Hewitt: Tomorrow Comes Today – Kevin Wesbroom
It was not so long ago that finance directors saw pension plans in a very positive light. The plans had relatively predictable and manageable cash costs, often delivering balance sheet surpluses and additional profits in some cases.
They were also seen as a very useful tool for retention of experienced workers and persuading people out of the door as differing workforce needs emerged. The finance focus was on minimising the long-term cost but the risks and responsibilities lay at the door of the HR director. Of the four key risks inherent in these plans – financial, strategic, governance and regulatory – strategic risk was at the forefront of everybody’s minds, ensuring that pension plans attracted and retained the best talent available.
The changing viewpoint
While the plans themselves are basically the same as they were 15 years ago, the perspective of finance directors and the economic realties we all face have changed. A decade of consistently low interest rates, volatile asset returns and increasing life expectancy has more than eliminated the pension surpluses that were set aside to protect against such events, and company contribution holidays have disappeared.
Mark-to-market accounting and, for most companies, the immediate recognition of pension gains and losses on corporate balance sheets have led to many measures being taken with one- or two-year time horizons in mind. Stricter funding rules, combined with legislation designed to protect employees, may in fact have contributed to the demise of the very benefits they were designed to protect.
Across the world, minimum funding requirements, minimum benefit levels and onerous requirements for employers to fund pension plan deficits have done a good job of protecting those lucky enough to be provided with a defined benefit plan, but have contributed to the nervousness of employers to provide such plans.
The mantra of ‘minimise cost by maximising return’ has been replaced with one of ‘maximise control by minimising risk’. Consequently, pension provision has moved out of the domain of HR and onto the radar of CFOs.
In Hewitt’s latest Global Pension Risk Survey, covering over 170 employers spread around the world, 73% cited financial risk as their primary concern and only 4% named strategic risk. Tellingly, 50% indicated that finance departments were now primarily responsible for managing pension plan risk and almost half indicated that pension plans were a global concern to their organisation.
Pension risk is now seen as a short-term issue due to cash requirements, P&L charges and balance sheet deficits all being so volatile. We clearly have concerns about balance here. Are employers simply storing up future problems by replacing generous, defined benefit plans with ‘cheap and cheerful’ defined contribution plans? Will they be struggling to retain some key senior workers in a shrinking workforce, while at the same time being lumbered with workers in other areas that the company would rather shed but who are unmotivated and simply working as they cannot afford to retire?
For many employers, pension risk measurement remains a complete unknown. Our survey tells us that around one in four companies are still not measuring and monitoring pension risk, although we do anticipate this will change as the financial turmoil continues to impact pension plan assets and liabilities. But some treasury departments are now applying similar risk measures for pension plans as those they have used in other areas of the business for years, such as Value at Risk (VaR).
Advanced plan sponsors are then using this information to develop pension plan risk management strategies – for example, they may set VaR targets or ‘budgets’ for the balance sheet, the profit and loss account, the amount of cash required or a combination of all three. The strategy for managing the pension plans and possible changes to this strategy can then be tested against the VaR measures, to form an educated and quantified view of the impact and potential value of any strategy under consideration.
However, the weaknesses and limitations of VaR modelling have been highlighted by recent market events. We expect the most educated sponsors to be adopting a multifaceted approach to risk monitoring, which will include not just VaR, but also several other risk measurement techniques, such as scenario testing and stochastic projections.
It would not be a surprise that interest rate risk and equity risk were highlighted in our survey as the top two components of pension risk of concern to sponsors – in simple terms, the risks that liabilities would increase and/or that assets would fall. But, in the UK, longevity risk rivalled equity risk as a concern, which is interesting because the UK seems to be leading the way in recognising the impact of increasing life expectancy on pension obligations.
The growing recognition of pension plan risk has led to actions addressing those risks across the globe – notably the relentless closure of defined benefit plans. Closure to new entrants was found among two thirds of the plans we surveyed. The proportion closed to existing members was smaller – around one sixth, but with some significant variations by country.
Interestingly, further evidence of the dominance of accounting-led actions comes from the fact that Canada had the highest proportion of open defined benefit plans in our survey, and Canadian accounting does not yet require mark-to-market deficits on corporate balance sheets.
Plan closures, ceasing accrual and reducing future benefits have all limited the increase in pension liabilities for some sponsors, but these do nothing for managing the large liabilities already accrued in plans. In addition, many companies do not want, or are not able, to tweak their benefit structures any further.
