March 19, 2006

Pension shortfall
Advisors should take a cue from Teachers

The Ontario Teachers' Pension Plan recently announced that, despite another year of solid returns, its shortfall continued to widen. For a pension plan that has returned an annualized 11.7% per year since 1990 and 17.2% in calendar 2005; this may be confusing. But a peak into the underlying math should help clarify their situation and how it could affect decisions to take control over pension commuted values (instead of leaving money in the plan).

A bird in the hand . . .

At the end of 2004, OTPP had assets equal to 84% of the present value of its future pension obligations. After a solid year of 17.2%, the plan is now just 77% funded. As counter-intuitive as it seems, understanding the concepts of 'time value of money' and 'duration' can help explain why OTPP faces a rising funding liability despite solid returns.

The time value of money concept basically holds that a dollar today is worth more than a dollar at some future time. If interest rates are 5% today, you can take about $95, invest it at 5%, and receive about $100 in a year. If interest rates are 4%, then you'll need more money today - $96 (about 1% more) - to make sure you have $100 in a year's time.

Larger interest rate moves will cause larger changes in the amount of money needed today to provide for some future amount. Continuing with the above example, if rates fell from 5% to 2%, the amount needed today (to make sure you have $100 in a year) would rise from $95 to $98 (an increase of about 3%).

Interest rate sensitivity

A measure of interest rate sensitivity, 'duration' is basically the number of years needed to recoup your original investment when adjusted for the time value of money. The further out in time your future goal, the more sensitive will be the amount you need to invest today to reach that eventual goal (i.e. the higher the duration).

Again continuing the previous example, let's say that we instead needed $100 in 10 years (instead of just one year). Invested at 5% per year, you'll need just $61 today to make sure you have $100 in 10 years. If, instead, you can only earn 2% per year on your investment, you'll need more than $82 today to grow to $100 ten years forward (an increase of more than 34%).

To summarize, the amount of money needed today to fund some future goal rises (falls) directly with: i) the amount by which interest rates fall (rise), and ii) the number of years until your future goal.

Asset-liability matching

So, how does this affect OTPP's funding status? First, it's important to understand that pension plans try to match their defined liabilities (i.e. members' current and future pensions), with investments that are also 'long-duration' and interest-rate-sensitive. So, long-term bonds are ideal matches for funding pension liabilities. But pensions run into a mismatch problem.

The 27-year Government of Canada Bond maturing on June 1, 2033 bond only has a duration of about 15 years. By contrast, OTPP's pensions are going to be paid out for several more decades, which might imply a 'duration' of those liabilities in the range of 50 years. This is more than triple the duration of one of the longest maturity bonds available - hence the mismatch.

With all of this background, consider that long-term bond yields in Canada fell nearly 80 basis points (i.e. 0.8 percentage points) during calendar 2005.

Using an admittedly crude calculation, an 80 basis point decline in long-term rates in one year could drive up the present value of future pension liabilities by some 30%. Again, that's a rough estimate. And despite the excellent 17.2% return that OTPP generated last year, it becomes clear why the plan shortfall continues to grow. It also demonstrates why OTPP (and other big plans) have been buying up real estate and other higher-return investments in an attempt to keep pace with the rising cost of its future pension liabilities.

Impact on pension transfers

While advisors don't use actuarial calculations for retirement plans, they should take notice when a group as skilled and efficient as OTPP can't keep up to the pace of rising pension liabilities. Managing an individual retirement portfolio is certainly different but the decline in rates has similar implications.

While falling rates has nicely pushed up stock and bond prices, it also means that future will likely be leaner. For instance, buying bonds in the late 1980s provided not only coupon payments above 10%, but subsequently falling rates really juiced returns with the kicker of rising prices (i.e. bond prices rise when bond yields fall). Good luck getting double digit returns out of bonds that now yield 4% and could see prices fall if rates rise.

One could argue that allocating more to stocks is the answer. That can work for a while but once a portfolio is tapped for regular cash flow, keeping volatility to a minimum is imperative. And that's a constraint that doesn't fit with a stock-heavy portfolio.

In short, advisors must use sober return projections when estimating how much cash investors can expect to take from their portfolios month after month. A return target in the mid-to-high single digits is reasonable to expect. But better to design plans on some lower figure to account for uncertainty and volatility. This is not meant to deliberately 'under promise and over deliver' - but rather to reduce the risk of disappointment and regret. It's just prudent planning.