Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

Several recent experiences inspire this post. On the positive side, two weeks ago, I had the pleasure of spending time with my step niece, a darling little girl of 3. After just 15 minutes, I realized that her favorite way of getting attention is to scream "excuse me" as many times as it takes until nearby adults acknowledge her. Cute at first, it annoys after a few shouts but Lilly certainly gets her way.

On the other end of the experiential spectrum, my Sunday foray to Starbuck's introduced me to "Miss Manners Not." Though I was first at the counter and obviously not yet finished paying for a handful of gift certificates, a lady customer thrice reached over me and then pushed me aside to order a cup of joe. Not being shy, I murmured "sorry to be in the way." To my shock, she replied "it's okay." Yes, my first response was to tilt my cup in her direction ("oops") but give me credit for being an adult who quickly cooed sotto voce, "let it go." (You've met folks like this gal, right? Gotta love 'em for their arrogance and cluelessness.)

Here's the connection to all things pension.

Everyday brings new headlines about the retirement crisis. Just a few days ago, New York Times reporter Mary Walsh cites a new study that shows that 2007 investment gains for America's giant pension funds are fast being erased by early 2008 market tumult. Likely to add to the funding gap and compelling a need for cash infusions is a strategic move away from equity. More disturbing is that jumbo plans, in distress, could "swamp the federal insurance system," already reeling from certain airline and manufacturing company woes. Piling on is the Fed's lowering of interest rates which pushes up the size of defined benefit plan liabilities, exacerbating things. Given tighter funding rules, courtesy of the Pension Protection Act of 2006, plan sponsors have much less latitude in riding out the storm, if even possible. (See "Market Turmoil Has Taken a Toll on Big Pension Funds" by Mary Walsh, April 17, 2008. Also read "2007 Gains Reversed in First Quarter of 2008" by John W. Ehrhardt and Paul C. Morgan, "Milliman 2008 Pension Funding Study," April 2008.)

In January 2008, the U.S. Government and Accountability Office ("GAO") released an alarm bell in the form of its report entitled "State and Local Government Retiree Benefits." They concluded that "58 percent of 65 large pension plans" had funding ratios of about 80 percent in 2006, a decline since 2000. By extension, this means that 42 percent are in bad shape. (There is continuing controversy over whether 80 percent is deemed "safe" or instead suggests a need to worry.)

For individuals, new research cites the need for a long-term, relatively stable mix of stocks and bonds. In "Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios," Professors Harold J. Schleef and Robert M. Eisinger argue that the likelihood of having enough money to retire comfortably is depressingly low. As New York Times contributor and money talking head, Mark Hulbert, points out, life-cycle or "target date" maturity funds may not perform "in line with their long-term averages." (Read "The Odds for a Retirement Nest Egg, Recalculated," New York Times, April 20, 2008.)

Of course, if Louis Lowenstein, author of The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It is right, fees and revenue-sharing arrangements will continue to erode retirement savings (meager for most), making it tougher to reach even a low savings goal. While employers shed their traditional benefit plans, they nevertheless have a vested stake in wanting their employees to be self-sufficient. Happy workers are typically productive workers who spin gold for shareholders and performance-compensated executives.

For the still clueless pension decision-makers, oblivious to the merits of effective asset-liability management (the equivalent of my coffee shop lady), hopefully the onslaught of economic and regulatory indicators will create a stir. If not, perhaps my young niece will take her "excuse me, excuse me, pay attention" show on the road.

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Even British comic book hero Union Jack may not be able to save the day for some UK pension plans. According to data just released by the Pension Protection Fund, the net funding status for nearly 8,000 private defined benefit plans widened to 97.5 billion pound sterling. Worse than the 80.8 billion GBP gap reported for January 2008, this February 2008 number is deemed "highest since June 2003" and represents the fourth consecutive monthly gap. Another telling indicator of problems is the news that "In February 2008, the total surpluses of schemes in surplus fell to £32.6 billion from £37.3 billion1 at the end of January 2008." Twelve months ago, the "aggregate surplus of all schemes in surplus stood at £68.6 billion." Click to review the Pension Protection Fund data report.

Citing anemic equity performance and falling bond yields as the culprits, the report's authors add that lower bond yields resulted in a 8.1% rise in aggregate liabilities "while weaker equities have reduced assets by 1.5%." Noteworthy are the results of a survey commissioned by the PPF and carried out by KPMG that show that few respondents (defined benefit plans considered "large") employ liability hedging techniques. The chart that maps funding status to percent of liabilities seems to support a widely held belief that "where funding is severely low the schemes need to take a certain degree of investment risk to help get back to full funding, given the PPF is insuring a certain level of benefits."

