By Evan Inglis
Why are corporate pension plans reducing risk now, when conditions for de-risking seem so poor – interest rates are lower than low, and equities seem to offer reasonable if not favorable opportunity? In a nutshell, the question of how to invest pension assets is becoming a corporate finance issue rather than an investment issue. The corporate finance view looks at the pension plan from the perspective of a shareholder in the plan sponsor’s business. Plans are bigger relative to the size of their plan sponsors than they used to be, and they cannot be ignored in thinking about the financial prospects of the plan sponsor’s business.
While pension accounting and funding rules still incorporate a lot of smoothing and averaging, they have moved close enough to pure market measurements that short-term volatility in the funded status is an issue. Despite the conventional wisdom that pension plans are long-term investors, most corporate pension plans can no longer take this view. Although the transition is slow for many, corporate pension assets are being allocated with a shorter term view in mind.
There are number of reasons why the corporate finance view of pension investing leads to very different approaches than have been used in the past. These include:
- Business results are cyclical and equity investment makes pension costs cyclical as well. Another way to say this is that corporations double up on beta (their own corporate beta, plus the beta in their pension investments) to the extent that they invest pension assets in equities.
- Unpredictable pension results causes lots of problems for a corporate plan sponsor. Some of the problems relate to the plan itself (such as additional notices and benefit restrictions). Other problems include difficulty in planning capital expenditures, hits to balance sheet equity and investor concerns about uncertainty in earnings and cash flow.
- Uncertain pension information results in a higher required return for a corporation’s equity. Because future earnings become less predictable, a higher return is demanded on equity investment. Equity investment in a pension plan adds no value for a corporation.
- Financial stakeholders in a corporation have access to all the equity exposure they want. Their individual efficient frontiers (presumably) guide their investment decisions and additional equity exposure through corporate pension plans is less efficient and effective than an investor simply allocating more assets to equity directly in his/her portfolio.
- Because bonds are taxed at a higher rate than equities, equities provide less compensation for the risk taken when they are held in a non-taxable pension trust.
- When financial analysts look at a pension plan sponsor’s financial information, they typically reverse out the smoothing in pension expense information. They may also expand the balance sheet by consolidating the pension assets and liabilities similar to the way a subsidiary would be treated. With this view, key financial metrics such as the debt to equity ratio look very different and the risk posed by the pension assets and liability is apparent.
The investment perspective for a pension plan focuses on the pension plan by itself, without the context of the sponsor’s business. We typically use the capital asset pricing model (CAPM) and asset-liability studies to find the asset allocation with the best risk/return tradeoff. This is a useful model, but it doesn’t usually capture the impact of risk taking on the business and the owners of the business. Still, even limiting our view to this investment perspective, the wisdom of making large equity investment in corporate pension plans can be questioned for these reasons:
- The equity risk premium is smaller for pension plans, given that the lowest risk investment is long duration bonds, the compensation for taking on equity risk is smaller than for other investors.
- Many pension plans have short time frames for equity risk to pay off. Frozen plans will be forced to be fully funded within seven years by PPA rules1.
- Most corporate pension plans intend to reduce their equity exposure over the next several years, which may put downward pressure on equity prices and upward pressure on long bond prices. First movers out of equities and into long bonds may have an advantage.
It’s hard to get excited about investing in bonds with yields as low as they are in the middle of 2012, but for corporate pension plans, the problems with mismatching assets and liabilities have become all too apparent during the 2000’s. It’s ironic that the de-risking of pension plans has accelerated as interest rates have dropped.
Why has it taken so long for these compelling considerations to become drivers of pension plan investment strategies (indeed, even today many plans have still not made this adjustment) and other de-risking?
If we wound the clock back 30 years, and looked at pension plans at that time, we would find much smaller, younger plans. Smaller plans did not have the same impact on corporate finances and the corporate finance perspective could be ignored without causing problems. Plans grew dramatically during the 1980’s and 1990’s but during that time, consistently high equity returns masked the potential financial problems that plans might pose and plan sponsors, actuaries and investment professionals, did not need to learn good risk management. However, as we move through time to the 2000’s when equity markets took a turn for the worse, we also find rules that changed to recognize the financial situation of pension plans more immediately and directly. Plan liabilities had grown large as populations aged and interest rates dropped, so pension plans had a bigger impact on businesses.
As of 2012, tough lessons have been learned and plan sponsors are changing their approach, some slowly, some dramatically. Not all of them are conscious of the shift from an investment perspective to a corporate finance perspective, but the actions (closing, freezing, lump sum settlements, and group annuity purchases) tell the story. Buying a group annuity contract or offering lump sum payments to participants are, from a risk management perspective, very similar to investing in long duration bonds. All of these actions lock in costs and we have seen very large initiatives (e.g., at GM, Ford, Verizon) in 2012 to do just that, even with interest rates at historical lows—good evidence that perspectives have changed.
For actuaries and investment professionals working with pension plans, it may be useful to describe explicitly the corporate finance considerations to DB plan sponsors who are struggling to deal with pension risk. Essentially, we want to encourage plan sponsors to see the financial impact of a pension plan from a shareholder’s point of view. This may lead to more satisfactory outcomes over the long run. Many pension plans will not survive the economic turmoil of the last decade, but even the ones that may terminate in the near future will benefit from good risk management by understanding the plan in the context of the plan sponsor’s business.
Evan Inglis, FSA, CFA, is principal and chief actuary at Vanguard, Investment Strategy Group in Wayne, PA. He can be reached at r_evan_inglis@vanguard.com.
1MAP-21 legislation may effectively extend this period when the lower bound of the interest rate corridor applies.