A Stochastic Analysis of Policies related to Funding of Defined Benefit Pension Plans

Canadian jurisdictions have reformed their pension legislation that governs the funding of defined benefit (DB) pension plans. They have moved to a new funding model (known as “going concern plus”) that puts less emphasis on solvency funding while strengthening the requirements for going concern funding. The paper focuses on policies that are likely to have major impacts on the risk and cost of a pension plan under the new funding model. They include investment policy, surplus policy and funding reserve policy. The paper presents a pension projection model that enables us to project the assets, liabilities and funded ratio of a pension plan over an extended period, without having to specify the plan’s benefit provisions and the demographic data of its membership. By applying the model to a stochastic economic environment, we are able to gain insights into the uncertain nature of pension funding dynamics.
We explore the long-term impacts of the aforementioned policies, in terms of the variability in the funded ratio and the risk of the plan being underfunded. Going concern funded ratio (ratio of assets to liabilities) is employed as the key metric for evaluating funding risk. We obtain insights into the tradeoff between funding costs and the risk of the funded ratio for different investment mixes. Asymmetrical treatment of surpluses and deficits could increase a plan’s exposure to the risk of underfunding over time. Furthermore, including a funding reserve or provision for adverse deviations (PfAD) in the funding requirements could help improve the funding level of a plan and reduce its risk of being underfunded in the long term.
We design a risk-based PfAD to meet the long-term funding goal (target funded ratio) of a DB plan. A plan with a riskier investment policy will require a higher level of PfAD. Our analysis also suggests that membership profile is not a primary driver of funding risk, and the PfAD stipulated in the funding reserve policy for a plan should vary in accordance with the evolving funding position of the plan. Insights captured from our modeling results may support pension regulators or policymakers in developing appropriate funding policies, to ensure pension plans will operate effectively over the long term.
 
Find the Q&A here: Q&A on 'Pension Issues in a Changing World'