A Pension Rock and a Hard Place

Not surprisingly, the conversations about pension reform are getting louder and taking place more often. Calls for further transparency, political posturing and headlines regarding the link between municipal debt service and questions about the contractual nature of pension IOUs are three of the many factors that are being hotly debated, with no end in sight. Interested parties are invited to read "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz, CPA. Published by the American Bankruptcy Institute, the authors bring attention to the fact that courts are making decisions about critical issues such as whether creditors, in distress, can move ahead of public pension plan participants. Click here to read more about the article and the connection between retirement plan promises and municipal bond credit risk.

Others are approaching the topic of public and corporate pension plan obligations from the perspective of younger workers being asked to subsidize seniors. In "Why We Need to Change the Conversation about Pension Reform" (Financial Analysts Journal, 2014), Keith Ambachtsheer writes that "Pension plan sustainability requires intergenerational fairness." He adds that suggestions such as lengthening the time over which an unfunded liability can be amortized or assuming more investment risk "effectively pass the problem on to the next generation once again."

Legislators are slowing starting to act, in large part because they cannot afford not to do so. According to Wall Street Journal reporter Josh Dawsey, New Jersey Governor Chris Christie has spent his summer with constituents, holding town hall meetings to explain his decisions about pension plan funding. See "Christie Plays Pension Issue Beyond N.J." (August 9-10, 2014). On August 1, 2014, he signed Executive Order 161 to facilitate the creation of a special group that is tasked with making recommendations to his office about tackling "these ever growing entitlement costs."

New Jersey is not alone. Prairie State politicos are attempting to forge reform. In "4 reasons you should care about pension reform in Illinois" (July 25, 2014, Chicago Sun Times reporter Sydney Lawson explains that the $175.7 billion owed to participants and bond investors will cost every taxpayer about $43,000 if paid today. According to its website, the Better Government Association estimates that replenishing numerous police and fire retirement plans in Cook County will "require tax hikes, service cuts or both."

The Big Apple retirement crisis  is no less massive. New York Times journalists David W. Chen and Mary Williams Walsh write that "the city's pension hole just keeps getting bigger, forcing progressively more significant cutbacks in municipal programs and services every year." A smaller asset base and decision-making that occurs across five separately managed funds are described as trouble spots for Mayer Bill de Blasio. Noteworthy is the mention of an investigation by Benjamin M. Lawsky, head of the Department of Financial Services, that seeks to understand how service providers were selected to work with New York City pension plans and the level of compensation they receive. See "New York City Pension System Is Strained by Costs and Politics" (August 3, 2014).

Curious about the extent of this New York City and New York State focused investigation, I asked one of my researchers to file a Freedom of Information Act request in order to obtain details. We are awaiting the receipt of meaningful results. So far, we are being told that information is not available to send. What is known so far, based on an October 8, 2013 letter from Superintendent Lawsky to Comptroller of the State of New York, Thomas P. DiNapoli, is that questions will or are being asked about retirement plan enterprise risk management and "[c]ontrols to prevent conflicts of interest, as well as the use of consultants, advisory councils and other similar structures."

Pandering for votes by promising lots of goodies may not be a successful recipe for reforming pensions that need help. Moreover, judges are in the driver's seat once a dispute about contractual status is litigated. In a recent opinion, a federal court of appeals ruling about lowering cost of living adjustments overturned an earlier decision that such an action was unconstitutional. See "Baltimore wins round in battle over police, firefighters pension reform" (The Daily Record, August 6, 2014). Click to download the August 6, 2014 opinion in Cherry v. Mayor and City Council of Baltimore, No. 13-1007, 4th U.S. Circuit Court of Appeals.

Like Homer's Odysseus who was caught between Scylla and Charybdis, policy-makers, union leaders and heads of tax groups are navigating some very rough waters indeed. We have not seen the end of these heated debates about what to do with underfunded municipal pension plans. Trying to align interests of seemingly disparate groups is only the beginning.

Private Equity Fund Limited Partners and Pension Funding Levels

Some pension plans invest in private equity funds or funds of funds. Certain private equity funds invest in companies with pension plans. This means that pension funds that invest in this asset class need to be aware of any deficiencies in their plans as well as those portfolio company plans to which they are likewise exposed. While the notion of "my brother's keeper" may not resonate well with stewards of billions of dollars, it is a reality. This is especially true, in the aftermath of the Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund decision, No. 12-2312 (1st Circuit, July 24, 2013).

