By Nilly Essaides
This year is a pivotal one for managers of corporate pensions: A new federal law (the Pension Protection Act, or PPA) is now in effect changing some of the critical “rules of the game” for sponsors, e.g., lifting the target funding level to 100 percent. A flat yield curve is making it hard to enhance total returns, and there’s talk that slower growth in the US will pull rates even lower (see related story). Finally, Phase One of a FASB pension accounting rule is coming into effect.
Any one of these would be a challenge. Ditto for this confluence of trends, which is hitting companies with defined benefit plans (DBs) the hardest. Some have had to freeze their plans, or worse, go bankrupt in order to restructure their obligations.
And while everyone got a bit of a break in 2006, as rising equity prices helped lift many corporate plans to fully funded status, these levels may not be sustainable. Most plan sponsors foresee having to fund further, and the majority of DBs are still taking on new participants (see graphs below).
A ONE-TWO PUNCH
The persistently flat yield curve and the PPA “double whammy” has forced a dramatic overhaul of the way companies manage their pension money.
- In the old days, pension investment objectives were to maximize total return against the profile of long-term liabilities. The risk was that expected returns would fall short of projections, but there was a lot of leeway for making the projections as well as realizing the actual returns.
- Now that the PPA has upped the target funding level essentially to 100 percent, and the penalties or leeway around that target have diminished considerably, pension managers are focused on minimizing the variance between the returns on their assets and the implied returns on their liability—the funding status variance.
The reason is simple: wide swings from under- to overfunding status around this narrower goal-post defined by the PPA will hurt companies on two levels:
1) Trapped assets. The PPA did provide greater flexibility for companies to pre-fund their pensions during high-liquidity times (up to 150 percent). With many companies sitting on large piles of excess cash, that’s clearly an option. (Of course, many of the very cash rich do not carry the burden of DB plans of yesteryear). The treasurer of one veteran tech company noted that indeed her company’s Board decided to deploy some of the excess by funding the pension plan.
This liquidity buffer can help forestall later calls on cash, but it comes at a cost: more money potentially invested producing returns below WACC. Meanwhile, the PPA put greater restrictions around the use of surplus funds, which again hit the old DB plans the most. The funds can be used to offset the cost of ongoing benefit accrual, but most plans are no longer accepting new participants. Meanwhile, any residual surplus assets post-plan termination can be retrieved but after paying a prohibitive excise tax.
2) Unpredictable cash flows. Playing it close is not a solution either because it raises the risk of falling short of the required funding target, if rates move up or down and with it the potential for an unforeseen “cash call.”
To make things worse, the PPA has introduced the potential for increased volatility in returns, because the law altered the period of time that companies can “smooth out” those returns (used to be five years and is now two); as a result, any change to rates will more quickly alter the valuation of the assets. This is especially painful in the current environment. “We had been operating on the basic assumption that interest rates are low but will normalize,” one pension manager confessed. But as rates held steady, the effect on the asset values has been magnified by the condensed smoothing period.
THE DURATION DILEMMA
Driving the volatility risk in the funding variance is the mismatch between the duration of pension assets and liabilities. Traditionally, pension assets were short duration (primarily equities) and pension liabilities had a very long duration profile.
Clearly that makes sense from a total return standpoint, but the duration mismatch can lead to wide swings in the gap between the fair value of the liabilities and the assets. Given the mega size of many corporate DB plans, even a 1 percent shift up or down in interest rates can push the plan under the funding target or else put it in an excess position.
What’s worse, under the PPA, revised actuarial assumptions (admittedly long overdue) that take into account longer life spans have extended the liabilities’ duration even farther out the curve. “The result of this duration mismatch is that asset and liability value may not move in tandem when interest rates change,” noted a recent report from Mellon Asset Management.
To assess their exposure to funding variance, companies must run sensitivity analyses on their pension assets and liabilities within the broader balance-sheet context; e.g., if interest rates move up, pushing the value of the assets down, perhaps under the target funding level, just as interest expense is rising, treasury will be faced with a bigger squeeze on liquidity.
