Segmentation: The dawn of a new risk management strategy
Managing the risks of a defined benefit pension plan is among the main concerns of many plan sponsors. Think you’ve heard everything on the subject? Guess again! Segmentation, an innovative investment strategy, makes it possible to better manage risks without increasing contributions. Too good to be true? You be the judge!
The segmentation strategy was designed to efficiently manage the risks of a pension plan’s maturity. The strategy consists of building separate investment portfolios for two groups of members at a given date: the group of retired members at that date and the group of active members.
- A matching fund, for which an investment strategy focused on managing interest rate risks is adopted, is created to support the payment of pensions of the group of retired members at segmentation.
- A balanced growth fund, for which an investment strategy with high exposure to growth assets is adopted, is created to support the liabilities of active members. The evolution of the maturity of this group of active members, which will eventually include members who will retire after the segmentation date, will guide the evolution of the balanced growth fund’s investment strategy.
An important feature of this strategy lies in the fact that there are no transfers between the two groups after the segmentation date, making it possible to adopt specific and truly independent investment strategies based on each group’s demographics. Separate reflection process, separate goals, separate strategies.
In addition to improved maturity management, a significant benefit of the strategy lies in the plan’s funding. Indeed, as segmentation requires the real and physical creation of two separate investment portfolios for groups of specific members, the strategy allows for the use of two discount rates:
- The liabilities of retirees at segmentation is valued using a discount rate based on the matching fund’s expected return.
- The liabilities and service costs for active members at segmentation are valued using a discount rate based on the balanced growth fund’s expected return.
The higher expected return of the balanced growth fund, optimized according to the demographic profile of the group of active members, allows for the implementation of the strategy without increasing contributions with respect to service costs. It can also lead to the adoption of margins in determining the discount rate of the group of active members to be used as a contribution stabilization tool.
The strategy also includes the following benefits:
- Can be applied in most jurisdictions, notably for plans registered in Quebec and federally registered plans.
- Aside from the creation of two separate portfolios, the strategy’s implementation has no impact on the operation of the plan. One single plan, one financial statement, one actuarial valuation, etc.
- The creation of the matching fund can be an interim step toward an annuity purchase, when conditions are favorable.
Given the significant improvement of pension plans’ financial situation on a going concern basis in recent years, the ideal conditions are now in place to reduce risks and stabilize your future contributions. Will you seize this opportunity?
Backed by more than 25 years of experience, our specialists have assisted several clients in the development of risk management strategies. We can help you to pursue your thoughts. Contact us today!