Although nobody squirrelling away their income into pension funds wants to see their savings invested in risky assets, a certain level of risk is necessary in order to get the best possible return for customers. In order to avoid any serious pitfalls, managers employ stringent and methodical risk strategies.

A widely held principle is that risk management strategies must evolve and react to changes in the market. This also applies to the wider regulatory framework that the pensions systems operate in, and countries worldwide have looked at ways in which they can reform their pension systems in order to cater for the rising number of retirees.

In Canada, reforms to the pension industry have proven difficult to implement as the government has struggled to form a consensus over the issue of how to sustain the country’s pension pot. One of the country’s leading pension funds, the British Columbia Teachers’ Pension Plan (TPP), has been looking at ways it can change the way it manages risk, and is one of several Canadian public sector pension plans that have been pioneering new risk-sharing and governance arrangements.

World Finance spoke to Linda Watson, Chair of the BC Teachers’ Pension Board of Trustees, about how the changes in risk management have been implemented and why they were necessary.

Sharing risk
The TPP employs two distinct strategies to share risk between members and employers. “The TPP has shared sponsorship risks of the plan equally since 2001,” says Watson. “If an actuarial valuation indicates financial or demographic losses, the plan’s contribution rates must be increased equally for members and employers. The second strategy is that the TPP works hard to offer a fully indexed pension; however, the plan’s defined benefit pension promise extends only to the non-indexed pension. The inflation adjustments are sustainably pre-funded but they are contingent benefits. It is the plan members who bear the risks associated with funding inflation protection.”

The two approaches have been used to create a unique strategy that is different to the traditional defined-benefit and defined-contribution plans used elsewhere. “Together these features produce a financially and politically sustainable framework. Governance arrangements and supporting service organisations have been structured to reflect the risk sharing arrangements.”

The TPP was inspired to discuss changing its risk-sharing and governance arrangements towards the end of the 1990s by a desire for greater involvement from the teachers in governance issues. “At that time the TPP had an unfunded liability, but financial markets had been performing well and the unfunded liability was diminishing,” says Watson. “The teachers, represented by their union, the BC Teachers’ Federation, wanted to share in the improving financial position of their plan and to participate fully in the governance of the plan. The British Columbia government, as sole sponsor of the plan at that time, was willing to share control of the plan and was also seeking to share the plan’s financial risks. Other BC public sector pension plans (the College, Public Service and Municipal plans) were in similar situations. The key stakeholders in each of these sectors also negotiated a shared governance model with the government.”

The old way of sharing the financial risk gave the government more control than members, which led to resentment at a lack of say in the decisions of the fund. “Under the old arrangements, the government, as the sole sponsor, was responsible for any unfunded liabilities, had the sole claim on any surpluses, and had full control over the plan’s governance, administration and investment management,” says Watson. “During good times, members could come to resent government’s access to surpluses and its control over all of the decisions and operations. During bad times, taxpayers could resent the cost of addressing public sector pension plan unfunded liabilities without any assistance from the plan members. There was a need for more equal sharing of both the governance and the risk bearing.”

Coming to an agreement with the government led to the formation of two entities that would help with the running of the public sector pension plans, says Watson. “First, the government created two new corporations that could provide appropriate support for self-governing jointly trusteed pension plans. The British Columbia Investment Management Corporation (bcIMC) and the BC Pension Corporation were formed to serve the Teachers’, College, Public Service and Municipal pension plans.

“The government also provided a legislative framework within which the stakeholders of each public sector pension plan could negotiate new joint governance arrangements. Each of the province’s large public sector plans was given the option of staying with the status quo, or shifting to new governance and sponsorship arrangements.”

Watson adds that each of the stakeholders had to agree to the new governance structure before it was implemented. “For any sector wanting to move to new pension arrangements, all of the identified stakeholders in the sector had to agree on a new framework. None of the participating partners or sectors would be compelled into new arrangements that they did not support. The government also agreed to fulfil its responsibilities under the old governance arrangements, and also to exercise its claims on surpluses, before transitioning to joint governance. For the TPP, this meant that the government addressed the TPP’s unfunded liability before transferring responsibility for a fully funded plan to a new board of trustees.”

Good for the community
The new framework provides more value to members in the form of increased savings, meaning a more secure retirement compared to those without a pension.

[A] certain level of risk is necessary in order to get the best possible return
for customers

The income also benefits the wider community. According to a recent economic impact study, public sector pension plans in British Columbia tend to offer benefits to the whole of the Canadian economy and communities, as well as individual plan members. This is because they increase domestic investment, while also ensuring the country has more investment capital. Another advantage is that plan members are better prepared for their retirements so do not rely on government programmes that supplement low incomes, and self-funded plans do not rely on future or previous generations to sustain them. In fact, investment returns fund 80 percent of the pension benefits paid to plan members.

Investment decisions have evolved from the new governance arrangements so that they are free from the political constrictions of before, says Watson, as well as encouraging more responsible investment practices. “The inclusion of an investment management corporation in the new governance model was intended to ensure that plan investment decisions are made independently and free from political influence.”

Watson says that the key features of the Teacher’s Pension Plan strategy are threefold – strong governance, an exemplary fiduciary role, and responsible investing. She says that well-managed and well-funded defined-benefit public sector plans are sustainable in British Columbia, as they have a proven track record of being able to endure challenging economic times, in part due to the sharing of risk in the joint trusteeship. The responsible investing strategy places particular emphasis on environmental, social and governance concerns being factored into investment decisions in order to manage risk, protect capital, and generate long-term value for the pension fund.

“The Teachers’ Pension Board of Trustees has maintained an emphasis on responsible investing, and encouraged bcIMC to make responsible investment considerations part of all of its investment and risk management decisions,” says Watson. “The board has also shifted asset allocations gradually to a more global exposure, and toward less liquid asset classes such as real estate, infrastructure, and private equities. We take a proactive approach to assess innovative investment ideas, while also ensuring that strong investment performance and financial growth are achieved through diversification.”

The bcIMC, which manages the assets of 40 institutional clients, now has a global portfolio of more than $100bn, and is one of Canada’s largest institutional investors within capital markets.

Watson says that since the changes to the TPP were implemented, all the key stakeholders have remained very supportive of the joint trusteeship. This is due in part to the very low management expenses, while the service to both employers and members has greatly improved. The success of the TPP, along with the other BC public sector pension plans, has even led Moody’s Investor Services to cite British Columbia’s public sector pension plans as one of the positive factors that support the province’s AAA credit rating.