The investment strategy of assets is the key way to address risks associated with the accrued liabilities and two strong themes emerged from the survey. The first was to hold assets that behave more like your liabilities, holding more bonds at a simple level, increasing the duration of those bonds, or implementing full liability driven investment (LDI) solutions (e.g. via swaps investments). This calls for a much deeper level of understanding of the plan’s liabilities from asset managers, trustees and sponsors alike.
The second theme was diversification of return seeking assets. This could be more overseas holdings or it could mean moving into more complex investment areas such as property, commodities, currency, and infrastructure and even – dare one mention it – hedge funds.
The twin themes of asset/liability hedging and greater diversification of the remaining return seeking investment portfolios, coupled with the volatility of current markets make the high level investment strategy more important today than it ever has been in the past but also call for greater monitoring, appreciation and understanding of the underlying assets and the managers employed.
Quarterly meetings of well meaning amateur trustees seem anachronistic in these conditions. It really is time for companies to take control of the investments of their pension schemes, setting asset allocation strategy and then outsourcing the management of pension plan investments, covering the hiring and firing of managers, tactical asset allocation and implementation of matching strategies. Delegating to outside professionals using fiduciary management or other mechanisms offers speed of execution to match the market, while allowing sponsors to regain and then retain control of their overall investment policy.
Another emerging area, which seems to have a particular UK emphasis or obsession, is the growing interest in the buy-out and buy-in market, offloading liabilities to insurance companies that are arguably better placed than the sponsoring company to bear long-term pension risks.
Our survey showed a huge interest in buy-out for UK sponsors. In fact, two thirds said they intended buying out their benefits within the next five years. But look just a little closer to see what the biggest barriers are to going down this route – number one is the cost. 2008 in the UK saw around €15 billion of buy-out transactions take place, in conditions that were considerably more benign than those which now exist.
Most sponsors now have an even greater desire to pass over liabilities to insurers but, after recent asset falls, much less ability to be able to afford to do so. If a full buy-out is not affordable then perhaps schemes should look to partial buy-ins of, for example, their pensioner liabilities.
Schemes that have pensioner liabilities backed by government bonds may be able to exchange this part of their portfolio for a buy-in policy, gaining not just a yield pick up, but protection from future longevity improvements into the bargain. For others the obvious action may lie in some careful preparatory work – sorting out investment policy, legal work, authorities, member communications and the like – so that, if and when markets rebound, sponsors can make sure they do not miss the buyout boat the second time around.
Do-it-yourself buy-outs are also becoming popular. Why pay an insurance company profits when you can do it yourself through combinations of interest rate, inflation and longevity swaps? New combined funding and investment strategies have emerged, coupled with alternative ways of financing pension plans: escrow accounts, asset charges, letters of guarantee.
Suffice to say, we expect that during 2009 all employers will be having conversations with their actuarial advisors and their investment advisers over the innovative ways in which they can firstly measure and then manage – which will normally mean reduce – their pension risks and costs. Based on the feedback received in the survey, we can offer a few pointers to handling pension risk more effectively, based on the ‘best in class’ participants in our survey:
- Identify and measure your risk exposures within agreed corporate risk tolerances and then reassess them frequently. Consider whether pension risk should become part of an enterprise-wide approach to risk.
- Uncover hidden risks such as longevity and currency exposure, and learn about new tools and techniques to manage longevity risk.
- Consider the other aspects of pension risk beyond just financial considerations. Plans still need to support your strategic talent needs, you should still have clear governance guidelines and reporting, while the need to monitor regulatory changes and local plan compliance is greater than ever.
- Consider a multi-faceted approach to risk measurement, including assetliability studies, scenario testing and VaR metrics.
- Develop an integrated approach to the financing of your pension plans, showing how funding contributions and investment policy will respond dynamically to changes in market conditions.
- Develop a global strategy – it is better to fund pension plans in some countries vs others, normally for tax reasons, so make sure that your global spend on pensions is targeted to get the best value for money.
- Look to optimise your existing plan assets. Consider new investment opportunities, diversification, liability matching, buy-outs and buy-ins and new products and approaches to constantly check that you have the most efficient asset mix available.
- Review your governance arrangements for asset management.
- Ensure that you fully understand new measurement approaches and new tools and products that are being developed to help you address your pension plan risks.
- Seek full recognition from analysts and shareholders for properly managing your pension risks. Join those using best practice (nearly 25% of companies) that are offering additional briefings or footnote information to these interested parties. FDE