Despite the "record year" described by Wall Street Journal reporter Ryan Dezember, private equity investments, like any other, necessitate careful due diligence on the part of institutional investors that seek a seat at the limited partner table. (See "Private Equity Enjoys a Record Year: Firms That Buy and Sell Companies Are Set to Return More Than $120 Billion to Investors in 2013," December 30, 2013). A critical question is whether continued gains will be diminished if a portfolio company has to divert cash to top off an underfunded pension plan. One way to address the issue is for a pension plan, endowment or foundation to ask the private equity fund general partner how much attention they pay to ERISA economics.

There are numerous other queries to make. In the March/April 2014 issue of CFA Institute Magazine, ERISA attorney David Levine (with Groom Law Group, Chartered) and Dr. Susan Mangiero, CFA (with Fiduciary Leadership, LLC), provide insights for improved due diligence, in a post-Sun Capital world. Suggested action steps include, but are not limited to, the following items:

  • Ask whether a private equity fund is "relying on the position that it is not a 'trade or business' and is therefore not subject to liability for a portfolio company's" ERISA plan deficit;
  • Request to see a list of the holdings for purposes of knowing whether a particular private equity fund has a majority ownership in any or all of its portfolio companies;
  • Investigate whether the Pension Benefit Guaranty Corporation ("PBGC") has red flagged any of the pension plan(s) of a business that is part of a private equity fund's portfolio;
  • Understand how, if at all, a private equity fund is planning to solve a pension plan underfunding problem;
  • Acknowledge that a portfolio company's ERISA liabilities could make an exit difficult, whether via an Initial Public Offering or an acquisition, and that this in turn could lengthen the time before a limited partner can cash out;
  • Identify the extent to which a private equity fund regularly examines the degree to which any or all of its portfolio companies are parties to labor contracts that may be difficult to modify; and
  • Be aware that this important legal decision could invite more litigation and regulatory actions that, regardless of outcome, have a cost and therefore a potential impact on future private equity fund returns.

If you have any difficulty in accessing our article, please send an email request to contact@fiduciaryleadership.com.

Institutional Asset Allocation

My comments about institutional asset allocation, along with those made by Mr. Ron Ryan (CEO, Ryan ALM) and Lynn Connolly (Principal, Harbor Peak, LLC), were well received on January 8, 2014. Part of a joint program that was sponsored by the Quantitative Work Alliance for Applied Finance, Education and Wisdom ("QWAFAFEW") and the Professional Risk Managers' International Association ("PRMIA"), our audience of investment professionals added to the lively debate about topics such as strategic versus tactical asset allocation, fees, role of the pension consultant and the likely capital market impact due to the implementation of strategies such as liability-driven investing ("LDI") and/or pension risk transfers ("PRT"). 

With the size of the U.S. retirement market at $20 trillion and counting, big money is at stake. Bad asset allocation decisions can lead to a cascade of economic woes. It is no surprise that fiduciary breach allegations in the form of ERISA lawsuits are increasingly focused on questions about the appropriateness of a given asset allocation mix and whether an investment consultant or financial advisor has helped or hindered the way that pension monies are allocated. Noteworthy is that scrutiny about the efficacy of the asset allocation process and resulting money mix can, and has been, applied to both defined benefit and defined contribution plans. Keep in mind that asset allocation decisions are likewise central to assessing popular financially engineered products such as target date funds. Accounting issues and how changing rules influence asset allocation decisions are yet another topic that we will tackle in coming months.

Click to access Susan Mangiero's asset allocation slides, distributed to members of the January 8 audience, and meant to peturb a discussion about this always essential topic. Interested readers can check out "Frequently Asked Questions About Target Date or Lifecycle Funds" (Investment Company Institute) and "Annual Survey of Large Pension Funds and Public Pension Reserve Funds: Report on pension funds' long-term investments" (OECD, October 2013).

If you have a specific question about asset allocation and/or the procedural process associated with asset-liability management, send an email to me.

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Hedgeco.net, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

De-Risking, HR Strategy and the Bottom Line

In case you missed our December 10, 2013 presentation about pension de-risking, sponsored by Continuing Legal Education ("CLE") provider, Strafford Publications, click to download slides for "Pension De-Risking for Employee Benefit Sponsors." It was a lively and informative discussion about the reasons to consider some type of pension risk management, considerations for doing a deal and the role of the independent fiduciary. The transaction and governance commentary was then followed with a detailed look at ERISA litigation that involves questions about Liability Driven Investing ("LDI"), lump sum distributions and annuity purchases.

Some of the issues I mentioned that are encouraging sponsors to quit their defined benefit plans in some way include, but are not limited to, the following:

  • Equity performance "catch up" from the credit crisis years and the related impact on funding levels, leading some plans to report a deficit;
  • Need for cash to make required contributions;
  • Low interest rates which, for some firms, has ballooned their IOUs;
  • Increased regulation;
  • Higher PBGC premiums;
  • Rise in ERISA fiduciary breach lawsuits;
  • Desire to avoid a failed merger, acquisition, spin-off, carve-out, security issuance or other type of corporate finance deal that, if not achieved, could lessen available cash that is needed to finance growth; and
  • Difficulty in fully managing longevity risk that is pushing benefit costs upward as people live longer.

