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

According to "Bonds' Pricing Is Questioned In Email Trail, Former Trader at RBC Alleges Mismarking Of Plain-Vanilla Issues " (October 26, 2007) Wall Street Journal reporter Susan Pulliam describes alleged fraud at one of the large Canadian banks. Whether government and corporate bonds were incorrectly valued to hide losses remains to be seen. However, if true, this is serious stuff.

Pension fiduciaries should be regularly asking external managers about their trading checks and balances. However, in light of recent negative headlines, one wonders (a) whether sufficiently tough questions are being asked (b) who is doing the investigation and (c) whether risk management and valuation best practices are more myth than reality at some organizations.

ERISA and state pension laws make it clear that fiduciaries have a solemn obligation to properly select and review external money mangers. Are breach of duty complaints likely to ensue for those plan sponsors who have selected "troubled" money managers and cannot provide evidence of a disciplined and comprehensive review of their risk management and valuation policies? 

Our forthcoming November 6, 2007 webinar will look at trading controls and the selection and review of external money monagers. Click here for more information.

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Have the last few months of negative headlines scared you yet? If not, don't be too complacent. According to a recent survey conducted by Greenwich Associates, institutional investors have grown weary of structured financial products and fixed income securities. According to a summary provided by CFO.com writer Stephen Taub, a worldwide credit crisis "has caused a nearly complete disruption in the trading and use of many fixed-income products." Even trading in ordinarily liquid corporate bond markets has reportedly been difficult, leaving many scratching their heads as to whether the credit crisis is a short-term blip or a long-lived problem. Taub adds that the survey predates the Fed's recent rate cut. (Click here to read "Liquidity Crunch: How Long Will it Last?")

In his September 20, 2007 testimony before the House Committe on Financial Services, U.S. Treasury Secretary Henry Paulson describes the "interconnectedness" of global capital markets and the fallout from concerns over sub-prime mortgages - reduced investor confidence, reassessment of risk, and temporary diminuition of liquidity. Describing self-correction tendencies of financial markets, Paulson's more sanguine take can be accessed by clicking here.

After a recent bridge game, I had a chance to ask my friend, Dr. Lucjan Orlowski, for his view of the world around us. As Senior Fellow at the Center for European Integration Studies (ZEI) at the University of Bonn; a Senior Fellow at the Center for Economic and Social Research (CASE) in Warsaw; a Research Fellow at the William Davidson Institute (WDI) at the University of Michigan School of Business, and a Research Professor at the German Institute for Economic Research (DIW) in Berlin, Orlowski's opinion counts in more ways than one. His prognosis? Not very good - In fact, he was downright gloomy with respect to jobs growth and continued ill-effects of this summer's incorrect pricing of default risk. Click here to read Lucjan's impressive bio.

So what does all of this mean for pension funds? Let us count the ways.

1. Diminished liquidity could imperil a plan's ability to meet its short-term obligations. This is especially serious for mature plans or in situations where labor contracts offer few opportunties to revise cash outflows. How should strategic asset allocations change to reflect a sustained credit crunch (if you accept that premise)?

2. Fewer companies are making their way to capital markets. Will a reduction in fixed income security issuance and/or a widening bid-ask spread make it more difficult for pensions to execute any type of liability-driven investing tactic that involves bonds or bond derivatives?

3. Will a weakening U.S. dollar, likely to experience even more downward pressure as oil producers switch to Euro invoicing, compel plans to seek out international assets? Will plan sponsors need to ask external asset managers more questions about risk controls, notably currency hedging techniques, as a result?

4. Could lower U.S. interest rates push some plans over the edge in terms of funding status and inevitable financial consequences?

5. Will changing correlation patterns, and the related reduction of diversification potential, leave defined benefit plan sponsors in a position of having to take on more risk? In the event that FASB requires additional pension investment risk disclosure, will corporate plan sponsors begin to feel pressure from shareholders as market volatility is more explicitly embedded in financial statements?

These are but a few possibilities for those who see the glass half empty and draining fast.

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There is a lot of evidence, anecdotal and otherwise, that various capital markets are affected by policy. The impact on price and trading volume depends on a host of factors, not the least of which is the nature of the new rules and regulations. So it is with government bonds, domestic and foreign.

In the aftermath of the Pension Protection Act of 2006, many plan sponsors, under pressure to address funding gaps, are adopting an active stance towards interest rate risk management. While strategies can and do vary, trading in bond markets in the U.S. and elsewhere have been affected by a surge in demand for longer-term bonds. According to Reuters journalist Richard Leong, "Appetite for 30-year bonds and other long-dated assets has been fierce as pension fund managers have been stocking up on them to ensure they have enough income-generating assets to meet future obligations, traders and investors said." Additionally, stripped bonds "offer longer duration and more predictable income than a cash bond." (See "Pension demand leads to long bond stripping," December 7, 2006.)

By definition, a stripped bond represents a decoupling of the interest portion from the repayment of principal. The latter is sold as a zero coupon bond. According to Investor Words, "Strip is an acronym for Separate Trading of Registered Interest and Principal of Securities."

Much more will be written about interest rate risk management in later posts. For now, you can find definitions, checklists and step-by-step examples in a book I wrote in 2005 for John Wiley & Sons. Entitled Risk Management for Pensions, Endowments, and Foundations, there is an entire chapter about fundamental concepts. Other chapters address futures, options and swaps, respectively.

Competing methods and products to manage interest rate risk abound. However, the tradeoffs are far from identical. This means that plan sponsors are quickly having to learn about financial risk control, whether they like it or not.

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"A Different Strategy on Pensions" by New York Times reporter Mary Williams Walsh (September 9, 2006) showcases International Paper Company for its use of swaps as a way to hedge interest rate risk. She writes that "International Paper's $7 billion pension fund, which covers 175,000 people, is three years into a broad revamping, one that the company believes will protect it from the forces that wreaked havoc in the last few years."

Several points are worth mentioning.

First, the Pension Protection Act of 2006 makes a practice known as smoothing more difficult. The implication? It will be harder for companies to disguise funding problems going forward. Changes due out any day from the Financial Accounting Standards Board are likewise expected to put the kibosh on this type of illusory reporting mechanism. CFO.com reporter Helen Shaw writes that FASB Chairman Bob Herz opposes smoothing and favors a more accurate representation of funding status. (Click here to read her 2005 article.)

Second, defined benefit plans are affected by changes in interest rates (and related yield curve shifts). As rates drop, pension liabilities increase. (The extent to which they rise depends on a host of factors.) Moreover, a drop in rates (depending on the cause) could depress the return (assumed and realized) on some (not all) investments, thereby widening the pension gap and making things worse.

Third, the effectiveness of any interest rate hedging technique is influenced by current levels of interest rates, capital market conditions, the shape of the yield curve, the steepness of the yield curve, choice of instrument and so on. That's why Fed watching is such a popular activity.

Fourth, the pension situation is not hopeless. While some companies and municipalities are in dire straights (perhaps well on their way to financial distress or outright failure), other organizations can and should consider what works, what doesn't work and why.

Pension governance best practices are worth the time. Millions of people count on decision-makers to evaluate plausible solutions as a way to keep their word.

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