A global survey of pension fund managers shows two key risks are ignored.
Two critical risks are not being addressed adequately when it comes to managing pension funds. According to a recent study by the EDHEC Risk Institute, pensions globally ignore economic exposure and sponsor risk.
The survey, “The Elephant in the Room: Accounting and Sponsor Risks in Corporate Pension Plans,” was part of a two-year research project by EDHEC-Risk and AXA Investment Managers.
Accounting risk is an important component for sponsors of pension plans. Within existing accounting guidelines, sponsors must use a risk-free rate with credit spread to determine the appropriate valuation of pension assets. But according to the EDHEC-AXA survey, only a small percentage of the respondents are hedging the economic exposure associated with changes in these rates.
Although more transparency in accounting is encouraged, many fear the final outcome of future accounting rule changes will be so erroneous that it will cause sponsors to close funds or stop providing defined benefit plans altogether. This is the first “elephant in the room,” according to EDHEC-AXA.
The second is that of sponsor risk. Eighty-four percent of pension funds fail to manage sponsor risk, the survey showed. Some respondents said the presence of pension fund insurance is the primary reason for not hedging against sponsor risk, when in fact pension fund insurance only partially covers losses if a sponsor defaults.
The importance of sponsor risk is highlighted by the recent bankruptcies that involved significant reductions in pension fund balances. With the continued global economic pressure, the fear is that many more corporations will terminate their pension plans as a result of bankruptcy. When a company files bankruptcy, they sometimes choose to terminate the existing benefit program. When that happens, the Pension Benefit Guaranty Corporation (PGBC) takes over to pay benefits to retirees. In some cases employees may not receive the full value as promised by the employer.
So why do these exposures go unhedged? In the case of accounting risks, respondents cite the risk of future accounting rule changes as the primary reason. Sponsors do not want to lock into hedge commitments with the imminent possibility of sweeping changes to current accounting guidelines.
In the case of sponsor risk, pension fund managers say an important reason for not hedging the default risk is that they do not want to send a ‘perceived’ message to the market by placing hedges against future default.
The EDHEC-AXA survey included 100 CFOs and pension fund managers from across the globe, with a combined total of more than EUR 730bn under management. Forty-one percent of respondents were from continental Europe, thirty-six percent from the UK, twelve percent from the US and nine percent from other non-European countries. Two percent did not respond to the survey.
The majority of these respondents have defined benefit plans, fifty-four percent of which are open and forty-six percent of which are closed.
The EDHEC-Risk Institute is part of the EDHEC Business School, one of Europe’s leading business schools.