While true that numerous executives have fiduciary fatigue and want to spend their time and energies on something other than benefits management, it is not always a given that restructuring or extinguishing a defined benefit plan is the right way to go. Indeed, some sponsors have reinstated their pension offerings in order to retain and attract talented individuals who select employers on the basis of what benefits are offered.

Given what some predict as a worrisome shortage of talented and skilled workers, the links among HR strategy, employee satisfaction and the bottom line cannot be ignored. For those companies that depend on highly trained employees to design, produce, market and distribute products, the potential costs of losing clients to better staffed competitors is a real problem. According to the "2013 Talent Shortage Survey," conducted by the Manpower Group, "Business performance is most likely to be impacted by talent shortages in terms of reduced client service capability and reduced competitiveness..." A report about the findings states that "Of the 38,618 employers who participated in the 2013 survey, more than one in three reported difficulty filling positions as a result of a lack of suitable candidates; the 35% who report shortages represents the highest proportion since 2007, just prior to the global recession."

As relates to the well-documented shift by companies and governments to a defined contribution plan(s), I recently spoke to a senior ERISA attorney who suggested a possible re-thinking of the DB-DC array, based on discussions with his clients. The conclusion is that a 401(k) plan is sometimes much more expensive to offer than anticipated. For employees who lost money in 2008 and beyond and cannot afford to retire, they will keep working. The longer they stay with their respective employer, the more money that employer has to pay in the form of administration, matching contributions, etc.

A plan sponsor has a lot to consider when deciding what benefits to offer, keep, substitute or augment. Dollars spent on benefits could reap rewards in the form of a productive and complete labor force. With full attribution to the seven fellas in Disney Studio's Snow White, will your employees be singing "Heigh-ho, heigh-ho, it's off to work we go" or will they instead bemoan their stingy boss and search for a new work home, with better economic lollipops, thereby leaving a business deprived of precious human capital?

Pensions Going Postal

Pension issues are hard to miss these days. What is notable is that pension plans influence corporate finance activity in several ways. First, they are collectively and, in some cases, individually, large and hard-to-ignore investors. Second, benefit economics can sometimes mean the difference between a deal such as a restructuring or merger or acquisition moving forward or getting stalled.

The over subscribed Initial Public Offering ("IPO") of the venerable postal system organization known as the Royal Mail Group, Ltd. ("Royal Mail") is a good example of pension plan sway.

Listed on the London Stock Exchange and trading under the ticker of RMG.L, Bloomberg reports that Royal Mail equity climbed nearly forty percent on its first day of trading with active volume early on. (See "Royal Mail Stock Jumps 38% on First Trading Day After IPO" by Kari Lundgren and Thomas Penny, Bloomberg, October 11, 2013). As a result of what most market participants call a successful launch, critics reiterated their plaint that Royal Mail should have gone for much more. Certainly the topic of pricing surfaced only to be met with concern about whether institutional investors would support the equity issue at a higher price. (See "Government tried to raise Royal Mail IPO price" by Himanshu Singh, CityWire Money, October 12, 2013). As it turned out, interest was strong and fears about a weak debut were ill-founded. According to Chief Business Correspondent for The Telegraph, Louise Armitstead, only 300 out of 800 pension fund and life insurance companies were able to get shares in Royal Mail with "the institutional offer [being] 20 times oversubscribed." (See "Royal Mail: 500 institutions miss out on shares amid record demand," October 10, 2013).

A few days later, those buyside squeaky wheels must be happy indeed. According to "Landsdowne grabs huge stake in Royal Mail sell-off" (October 11, 2013) by CNBC business editor, Helia Ebrahimi, sovereign wealth funds and hedge funds were each allocated about 50 million GBP and "that not enough stock was given to U.K. pension fund managers." Moreover, union workers continue to have questions about the economics of a proposal to limit Royal Mail employee benefits. In "Unite members vote against Royal Mail pensions cap," Professional Pensions reporter Taha Lokhandwala writes that the "announcement outraged unions as the scheme was in surplus at the time." Keep in mind that, the Royal Mail pension assets of 27 billion GBP and liabilities of 37.5 billion GBP were transferred to the U.K. treasury in 2012 in order allow Royal Mail a chance to better compete. See "Government to take over Royal Mail pension scheme deficit from next month," Out-Law.com, Pinsent Masons, March 23, 2012.

