has changed,” says David Burke, Watson Wyatt’s retirement practice director. “But the biggest story is what’s happening in between.”

Burke says the volatility has been driven by unstable equity markets and the yield on AA corporate bonds. The corporate bond yields have compensated for the drop in equity markets, and that can explain the slight net improvement. It also helps that there are big spreads between corporate bonds and Government of Canada bonds.

But Burke is worried that the spreads may be too high and that if levels return to normal, the effect on pension funded ratios could be significantly negative.

Clients who are betting on their pension plans for retirement don’t have to worry, though. Burke says that in the short term, these wild swings aren’t that significant. “What this means is that the plan impact on the balance sheet is going to be more negative or positive depending on what happens in the market,” he explains.

“Plan sponsors might look at the financial position of the plan itself on a cash basis,” he adds. “That has probably deteriorated because asset returns haven’t been very good.”

It’s unlikely pension plan members will really know how well their sponsor is doing right now, as most plans report at the end of the year, not midway. If the markets improve, the drop that Watson Wyatt is seeing will be just an insignificant blip on the radar. “However, if things don’t pick up,” says Burke, “this is a potential indication of what the future holds.”

If ratios continue to drop, Burke says, plan employees still might not feel the effect. “This is not a defined contribution plan, where if the market goes down 3% the value of the pensions drop 3%,” he says. “In this case, the financial position deteriorates. It won’t have a direct impact, but it might have longer repercussions.”

While this short-term forecast isn’t a reason to panic, it should get sponsors rethinking their investment strategies. Burke says the drop in pension funded ratios means there’s a mismatch between the way liabilities are moving and investment assets.

“If the sponsor wants to earn an appropriate return in investment, consider the fact that he’s really trying to beat the liabilities, not the guy across the street,” says Burke. “In other words, make sure your assets are increasing more than liabilities.”

Burke adds that plan sponsors might want to reconsider their risk profile. He says they should be thinking about their level of risk, and if they can manage it through their investment strategy or by changing the plan. “The key question is ‘How much risk can I absorb, and under less than ideal situations, how much can I afford?'” he explains. “That should be the driving decision around everything else.”

But just because a plan sponsor is reviewing its strategies, that doesn’t mean it should make changes just yet. Burke says there’s no need to do anything drastic. Instead, plan sponsors should watch the markets, and their ratios, a little closer. “This is about being on top of things. If the market keeps dropping, people shouldn’t be shocked when in December they get a nasty surprise,” he says. “This is more about observation and due diligence than about action at this point in time.”

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Bryan Borzykowski