Does this mean that regulatory subsidies discourage hedging? If so, the UK would not be unique in terms of a rational but perverse response to changed incentives. (The notion of unintended consequences is one of the free market economic arguments against regulation, especially when "innocents" end up paying the bill.)

Click to access the January 2008 survey entitled "Pension Protection Fund: Investment Strategy and LDI Survey."

On a related note, a survey of US and Canadian plan sponsors, focused on their pension risk management practices, is due out shortly. A collaborative effort on the part of the Society of Actuaries and Pension Governance, LLC, the results support those of the aforementioned UK survey with respect to lower than expected amount of hedging (of both assets and liabilities).

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There is something for everyone when it comes to U.S. national debt. Unfortunately, that "something" is a gigantic IOU to the banks, insurance companies, mutual funds and international investors who buy our government bonds and bills. Click here to access statistics about ownership of U.S. government securities. According to "National Debt at Record $9 Trillion" by Associated Press International reporter Martin Crutsinger,  "It took the country from George Washington until Ronald Reagan to reach the first $1 trillion in debt."

Zowie!

Lest you confuse the deficit with debt, the U.S. Treasury offers Frequently Asked Questions that describe the deficit as "the fiscal year difference between what the United States Government (Government) takes in from taxes and other revenues, called receipts, and the amount of money the Government spends, called outlays." In contrast, the total debt includes accumulated deficits "plus accumulated off-budget surpluses." Click here to read other factoids about our crushing economic situation.

Ignore the finger pointers in Congress who explain why U.S. debt is racing past $9 trillion (that's 12 zeroes). Focus instead on the school of thought that taxpayers (especially younger ones) are on the hook. According to the U.S. debt clock site, "the estimated population of the United States is 303,509,977 so each citizen's share of this debt is $30,036.47."

In retirement land, this slice of Uncle Sam's spending frenzy hurts. With more than a few companies, and state and local plan sponsors, cutting back on benefits, taking on more debt has as much appeal as getting a tooth pulled, without novocaine. Click here to see how quickly national debt is mounting. Refresh your screen several times to appreciate the speed with which we are being pushed into an economic hot zone.

For companies seeking to grow, increased national debt crowds out other borrowers. This in turn has the effect of raising the cost of capital which typically means lower profits and decreased share price. Why is this important to plan participants?

Simply put, the probability of payout at current benefit levels critically depends on the plan sponsor's financial health. Additionally, troubled companies are not likely to hire. For those retirees seeking a return to the workforce, that's unwelcome news indeed. Don't forget the pension asset-liability management challenges associated with excess leverage. To finance its funding gap, the U.S. government issues more bonds and/or raises taxes. The former impacts the shape and magnitude of the yield curve, which affects a plan sponsor's ability to manage interest rate risk. The latter impedes new spending and truncates growth, dragging corporate earnings downward.

The bottom line is that none of us escapes this problem. What a mess!

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In discussing his relationship with service providers, a plan sponsor recently told me that he feels like a juicy steak to a hungry lion. Everyone wants his business and he struggles to keep up with the many requests for meetings with consultants, actuaries and asset managers. According to "Pensions may be outsourced : Banks look to take the plans and their assets off the hands of employers" (October 31, 2007), that fiduciary may be even busier now, fending off requests to assume his company's defined benefit plan(s).  As Los Angeles Times reporter Jonathan Peterson describes, Citigroup has just received an okay from the Federal Reserve to "take over" a $400 million retirement plan, sponsored by Thomson Regional Newspapers.

If a harbinger of things to come (and banks are definitely gearing up for this business), risk management acumen and internal controls should be front and center. After all, if a liability is transferred from the original plan sponsor to a large bank, it will be discomfort indeed if that bank struggles with keeping its own house in order. The stakes are too high. Lest you think that big always means better, keep in mind that we've just gone through a rollercoaster summer with a handful of financial giants reporting losses.

As regulators examine the efficacy of pension buyouts by banks in the U.S. and elsewhere, this blog's author recommends that a bank's pension-related risk control abilities be made publicly available for analysis and review. The last thing we need is a concentration of pension assets in a few shaky hands. Better that everyone is comfortable upfront with the buyers' abilities in the areas of risk management, operational processing and good pension governance.