In contrast to the appearance of a financial home run for the Royal Mail deal, with respect to excess demand for stock and a clean-up of the nearly 10 billion GBP unfunded pension deficit, The Deal reports a third missed contribution to the U.S. federal mail system's pension plan as it falls "behind by another $5.6 billion." In "U.S. Postal Service skips third pension payment" (October 6, 2013), author Lisa Allen quotes union representative Sally Davidow as blaming the 2006 Postal Accountability and Enhancement Act for "an onerous requirement that the service prefund 75 years' worth of retiree health benefits in 10 years, without allowing the agency to increase postage rates above inflation or offer new services to offset the added costs." With the price of a first class stamp soon to rise to 46 cents, and another hike for three cents more in the works, one wonders if the American mail service should look to its English counterpart and consider a pension transfer and privatization that might, if well structured, advantage employees and taxpayers alike.

Financial Executives Address De-Risking and ERISA Benefit Programs

According to "Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013" (CFO Research and Prudential Financial, Inc. - July 2013), numerous changes are underway. The opinions of senior financial executive survey takers validate the continued twin interest in expanding defined contribution plan offerings and managing the liability risk of existing defined benefit ("DB") plans. The strategic import of benefits as a way to attract and retain talent is recognized by "nearly all respondents in this year's survey." Regarding the restructuring of traditional pension plans, this report states that nearly four out of every ten leaders have frozen one or more DB plans yet recognize the need to manage risk for those plans as well as for active plans. Liability-driven investing ("LDI") programs are being adopted by "many companies". Transfer solutions are being "seriously" considered by roughly forty percent of companies represented in the survey. Almost one half of respondents agree that a return to managing its core business could be enhanced by doing something to address pension risk.

None of these results are particularly surprising but it always helpful to take the pulse of corporate America with respect to ERISA and employee benefit programs. I have long maintained that the role of treasury staff will accelerate. There are numerous corporate finance implications associated with the offering of non-wage compensation. As I have added in various speeches and articles echoing what numerous ERISA attorneys cite (and I am not an attorney), plan sponsors must carefully weigh their fiduciary responsibilities to participants against those of shareholders in arriving at a particular decision.

For a copy of the study, click here.

Interested readers may also want to check out the reference items listed below:

If you have further comments or questions, click to email Dr. Susan Mangiero.

Labor Force Shrinks - Hurts Economy

Labor Day always marks an assessment of where things stand with the state of employment (or unemployment as the case may be). This year is no different except that the news continues to get worse with respect to how many people are contributing to the country's bottom line.

According to MarketWatch contributor Irwin Kellner, the unemployment rate is a poor substitute for knowing whether people are ready, able and willing to work. In "Labor pains - don't count on jobless rate" (September 3, 2013), the point is made that the participation rate is at an all-time low. Excluding military personnel, retired persons and people in jail, fewer adults than ever before in the history of the United States are pursuing work. One reason may be that schools are not preparing young people to assume jobs that require a certain level of skills. Another reason is that being on the dole is a superior economic proposition for some individuals. Yet another factor is that long-term unemployed persons are too discouraged to keep going.

Indeed, I wonder if there is a productivity tipping point, beyond which a person says "never mind" to gainful employment. Certainly people with whom I have spoken talk about the need to work many more years beyond a traditional retirement age. However, they are quick to add that they enjoy what they do and sympathize with those persons who have jobs they loathe or are hard to do after a certain age. Some people simply believe that going fishing on other people's dime, as a ward of the state, is a rational response to current incentives.

The numbers are gigantic and that should put fear in the hearts of those who are pulling the economic wagon. According to labor expert Heidi Shierholz, "More than half of all missing workers - 53.7 percent - are 'prime age' workers, age 25-54. Refer to "The missing workers: how many are there and who are they?" (Economic Policy Institute website, April 30, 2013). The Bureau of Labor Statistics, part of the U.S. Department of Labor, estimated in July 2013 that there are 11.5 million unemployed persons, of which 4.2 million individuals fall into the long-term unemployed bucket since they have been out of work for 27 weeks or longer. Click to review statistics that comprise "The Employment Situation - July 2013."

The combination of no job and an anemic retirement plan, if one exists at all, are harbingers of doom for taxpayers and for plan sponsors that are under increasing pressure to help their employees. Mark Gongloff, the author of "401(k) Plans Are Making Wealth Inequality Even Worse: Study" (Huffington Post, September 3, 2013) describes a recent study that has the wealthiest Americans with "100 times the retirement savings of the poorest Americans, who have, basically no savings."

