- Pension Issues Likely to Come in Threes for Execs
hree
hot pension issues that got even hotter because of the huge financial crisis will
preoccupy corporate executives over the next three years.
The first could be the hardest: Keep or freeze the defined benefit plan.
Myriad pressures—including volatile investment returns and their unnerving impact on balance sheets, the cost of ever-rising participant longevity, and peer pressure from industry competitors and companies’ own boards of directors—will continue to goad corporate executives into ending traditional defined benefit plans in favor of defined contribution and hybrid cash balance plans.
Second on the list are pension liabilities. If a defined benefit plan is frozen—and in some cases, even if it isn’t—corporations likely will search for ways to move pension liabilities off their balance sheets and on to someone else’s. Industry experts agree that U.S. regulations probably won’t ever allow companies to unload pension liabilities on another company—a money manager, for instance—as is the case in the United Kingdom and Europe. But they think regulators eventually will permit insurers to create products that let corporations transfer pension liability risk, although the cost of that risk transfer might be prohibitive.
Finally, if the decision is to keep the defined benefit plan, corporate financial executives will be completely focused on asset management to meet pension funding requirements and smooth volatility.
Two approaches will prevail, according to financial executives. Those overseeing well-funded plans will manage assets to meet liabilities, known as liability-driven investing. Executives at companies with less well-funded plans will seek to maximize investment returns through the use of alternative investments, such as private equity, hedge funds, infrastructure, real estate and commodities.
"Anything that happens in the next three years with regard to defined benefit plans will be heavily influenced by the requirements of the Pension Protection Act of 2006," said Michael Hall, director, investment strategy, at money manager Russell Investments in Tacoma, Wash.
The PPA requires defined benefit plan sponsors to maintain higher funding levels, to value plan assets at market value quarterly and to account for the value of those assets on their corporate balance sheets, among other things.
"Pension plan sponsors used to have very long-term investment horizons, but that has really changed under PPA. Now with the requirement to mark to market under the Financial Accounting Standards Board, PPA really forces you to pay attention" to short-term investment returns, said William F. Quinn, chairman of American Beacon Advisors, which oversees the $9.1 billion pension fund of American Airlines Inc. in Fort Worth, Texas. Mr. Quinn also is chairman of the Committee on Investment of Employee Benefit Assets in Bethesda, Md., an association representing corporate defined benefit plans.
| THE THREE ISSUES |
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1 Should you keep your defined benefit plan, or freeze it? |
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2 Where do pension liabilities fit on your balance sheet—or do they at all? |
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3 Keeping defined benefit plans funded will mean devotion to asset management. |
"The No. 1 thing PPA did was to force defined benefit plans to pay attention to their funding and contribution levels," said Russell's Mr. Hall. "Quarterly performance determines whether the corporation must make a cash contribution to the plan and makes it a potential source of balance sheet volatility."
That volatility and the other regulatory changes wrought by the PPA will push more corporations to close their defined benefit plans, sources agreed.
For example, the PPA will force even frozen plans to be fully funded. Because those plans typically have declining liability levels, some will eventually have surplus assets. Once the assets are in the plan, "there’s not a real good way" to get the money out, said Robert J. "Bob" Leone, a principal in the Minneapolis office of Hewitt Associates LLC. He estimated that 30% to 40% of Fortune 500 companies’ defined benefit plans are frozen.
Trends down
"The fundamental question for society is whether we want
to save corporate defined benefit plans. Every financial incentive is pointed toward
their elimination. All trends now are toward winding down defined benefit plans,"
said Joe Craven, the New York-based senior vice president of American Century Investments
in Kansas City, Mo. Messrs. Craven and Quinn agreed that the only industries likely
to preserve defined benefit plans en masse are those with large, strong unions.
Other pension veterans are even more pessimistic.
"In my view, there’s really one issue, and that's retirement plans as we know them are going to be obsolete," said John Myers, retired president and chief executive officer of GE Asset Management Inc., which manages the defined benefit plan of General Electric Co. in Fairfield, Conn. Mr. Myers spent two decades managing the now $60 billion GE pension fund.
"It will be a slow, downward death spiral" for defined benefit plans, Mr. Myers said.