 

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Though there is a question about whether former Illinois Senator Everett Dirksen ever said "A billion here, a billion there, and pretty soon you're talking real money," the statement is apt.

A quick read of the headlines suggests things are going to get ugly fast, and with little chance of a let-up anytime soon. Federal Reserve Chairman Ben S. Bernanke, in his October 15, 2007 address to members of the Economic Club of New York was no less sanguine. He offered that "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks." Click here to read the full text of his speech.

Billions of dollars in losses, due to sub-prime problems and related woes, pummeled recent earnings for more than a few organizations, sending the equity markets into a tailspin on October 19, 2007. Pundits report that the Dow had its worst day since early August, with worries about a looming recession being only one of several fears. Twenty years after Black Monday (October 19, 1987), the term "deja vu" comes to mind. At that time, this blog's author worked on a futures and options trading desk and well remembers the frenzy that ensued. Names then considered "too big to fail," no longer exist. Sobering lessons learned?

Hopefully.

At a time of unprecedented technological advances in terms of analytical capabilities and information flow, why is it that risk management is still anathema to some? Arguably there will be times when "tail" events occur, despite the best intentions to create, implement and periodically review back-office, middle-office and trading desk activities. One possible silver lining is that organizations (for which this applies) go back to the drawing board to design a more effective set of checks and balances. Improved risk architecture could include any number of things, including the following:

• Frequent and thorough testing of valuation models by independent third parties
• Regular and more granular correlation analysis that (a) takes into consideration the reality that market convergence does sometime occur and (b) then tries to identify when it is most likely to present itself accordingly
• Assessment of hedge effectiveness, and by extension, (a) what factors create "hedge leakage" and (b) thereby leave an organization exposed to adverse market conditions
• Identification of risk drivers, along with both a quantitative and common sense ("smell test") assessment of their likely behavior and probability of occurrence
• Identification as to how to improve collateral management
• Better training for everyone involved in trading activity and oversight
• Improved (or creation) risk budget that explicitly lays out how money is to be allocated on a risk capital basis.

Some will win as markets tremble but what about the losers? After today, equity-laden retirement portfolios won't look so good. Entire employee teams are shutting down as the credit crisis takes hold. Depressed times will certainly force plan sponsors to rethink their investment decisions.

How much money has to disappear before billions mean something other than zeros on a piece of paper?

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While seen by some as a new-fangled name for an old concept ("keep your eye on the liability ball"), liability-driven investing ("LDI") is taking the defined benefit world by storm. Thought by some as a panacea for mismatched assets and liabilities, one type of LDI strategy entails the use of an interest rate swap (or a portfolio of swaps) whereby a plan sponsor receives a cash amount tied to a fixed rate (usually a specified treasury yield plus X basis points). Its obligation as a Floating Rate Payor is determined by the set level of a variable rate benchmark such as the six-month London Interbank Offered Rate ("LIBOR"). Like anything else, there is no free lunch. Besides the collateral a plan sponsor must pledge to the counterparty (such as a major bank), yield curve changes are another factor. Moreover, as LIBOR rises, the plan sponsor must pay more when swap settlement occurs. (This assumes the absence of an interest rate cap that could otherwise create a ceiling as short-term rates climb.) This is exactly what has been happening of late.

According to the Wall Street Journal, ("Libor Pops Up," September 6, 2007), LIBOR has steadily risen over the last few weeks. Even more troubling, its parallel moves with the Fed Funds Rate have been shattered by credit market turmoil. "In normal market conditions, Libor tracks the Federal Funds rate pretty closely, and as recently as July the two were just 13 basis points, or hundredths of a percent, apart. As of Wednesday's close, that gap had grown to nearly 50 basis points, or half a percent. With exposure to the U.S. mortgage market cropping up in seemingly unlikely places, such as banks around Europe, banks that lend at Libor are expressing concern, through the rising rates, that borrowers who appear safe may prove to have something ugly hiding on their balance sheets."

While the British Bankers' Association suggests stability as of September 7, 2007 (due to central bank intervention), one wonders if this can be sustained. After Friday's disappointing jobs number in the U.S. and statements from money folks worldwide ("The credit crunch is only just beginning."), plan sponsors may find themselves exchanging one problem (pension gap) for another (rising short-term rates that drive up swap floating obligations). 