My predictions are these. Even if you are a rugged individualist who keeps a tidy financial house, you will be paying for the economic misfortunes of others. Taxes are destined to rise, benefits may fall and you will likely have to work for a long time to pay for this country's dependents. Retirement plan trustees, whether corporate or municipal, will be under increased pressure to make sure that dollars are available to pay participants, regardless of plan design. In lockstep with expected changes in fiduciary conduct, ERISA and public investment stewards could face more enforcement, scrutiny and litigation that asks what they are doing and how.

More About Private Equity Funds and Pension IOUs

As I discussed in my July 29, 2013 blog post entitled "Pension Liability Price Tag For Private Equity Funds And Their Investors," a recent court decision by the First Circuit could mean the difference between "good" deals and "bad" ones. In "Doubling Down on a Bad Bet: Liability for Portfolio Company Pension Obligations After Sun Capital" (August 5, 2013), ERISA trial attorney with the McCormack Firm, Stephen D. Rosenberg refers to this legal opinion as "tremendously significant" as it will directly impact how acquisitions are structured, "in terms of examining whether it is possible to legally structure the acquisition and ownership of a portfolio company in a manner which will insulate the acquirer from unfunded pension obligations or, if it is not certain whether that can be achieved, will at least make it as hard as possible for potential plaintiffs to recover, thus hopefully dissuading future lawsuits..."

As creator of the popular and insightful Boston ERISA & Insurance Litigation blog, Attorney Rosenberg talked about the imperative to think ahead. Instead of trying to fix a problem after an acquisition has take place, he references my recommendations, as a business expert, to thoroughly value "the pension exposures of the target company" and account "for that exposure financially in the purchase price."

School is still out as to whether these actions are being done to the extent they should be. I have worked on due diligence initiatives that included a forward-looking assessment of cash needs and investment considerations. However, if everyone was tackling this type of economic analysis, in conjunction with a legal review, there would be no headlines about post-deal pension surprises. In other words, there are obviously some buyers that have not done sufficient homework and end up paying more than they had anticipated. If that happens too often, a private equity fund's general partners are ultimately going to get push back from their limited partners such as other pension plans, endowments and foundations. Why? Post-transaction costs impede performance.

Attorney Rosenberg and I both agree that doing the right things, prior to the closing of a transaction, is a good offense. As relates to pension-centric due diligence by a private equity fund, he adds that "Do that correctly, and you have already accounted for the possibility of being forced to cover the portfolio company's exposure; do that incorrectly, and you may have - as occurred in Sun Capital - doubled down on a losing proposition."

Pension Liability Price Tag For Private Equity Funds and Their Investors

I have long maintained that any individual or organization that invests in a company needs to check under the employee benefits hood before allocating money initially, and regularly thereafter. I can give you countless examples where incomplete due diligence led to an overly rich acquisition or investment that resulted in a new owner having to deploy cash to write checks to retirees and/or incur the costs of restructuring an otherwise untenable situation.

Failure to carry out a comprehensive ERISA-focused due diligence of a target portfolio company is not good for numerous reasons. Having done economic analyses of companies with underfunded pension plans, I know firsthand that it is often a rude awakening for investors such as private equity funds when they are confronted with the reality that what they want and what they end up with in terms of buying forecasted growth are not always the same. Reasons to worry include, but are not limited to, the following:

  • A private equity fund may not be able to realize its target rate of return because a portfolio company cannot sufficiently grow without cash that is now redirected to support employee benefit plans.
  • A pension plan that has invested in said private equity fund will be none too happy if performance falls short of expectations, especially for something that arguably should have (and could have) been considered and addressed as part of the original deal.
  • An unhappy pension fund investor may turn around and sue a private equity fund for alleged failure to have properly researched "what if" situations, taken on "too much" risk and disclosed too little information. Litigation in turn can be an expensive proposition for a private equity fund, making it even more difficult to achieve even minimum hurdle rates.

The issue of private equity ownership and portfolio company pension liabilities was heavily discussed as the result of a 2007 Appeals Board of the Pension Benefit Guaranty Corporation ("PBGC") decision about ownership, control and responsibilities for portfolio company pension plan gaps. In "Private Equity Funds: Part of the ERISA Controlled Group?" (December 19, 2007), O'Melveny & Myers LLP attorneys Wayne Jacobsen and Jeff Walbridge explained that "[i]f the PBGC's position endures, it could have significant ramifications for private equity fund investments in portfolio companies that sponsor defined benefit pension plans...[t]he fund could be required to use any or all of its assets, including the ownership interests of the fund in any or all of its portfolio companies, to fund the pension obligations of the bankrupt portfolio company."

Imagine the happy faces in private equity land when the U.S. District Court of Massachusetts opined on October 18, 2012 in favor of Sun Capital Partners III, LP and related parties. According to "Potential ERISA Title IV Liabilities of Private Equity Firms - Eliminated by the Sun Capital Decision?" (November 2012), Edwards Wildman attorney Mina Amir-Mokri describes the decision as a "significant victory for private equity firms" but explains that Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund was to be appealed.