To mitigate the variance risk, treasurers are working to more closely match the duration of the two sides of the equation. Theoretically, the absolute hedge of funding status variance is a perfectly matched asset and liability portfolio. But complete risk aversion is not an acceptable options for companies.
In the current rate environment, it’s a Catch-22: A flat yield curve at low levels accentuates the sensitivity but also severely reduces yield.
“The trade off is between predictability of contributions and inferiority of returns. Our shareholders don’t want to see a $300mn portfolio yielding an average return of 5 percent,” one pension manager explained.
VOLATILITY IS [NEVER] YOUR FRIEND
Finding a middle ground, where cash and return volatility are mitigated but assets do not collect dust is the purpose behind an increasingly popular concept in the pension world: Liability-driven investment, or LDI (see sidebar below). LDI is ALM with a twist: it looks for ways to minimize the changes in the funding variance, be they positive or negative. “The liability-based approach is not predicated on pessimistic expectations of market returns over the next 5 to 10 years,” noted a recent report by Eaton Vance Management. Indeed, if rates move up, the asset return/liability return profile also changes.
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LDI: THE NEW ALM LDI reflects the growing pressure on corporate fund sponsors to view their pension assets and liability through a single lens. Liability side no longer to be ignored. In the past, some treasurers reported that while they were involved in the asset side of the pension plan, they had no involvement on the liability side. That sort of bifurcation cannot continue. Because of the Pension Protection Act and other trends, pensions must be managed on an ALM (asset-liability management) basis. In the pension world, the buzz word is Liability-Driven-Investment or LDI. It is basically an ALM-based approach to asset allocation and duration selection. LDI does not necessarily mean switching to a 100 percent fixed-income portfolio, but it does entail assessing the return on the liability (NPV of the liability vs. NPV of assets) and trying to come up with ways to hedge the variance between the two. Finding a “market” value for both sides. What drives the variance calculation is the gap between the asset market value and the liability market value. And the forecast for this mismatch involves looking at the expected liability return, or the percentage change in the market value of the liability, which is analogous to the asset return. |
The simplest way to attempt to eliminate the potential for funding variance is to hold a portfolio of 30-year US Treasuries. But for some noise (because of the way the PPA calculates returns), the assets and liabilities would move in tandem.
Zero variance is not a realistic objective. Instead, companies will have a variance tolerance level that reflects their cash position and return expectations. That tolerance level, stressed through a variety of interest-rate scenarios, will drive treasurers’ and investment managers’ asset allocation decisions. They will have three basic levers with which to affect the duration profile/mismatch of their assets and liabilities:
1) Increase the duration of existing assets, e.g., swapping medium-term bonds for longer- term bonds;
2) Increase the proportion of fixed-income long-term bonds in the portfolio; and
3) Use fixed-income derivatives to mold existing average duration and enhance yield.
Already, companies are becoming more heavily weighted in fixed income. A study late last year by Tower Perrin revealed that over one-third of corporate plan sponsors are likely or very likely to increase the bond holdings in their portfolios. In the past, corporate pension plans were not enamored with derivatives as an asset class. But within the current constraints, and the volatility risk-management theme of LDI, investment advisers predict more companies will consider relying on structured products to help not only mold their duration profile but seek ways to enhance returns throughout.
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THE FASB REPORT The FASB is not sitting on the sidelines as the Federal Government reforms the pension industry. The Board has instigated a two-phase plan. Phase One, which became effective in January 2007, was designed to improve balance sheet transparency. Most important, it requires companies to disclose their funding status, i.e., the difference between the fair value of the assets and the projected pension obligations. “Phase One essentially required companies to move an existing footnote to the balance sheet, revealing no new information,” noted David Bianco, a research analyst with UBS in an August 2006 report. But the information will affect balance sheet numbers, e.g., debt-to-equity or price-to-book. |