Add market volatility and new regulatory mandates for disclosure to the mix and it's seat belt time for pension fiduciaries with financial decisions to make. Moreover, in "Why Libor Defies Gravity: Divergence of a Key Global Rate Points to Strain" (September 5, 2007), Wall Street Journal reporters Ian McDonald and Alistair MacDonald note that many other short-term rates are actually falling even as LIBOR and related financial instruments struggle. That's cold comfort if a corporate plan sponsor issues commercial paper or borrows via a short-term facility tied to LIBOR.

More to come about an increasingly important topic - LDI and pension financial management.

Editor's Note:

1. Click here to access LIBOR rates from the British Bankers' Association.

2. Click here to access H15 Selected Interest Rates from the Federal Reserve.

3. Click here to read derivative instrument FAQs, courtesy of the International Swaps and Derivatives Association, Inc.

 

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Memorial Day fireworks will be extra special for two airlines - American and Continental. In a pre-holiday move, Congress and the White House okayed the use of an 8.25% rate to determine the estimated DB liability, attempting to create parity for solvent airlines. (Higher discount rates lower the projected net unfunded liability for a defined benefit plan.) According to reporter John Crawley ("US Congress weighs new pension relief for airlines," May 24, 2007), this is "still below Northwest and Delta but more generous than the tougher formula required by lawmakers last year." Click here to read the article.

In response, the Allied Pilots Association (APA), "representing the 12,000 pilots of American Airlines (NYSE: AMR)" cautioned management not to use new rules as an an excuse to reduce funding. APA president , Captain Ralph Hunter, reiterated the unions' agreement to annual concessions of more than $600 million, motivated in part by the recognition of being "at risk in bankruptcy court." Click here to read the full text of the May 25, 2007 press release.

This is not the first, nor the last time, that discount rate discussions will take center stage. Questions about appropriate assumptions linger. (According to the H-15 Statistical Release, 20-year U.S. treasury bond yields as of May 21, 2007 were reported as approximately 5.02%.)

In a December 11, 2006 speech to CPAs, SEC Fellow Joseph B. Ucuzoglu cites an important element of the Pension Protection Act of 2006, taken together with the Financial Reporting Release No. 72. Registrants "should provide transparent disclosure in Management's Discussion & Analysis of the Act's anticipated impact on the company's liquidity and capital resources. Although in some circumstances it will be difficult to forecast precise funding requirements due to the annual recomputation required by the Act, it will often be possible to provide disclosure of the magnitude of cash commitments for future annual periods assuming present market conditions remain constant."

What are the implications?

1. New legislation allows additional airline carriers to use an estimated discount rate that is, by some accounts, "too high."

2. If the result is an artificially low estimated liability number, SEC filings could reflect an overly optimistic assessment of a company's liquidity situation and related ability to pay.

3. Plan participants may therefore want to take a tour "behind the numbers." After all, cash is required to pay benefits, irregardless of discount rate assumptions.

4. Don't stop with airlines. Compare reported discount rate assumptions with economic reality for a given plan. Does the number comport with current capital market conditions? Is it sustainable? If not, what is the likely TRUE impact on benefit plan payouts and the funding needs of the plan sponsor and isn't that important information to have?

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A flurry of activity is upon us in defined benefit land. The goal? Identify "high risk" plans early on. This, according to certain members of Congress, would be followed with additional funding by plan sponsors and thereby (hopefully) reduce the possibility of a government takeover. Critics counter that such a reform could make things worse, especially for already cash-strapped companies, struggling to stay in business. Moreover, they add that a risk classification based on unrealistic assumptions regarding early retirements at maximum benefit levels makes little sense.

The "Performance and Accountability Report: Fiscal Year 2005" shows a deficit of nearly $23 billion for the Pension Benefit Guaranty Corporation while estimating "future exposure to new probable terminations" at $108 billion, nearly four times the "damage".

In its primer on pension accounting and funding, the American Academy of Actuaries describes at least four types of numbers - service cost, accumulated benefit obligation, projected benefit obligation and present value of future benefits. They add that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."

Keep in mind that smoothing and credit balances are other considerations as we try to navigate our way through the maze of pension metrics. New rules that address (a) the treatment of a company's pre-funding of a plan and (b) whether a sponsor can continue to average a plan's value over several years could materially impact reported pension costs. (To the extent that capital market participants react to accounting numbers as inaccurate barometers of economic health, C-level executives could be busy with related financial tasks.)

Okay, we get it. There are lots of ways to measure pension deficits but which one tells us what we really want to know?

What is the truth?

Will the real pension deficit please stand up?

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