On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed the earlier decision and put private equity funds in a potential liability position once again. According to "Private Equity Funds Further Exposed to Portfolio Company Pension Plan Liabilities" (July 29, 2013) Latham & Watkins attorneys Jed Brickner and Austin Ozawa offer post-opinion practical hints such as the need for private equity firms to "carefully consider how to structure their funds and acquisition structures to avoid characterization as a trade or business and avoid inclusion in the same controlled group as their portfolio companies." Additionally, they urge private equity funds to pay attention to the "structure of their funds' investments"...possibly "dividing their investment between two or more of independently managed funds with distinct portfolios to support a finding that no individual fund (or group of 'parallel' funds) controls any portfolio company (and no set of funds is treated as a joint venture). Paul Hastings attorneys Stephen H. Harris, Eric R. Keller, Ethan Lipsig and Mark Poerio assert that private equity funds would do well to own "less than 80% of a portfolio company"...perhaps via "thoughtful adjustments to ownership structures and management operations" that can help to reduce the exposure to portfolio company pension liabilities. See "Private Equity ERISA Alert: Consider ERISA Pension Liability Risks from Portfolio Plans" (July 2013).

While legal experts weigh in on the important issue of what responsibilities belong to private equity funds, if any, to portfolio company ERISA plan participants, institutional investors such as pensions, endowments, foundations and family offices - and their investment consultants and advisors - should take heed. If a private equity fund's exposure to a portfolio company with a problem pension plan ends up shrinking the wallets of institutional investors, serious questions will understandably be asked about who should have done what and when.

Pension Plan Economics and Corporate Finance

Just published is an article I wrote about the urgent need for appraisers and deal-makers to make sure that they have adequately assessed the economics associated with defined benefit plan funding. Entitled "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Susan Mangiero (Business Valuation Update, July 2013), the objectives of this article are threefold: (1) shed light on the magnitude of the pension underfunding problem and the possible dire impact on enterprise value; (2) remind appraisers of the need to thoroughly understand and evaluate pension plan economics or engage someone to assist them; and (3) explain the adverse consequences on deal-making and corporate strategy when pension plan funding gaps are given short shrift. CEOs, Chief Financial Officers, private equity, venture capital, merger and acquisition and bank lending professionals will want to read this article as it showcases this timely and urgent topic.

Click to read my article about pension plan valuation.

In a related post, ERISA attorney Stephen D. Rosenberg wrote a commentary on his "Boston ERISA & Insurance Litigation Blog" (June 17, 2013) about why he believes that appraisers should not be designed as ERISA fiduciaries. He expresses doubt about whether imposing a fiduciary standard on appraisers will "improve the analysis provided to plan fiduciaries." He suggests that such a move by regulators could create a reluctance for valuation professionals to assume the liability associating with appraising a company with an ERISA plan.

For those who missed our program about appraiser liability, visit the Business Valuation Resources website to obtain a copy of "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser." The program took place on May 14, 2013. Speakers included myself (Dr. Susan Mangiero), ERISA attorney James Cole with Groom Law Group and Mr. Robert Schlegel with the Houlihan Valuation Advisors.

Economic Indicators to Include Focus on Pensions

In what most people would call a significant announcement, the U.S. Bureau of Economic Analysis ("BEA") will begin measuring economic growth this summer by taking pension finance into account. According to its March 2013 announcement, BEA will record defined benefit plan transactions on an accrual accounting basis. This entity, part of the U.S. Department of Commerce, will now include a pension plan subsector in the national income and product accounts ("NIPAs"). As much as possible, the BEA will "provide estimates of the current receipts, current expenditures, and cash flow for the subsector." The intended changes contrast with the current method of including information about disbursements and earnings of pension plans as participants' personal items and using a cash basis for reporting.

The goal of enhancing transparency about employer-provided defined benefit retirement plans is laudable. However, in reading the fine print, one wonders if the opposite will occur and users of post-implementation data will be more confused. For one thing, the BEA states that it will adopt an accumulated benefit obligation ("ABO") for "both privately sponsored and state and local government sponsored plans" and use a projected benefit obligation ("PBO") for federal government plans. This means that you will never be able to compare all defined benefit plans with a single set of rules. Second, the BEA describes a discount rate assumption that "will be based on the AAA corporate bond rate published by the Federal Reserve Board." Since debt issued by the U.S. is no longer rated AAA and recent regulations allow for temporary funding relief for corporate pension plans, how will BEA numbers compare and contrast with financial accounting numbers over time? Third, since certain data is not available prior to 2000, the BEA will extrapolate to generate "normal costs" for past years. Will their method of extrapolation allow for an accurate "apples to apples" assessment of historical pension earnings and costs? In the plus column, applying the same discount rate for private pension plans versus state and local offerings will help to better assess the economic viability for each sector.

