When new accounting and funding rules governing defined-benefit pension plans went into effect last year, many experts predicted the death knell for employer-sponsored pension plans. Instead, it appears a good number of companies are looking not necessarily at how to shut down pension plans, but at how to keep them viable in the new environment.
Congress passed the Pension Protection Act in 2006 in response to growing alarm about the badly underfunded status of employer-sponsored defined benefit plans. At about the same time, the Financial Accounting Standards Board dusted off pension accounting rules to bring pensions’ funded status onto the balance sheet and to eliminate some of the accounting tricks that allowed companies to smooth over volatility in pension assets and liabilities.
Hopper
“As the funding rules and accounting rules have changed, in essence they have made the application of how much to contribute to the plan, the expense or cost of the plan, and the measurement of the liabilities more transparent,” says Jerry Hopper, with the financial strategy group of Mercer Human Resource Consulting. “All of that must now be fully disclosed.”
Even for companies with well-funded plans, corporate preparers are worried about the volatility that will flow through to the income statement, says Jon Waite, a chief actuary with asset management firm SEI. That’s because the typical corporate pension plan is 60 to 70 percent allocated to equity investments, which tend to provide the greatest return over the long haul but also the largest gyrations in the short term.
Capital markets don’t like volatility, Waite says, so companies are starting to ask whether there are ways to keep pension plans in place but do away with the inherent volatility. “We’re seeing plan sponsors start to become very open to hearing what alternatives they have to regain some of that control, to manage volatility in different ways,” he says.
A recent study by Towers Perrin and CFO Research Services reflects the movement. Half of the 174 companies in the survey said they had modified their pension plans, but only 13 percent did so by fully “freezing” the plan, or closing it to new entrants and new contributions. In addition, 70 percent of companies say they are unlikely to terminate their pension plans in the next two years.
The upending of accounting and funding rules has led numerous companies to close their plans to new hires or to freeze benefits for existing employees, Hopper says. “That’s probably the No. 1 action we’ve seen over the last few years,” he says. Often when companies freeze a pension plan they shift employees’ focus toward defined-contribution plans, like a 401(k) plan, where a company’s only obligation is to meet an annual contribution requirement, giving employees more control and more risk over investment decisions.
But freezing a defined-benefit plan is not the only area where companies have control, Hopper adds. Nor does it fully address the volatility problem; because of rules governing employee benefits, companies can’t simply abandon the existing liability, so the plan assets and liabilities remain on the balance sheet and must continue to be managed.
“Some companies believe freezing the plan will reduce financial volatility more than it really does,” he says. “In the long term, when a company freezes a plan, it’s stopping the growth of the liability, but in the short term, it does not really reduce the financial volatility. A freeze reduces the cost of the plan out of the gate, but the benefits already earned to date are still there and it still has a long shelf life.”
So if a company wants to continue to offer the benefit and focus its efforts on managing the volatility, that leaves two areas to explore, Hopper says: contributions to the plan and investment management of the plan assets. While Congressional action requires companies to meet minimum funding targets to get more assets behind existing liabilities, some companies are considering even more aggressive contributions to the extent that their cash flow will allow.
“A lot of companies are worried about the call on cash,” Hopper says. “Some are voluntarily contributing excess now if they can afford it rather than face it later when there might be an unexpected call on cash.”
Options on the investment management side, however, represent the greatest potential for companies to manage volatility, he says. “Your investment of the assets is the most powerful risk management strategy available to companies now, by far.”
Volatility Management Strategies
Klinck
Brad Klinck, senior vice president for Aon Consulting’s retirement practice, says companies are exploring different approaches to how they manage their pension plan assets that would let them keep their plans in place, but minimize the volatility that flows through to earnings.
One approach is to shift more of a plan’s assets out of equity instruments and into other types of investments such as fixed-income securities, private equity, or more overseas investing, Klinck says. For example, companies are finding investment opportunities in Asia in places they’d never explored before, but where they’re earning the kinds of returns they need to keep plan assets growing at a steady clip, he says.
Companies also are taking a fresh look at derivatives, hedges, swaps, or currency exchanges, Klinck says. “The definition of what is prudent has changed over time,” he contends. “The broad classes of investments today may be the same as they were 20 years ago, but within those classes there are more sectors. Companies are still able to manage the risk but are better able to extract from the market the returns they’re looking for in an environment they’re comfortable with.”
It’s an approach that calls for a more specialized investment expertise, but investment management firms are establishing that expertise to meet the rising demand, he says.
“In the long term, when a company freezes a plan, it’s stopping the growth of the liability, but in the short term, it does not really reduce the financial volatility.”
— Jerry Hopper, Mercer HR Consulting
Hopper says movement away from equities also somewhat insulates plans from the effects of changes in interest rates, which is another influence on volatility. As a rule, when interest rates fall, the pension liability rises. Companies are starting to show more interest in increasing their holdings in fixed-income instruments like bonds because it makes the liability less sensitive to fluctuations in interest rates, he says.
Investment decisions driven by a concern for the liability is a somewhat fluid area, Hopper says; companies with different circumstances and different risk tolerance thresholds will look at the liability in different ways. “Liability-driven investing is a term that means a lot of different things to different people,” he says. “Historically many companies sponsoring pension plans focused solely on returns. Liability-driven means looking to the liability to provide guidance on how to invest assets.”
There are a number of interrelated factors that companies weigh to define their tolerance for pension risk, Hopper says. “This whole pension risk management is not one-size-fits-all because there are a lot of variables,” he adds. “How big is the plan relative to the business? Is the plan open or closed? How well funded is the plan today? What’s the current investment strategy? Is it an average plan with a lot of equity exposure, or have you taken risk down with less equity exposure?”
Meanwhile, Over At FASB …
As companies assess and perhaps redirect their pension risk strategy, FASB continues to pluck away at its longer-range plan for pension accounting rules. FASB has said its goal is to move toward full mark-to-market accounting, where companies will report on the balance sheet the fair market value of their pension assets and liabilities each period. Experts say that will lead to even more volatility.
“With the changes to funding and accounting rules, volatility has become an issue,” Klinck says. “Now with FASB’s Phase 2 project, there are larger looming changes on the horizon.”
Whatever approach a company chooses, a move away from long-term returns to reduce short-term volatility is likely to increase the cost of the plan over its lifetime. Those lower returns have to be made up with increased contributions, Hopper says. “In risk-return frameworks, there’s no free lunch,” he explains. “Generally, if you reduce the risk of a program, it increases the cost. It’s a trade-off.”
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