Issues in Pension Program Management

1. Issues in Pension Program Management June 14, 2004

2. Overview • Overview of the Universities pension landscape • Risk management • Governance • The Universities’ Forum

3. The Pension Landscape • Terminology • DB = Defined Benefit • Promise is a monthly pension • Determined by formula typically based on service and earnings • Typically risk rests with the sponsor • DC = Defined Contribution • Promise is specified contribution • Accumulates with investment returns • Lump sum value at retirement • Risk rests with the member

4. Pension Plan Income Replacement Ratios

5. The Pension Landscape • Basic history over the last 15 years: • Federal and provincial pension legislation reform in mid 1980s through early 1990s resulting in: • Increased minimum funding requirements • Limited RRSP room for many DB participants • Maximum transfer limits for DB plans • Maximum surplus limits in DB plans • No guidance on surplus ownership • Maximum pension limits that were frozen until 2004 • Different (yet similar) minimum standards legislation across each provincial jurisdiction

6. The Pension Landscape • Basic history over last 15 years (cont’d) • Strong investment returns from equity markets and falling interest rates through most of the 1990s resulting in: • surpluses in DB plans • DC plans appealing to employees – more conversion to DC primarily in the private sector • disputes over surplus ownership • Contribution holidays / improved DB benefits

7. The Pension Landscape • Basic history over last 15 years (cont’d) • Market setback in 2001-2002 with interest rates remaining low resulting in: • Disenchanted DC participants • Disenchanted DB sponsors • Significant deficit issues • Forced into benefit improvements / contribution holidays when surplus too high • Benefit promises are unaffordable in many cases

8. The Pension Landscape • Basic history over last 15 years (cont’d) • On top of all of this: • Complexity of having to deal with 11 different legislative jurisdictions • Rising administration costs • Need to implement supplemental plans for executives and quite possibly middle managers • Demands for improved pension governance • Increased fiduciary liability concerns especially around DC plans • Limited flexibility for phased retirement

9. The Pension Landscape • Sponsors questioning why they are sponsoring a pension plan? • Becoming an increasingly important element of an employee’s compensation • Proponents of a looming labour shortage forsee the importance that pension plans will play in recruiting and retaining key talent

10. The Pension Landscape • Within University circles, the influence of the past 15 years has resulted in many different combinations of plan designs: • DC with / without investment options • DC without investment options and DB minimum • DB with a DC minimum • Traditional DB with various forms of risk sharing • Converted Plan – closed DB and DC for new hires

11. The Pension Landscape • Challenges associated with University plan designs • General: • Is the pension deal clear and fair • Past use of surpluses to improve benefits • DC with / without investment options • Adequacy of benefits • Education – liability for bad decisions • DC without investment options and DB minimum • Adequacy of benefits better • Costs of DB minimum can be volatile • Liability associated with offering single DC fund

12. The Pension Landscape • Challenges associated with University plan designs • DB with a DC minimum • More “tools” to manage cost volatility but costs can be significant • Impact of maximum transfer limits • Traditional DB with various forms of risk sharing • Significant costs (regardless of who pays)

13. The Pension Landscape • Challenges associated with University plan designs • Converted Plan – closed DB and DC for new hires • DC challenges – adequacy of benefits and education • Added DB challenges: • evolution of the investment policy • evaluation of the current financial position • the surplus tontine

14. Risk Management • Risk management has become an important focus in past five years: • Old risks become material • New risks emerge • Approaches to pension risk management are evolving: • no risk management • identifying • evaluating

15. What are the Risks? • Traditional measures of risk have been: • Fluctuating contribution rates • Deficits and additional funding • Deficits and reduced benefits • Risks that are gaining much more attention: • Excess surplus and having to improve benefits • Thin line between being conservative and creating intergenerational inequities • Legal liability - not fulfilling fiduciary responsibility • Inadequate pension incomes

16. What are the Risks? • Key financial related risk measures are influenced by: • Hiring practices • Investment performance • Asset / liability mismatch • Early retirement programs • Longevity • Key fiduciary liability related risk measures are influenced by: • Governance practices • Administration • Member communication