Should the Public Employee Pension Transparency Act move forward, disclosures will be based on the BEA approach. Understanding what BEA numbers do or do not show will therefore be a critical exercise for policy-makers, investors and participants.

For a detailed discussion of these intended changes on the part of the BEA, read "Preview of the 2013 Comprehensive Revision of the National Income and Product Accounts: Changes in Definitions and Presentations," BEA, March 2013. Click to read about advantages of passing the Public Employee Pension Transparency Act. Click here to read criticisms of this proposed rule. On April 23, 2013, the U.S. Senate received a version of the Public Employee Pension Transparency Act in the form of S. 779. This proffered legislation cites a staggering $5.170 trillion in pension liabilities of the 50 states combined. It is no wonder that numerous individuals want a true tally of what is owed.

J.P. Morgan Predicts Gloomy Year Ahead For Pension Plans

According to its Fall 2012 issue of Pension Pulse, published by the J.P. Morgan Asset Management Strategy Group, 2013 is going to be "grim" for pension funds after a less than jovial 2012. Citing a drop in funded status for many U.S. plans this year, "despite a 14% stock market rally," trouble spots are unlikely to disappear any time soon, putting continued pressure on the size of liabilities.

To tame the beasts in the form of "funded status volatility, unfavorable changes in the index used to value pension liabilities and longevity assumptions that increase liability values," employers continue to explore de-risking transactions such as offering lump sums and buyouts. Contrary to popular belief, the authors point out that even companies with underfunded plans like lump sum arrangements. The appeal is in part motivated by tax rules that allow "certain plans to use backdated discount rates to value lump sum payouts" that are higher than current discount rates.

Although the evidence suggests an increased demand on the part of plan sponsors to de-risk, J.P. Morgan professionals reference a ceiling of about $70 billion more over the next four or five years before industry capacity is reached for pension risk transfers. Of course, any time that demand increases and supply remains static, prices will rise as a result. At the margin, that could encourage some organizations from de-risking.

The report goes on to describe a "surreal discount rate" situation as the result of some bank securities being downgraded below AA in June of 2012. The net effect - a change in the discount rate curve that "reduced the weight of financials" - left only ten issuers to make up 75% of the market value of the index. Arguably, this increases the "inherent concentration risk" which in turn could increase the volatility of the index, thereby sending employers off on a measurement roller coaster ride. Shareholders could then feel the pinch if companies have to add cash to a plan as funding levels sink.

Adding insult to injury, the authors describe a change in actuarial assumptions that could significantly push the costs upward for companies that sponsor pension and Other Post Employment Benefits ("OPEB") programs. Their assertions are that (1) "changing actuarial assumptions are likely to increase pension liabilities by 2% to 5%" and (2) uncapped post-retirement health care benefits could go up by 6% to 9%.

Taken individually or together, the various pressures on retirement plan liabilities suggest a busy year ahead for ERISA fiduciaries and their support staff.

Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties

Click to register for a January 16, 2013 webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties." Sponsored by Strafford Publications, this Continuing Legal Education ("CLE") webinar will provide benefits counsel with a review of pension de-risking approaches used by companies to reduce some of the risks involved with employee retirement benefits. The panel will offer best practices for leveraging the precautions to prevent ERISA fiduciary law violations when making transfers.

Description

As U.S. pension plans face record deficits, options for transferring some or all of a sponsor's plan risk make sense for many companies. General Motors, NCR and Verizon are a few companies that have chosen de-risking options in 2012.

De-risking transactions take many forms, from transferring company obligations to third parties, to offering payouts to plan participants, to undertaking liability-driven investing and other strategies. Counsel and companies must tread carefully to avoid ERISA-based litigation or enforcement actions.

Prudent de-risking requires thorough financial analysis and clear demonstrations that fiduciary standards under ERISA are met. Counsel should guide companies on how to establish the reasonableness of decisions and prepare to defend against possible court challenges.

Listen as our panel of experienced employee benefit practitioners provides guidance on precautions for companies undertaking transfers of pension plan obligations to third parties or other de-risking options. The panel will outline best practices for assembling a thorough financial review, complying with ERISA requirements, and responding to potential legal challenges from plan participants.