Tim Barron, president and CEO of consultant Rogerscasey Inc. in Darien, Conn., said U.S. industries "will have to get more intelligent about how they offer benefits."
"I think corporations may unite to offer strong defined benefit plans, along the lines of multiemployer pension plans or Australian superannuation schemes," Mr. Barron said.
"These industry plans will be attractive because they will keep these companies competitive with each other and the rest of the world, and it will definitely be cheaper for companies to pool the liability risk. It will be less expensive for these companies to self-insure than to pay an insurance company a 1.5% annuity fee to assume the liability risk," he said.
Mr. Barron was referring to the practice becoming popular with European corporate pension plans of insuring themselves against pension liability risk or selling their pension liability. In the U.S. corporate executives have talked about transferring pension liabilities, but widespread adoption is unlikely because of the cost.
"No one will go to full neutralization, the full assumption of liabilities, because the insurance will be so expensive," said American Century's Mr. Craven.
Barbara Novick, vice chairman of asset management giant BlackRock Inc. in New York, agreed. She noted that while insurance companies "are saying this will be a really big business, a pension close-out is not a trivial decision."
Ms. Novick said larger companies with small "orphaned" plans—defined benefit plans from acquired companies that are now closed to new participants—may find the idea of passing the liability on to another party appealing and affordable. But for larger defined benefit plans, the proposition probably is too expensive in this interest-rate environment, she said.
Sunny Patpatia, president and chief executive officer of Patpatia & Associates LLC in Berkeley, Calif., a management consulting firm focused on the asset management industry, agrees that cost is an issue. He also said that the Department of Labor would be unlikely to allow a corporation to transfer all of its liability to an insurer.
However, Mr. Patpatia said his firm is researching ways to pass some pension liability from a company he wouldn’t name to an insurer, thus removing that portion of the liability from the balance sheet.
Meanwhile, among executives at companies that keep their defined benefit plans, "what's most important to them is not writing any more checks for the pension plans," said Alan Dorsey, managing director and alternative investment strategist, Neuberger Investment Management in New York.
"This really brings the focus back to [investment] performance in order to bring up the funded status. Pension executives struggle with a yin and yang between wanting to immunize their risk when the market dips and making up performance when markets improve," Mr. Dorsey said.
Well-funded defined benefit plans are inclined to reduce their risk of equity volatility by using more long-bond swaps and more low volatility hedge funds of funds, he said. Less well-funded or underfunded plans are more likely to seek returns uncorrelated to equity markets by investing directly in hedge funds, private equity and portable alpha approaches. Sources said U.S. pension executives also might try to emulate their European counterparts by trying to find ways to hedge longevity risk, or sell that risk to the market. Russell's Mr. Hall, for example, said he thinks U.S. corporate plan executives will figure out a way to use derivatives to get rid of that risk.
'I think executives will try to set up a kind of mortality swap using the Goldman Sachs mortality index. It could be a trade you set up with an insurance company, but the trick will be making sure there are enough parties out there who want to be on the other side of the risk," Mr. Hall said.
Falling returns
American Beacon’s Mr. Quinn said the biggest challenge will be
meeting the funds’ 8% to 10% return expectations. "It is much harder to achieve
those levels than it used to be. People clearly are looking for other places to
find return."
To deal with lower expected returns, Mr. Quinn said he and his staff are upping the private equity allocation and actively seeking opportunistic investments in hedge funds, portable alpha, infrastructure and other absolute return strategies less correlated to stocks and bonds. And like many corporate pension plans, liability-driven investments play an important part in matching returns to future pension liabilities, he said.
Some experts believe that defined benefit plans will survive and possibly enjoy a revival.
"As employers feel the pain of an aging work force, they will see the value of [defined benefit] plans,” said Armand Yambao, principal at Ennis, Knupp + Associates Inc., Chicago. "It won’t be the 1970s version" of a defined benefit plan, said Carl Hess, global head of investment consulting at Watson Wyatt Worldwide in New York. "It’ll be DB 2.0."
—Crain's Benefits Outlook Online, November 2008
Christine Williamson is a reporter for Pensions & Investments in Chicago. Drew Carter is a reporter for Pensions & Investments in London. To comment, e-mail editors@workforce.com.