17. Approaches to Managing Risk • Identification • Education – increasing awareness • Shifting priorities from transactional to strategic • Controlling expectations – defining the “pension deal” or who should bear the risk

18. Approaches to Managing Risk • Quantifying • Evaluation of margins in assumptions • Efficient frontier analysis for investments • Stochastic modeling or projected valuations of financial factors • Models impact on plan of repeating history into future under different benefit, funding and investment polices • Obtaining legal opinions • Benchmarking practices

19. Approaches to Managing Risk • Evaluating • Examining all pension risks in a holistic fashion • Assessing reserves – both within and external to the pension plan • Evaluating pension risks in context with other non-pension risks • Contrasting pension risks to benefits

20. Approaches to Managing Risk • Organizations have typically “signed-on” for identification • Many are or have moved forward to quantification • Most struggling with evaluation due in large part to: • pension risks only recently creating concerns • Managing of pension risks are often viewed as being “external” to the sponsor

21. Approaches to Managing Risk • Generally, organizations find pension risks harder to manage because: • Longer tail liabilities • Conflicting expectations • Fiduciary responsibility – may differ from institution’s objectives

22. Evolution of DC Risk Management • Increase in DC plans has introduced a different set of risks that need to be managed • Risks with which DC sponsors currently struggle: • Where to reside on the communication continuum (I.e. information vs. education vs. advice) • Where to reside on the investment continuum (I.e. the degree of investment choice to offer) • Level of risk passed on to employees • Recent CAP guidelines expected to help clarify (?)

23. Governance • Significant attention now being paid to pension plan governance • A result of similar factors giving rise to increased focus on corporate governance • Added dimension stemming from fiduciary responsibility recognized in statute and trust law • Current state: • General concern expressed by regulators • Guidelines established for industry standard • Self assessment and regular governance reviews becoming common place

24. Governance • Issues being encountered: • Assessment and review can be perceived to be overwhelming • Realigning risks with control • Expense control • Enhancing investment structures

25. Governance Issues • That “overwhelming feeling”: • CAPSA guidelines are considered comprehensive • Roles / responsibilities / delegation • Risk management / monitoring / objective setting • Communication / information flow • Where “revolutionary” approach taken – concerns this may be adding to governance risks • Where “evolutionary” approach taken – concerns that evolution is not rapid enough

26. Governance Issues • Realigning risks with control: • Governance reviews can lead to a realization that those taking the risks do not necessarily have appropriate control • Can lead to renegotiation and/or clarification • Particularly important in DC environments

27. Governance Issues • Expense controls • Expenses paid from pension plan funds have come under significant scrutiny • General rule - only expenses which result in a direct benefit to the members can be paid from the plan • At the same time, sponsor costs are increasing as is desire for sponsor to charge plan for “services rendered” • Ambiguity surrounds expenses such as accounting costs, governance reviews and pension design

28. Governance Issues • Enhancing Investment Structures: • Growth of pension plan assets has led to “creative” investment approaches • Typically, investment policy is handled by a pension / HR committee of the Board • Consideration now being given to separating the pension investment function from the broader pension governance framework • Theory is that it results in more effective investment management • Continued search for the “holy investment grail” – alternative investments, private placements, real estate, etc.

29. Universities’ Forum • Forum of pension plan reps from various Western Canadian Universities sponsored by Aon • Session took inventory of key pension issues currently being faced • Discussion of issues followed

30. Universities’ Forum • Key discussion points: • Funding policy for DB plans • Maximum surplus limits • Sustainability of current benefit and contribution levels • Communication and education policies • Information vs. education vs. Advice • Formal communication needs assessment - none

31. Universities’ Forum • Key discussion points (cont’d) • Investment policy • Asset Liability Management (ALM) • Alternative investments – exploring but not significant interest yet • Foreign investments – significant number use derivatives to exceed cap – some as high as 45%

32. Universities’ Forum • Key discussion points (cont’d) • Governance • Structure – significant diversity • Communication to membership – how much? • Protecting the “volunteer” • DC liquidation strategies • Significant interest in offering RRIF through registered plan • Use of variable annuities – limited use in future as no new ones can be setup

33. Questions / Comments