Outline

  1. De-risking overview
    1. Current trends
    2. Different approaches
      1. Transfers to third parties
      2. Lump sum payouts for participants
      3. Investment strategies
  2. Procedural prudence
    1. Financials
    2. Government filings and participant notifications
    3. Meeting ERISA fiduciary requirements
      1. Prudence
      2. Care
      3. Loyalty
  3. Potential challenges from plan participants
    1. Grounds for challenges
    2. Likelihood of success

Benefits

The panel will review these and other key questions:

  • What kind of financial reviews are needed to support a de-risking transaction?
  • How can pension providers demonstrate they have met their ERISA standards of prudence, care and loyalty to plan participants?
  • What steps should be taken in preparation for termination of a pension plan?

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

Faculty

Susan Mangiero, Managing Director
Fiduciary Leadership, LLC, New York Metropolitan Area
 

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Nancy G. Ross, Partner
McDermott Will & Emery, Chicago

She focuses her practice primarily on the area of employee benefits class action litigation and counseling under ERISA. She has extensive experience in counseling and representing employers, boards of directors, plan fiduciaries, and trustees in matters concerning pension and welfare benefit plans. Her experience includes representation of pension plans, ESOPs, trustees and employers.

Anthony A. Dreyspool, Senior Managing Director
Brock Fiduciary Services, New York

He specializes in the investment of assets of ERISA-covered employee benefit plans and all aspects of ERISA fiduciary law compliance.  He has more than 30 years of experience with respect to ERISA matters and has substantial knowledge in the structuring and formation of private real estate and equity funds for the institutional investment market.

CFO Magazine Article About Pension De-Risking

In case you missed the launch of "Applied to Pensions, Risk is a Four-Letter Word" by Dr. Susan Mangiero and ERISA attorney Nancy Ross (CFO Magazine, November 8, 2012), experts conclude that Chief Financial Officers need to do their homework before entering into a particular deal. "Beyond the obvious number-crunching needed to vet what's often a large dollar transaction, the decision to de-risk should minimally include:

  • A thorough evaluation of the financial, operational, and legal strength of the annuity provider as required by the U.S. Department of Labor Interpretative Bulletin 95-1.
  • Independent pricing of any hard-to-value assets that will be contributed as part of a de-risking deal.
  • Economic assessment of opportunity costs in a low interest rate environment and whether it is better to delay a transaction or close immediately.
  • Review of vendor and counterparty contracts that may need to be unwound in the event of a full transfer of pension assets and liabilities to a third party.
  • Review of direct and indirect fee amounts to be paid by a plan sponsor as the result of a de-risking transaction.
  • Assessment of litigation risk associated with plan participants asserting that they've been unfairly treated as the result of a pension de-risking arrangement.
  • Creation of a strategic communications action plan to ensure that plan participants, shareholders, and other relevant constituencies are provided with adequate information."

In a related commentary, ERISA Stephen Rosenberg describes the chaos in the defined benefit plan market that continues to give plan sponsors pause about staying with the status quo. Click to read "On Getting Out of the Pension Business."

Global Pension Assets: Another Tough Year

Hot off the press, the OECD's September 2012 issue of "Pension Markets In Focus" includes some notable statistics about pension schemes around the world. While aggregate assets increased to over $20 trillion (as of December 2011), post-fee real rates of return were miniscule at best. With an average annual rate of return of -1.7%, few winners bested the market at large. The award for the highest performing pension system went to Denmark with an annual return of 12.1% in 2011, followed by the Netherlands (8.2%), Australia (4.1%) and Iceland and New Zealand, each turning in a modest 2.3%. Turkey, Italy, Spain, Japan, the United Kingdom and the United States realized negative returns.

The news is not all grim.

According to André Laboul, OECD Head of the Financial Affairs Division Directorate for Financial and Enterprise Affairs, assessments of performance that consider many years show that the traditional 60% equity and 40% long-term sovereign bond mix have generated positive returns that range from 2.8% in Japan to 5.8% in the United Kingdom. Of course, many factors are at play, not the least of which is how much latitude an investment committee or policy-making body has to allocate monies locally versus internationally, the rate at which assets grow (and can be put to work) and the fees that are paid to various service providers.

Regarding asset class exposure, OECD researchers note that pension funds' allocation to "public equities declined significantly compared to past years." This trend is likewise noted in the "Global Pension Assets Study 2012." Published by Towers Watson in January, this compilation of interesting data points shows that the Netherlands and Japan have a "higher than average" allocation to bonds. In contrast, "in 2011, Australia, the UK and the US retained above average equity allocations." Apportioning more monies to alternatives is an undeniable reality for retirement plans in multiple countries

Since more than a few people posit that asset allocation decisions dominate portfolio returns, it is critical to track who is investing in what. Pension de-risking activity will likely have an impact on defined benefit plan portfolio mix going forward if, as experts suggest, more companies decide to exit or modify their exposure to the "pension business" by freezing a plan, using derivatives, offering lump sum payouts, entering into group annuities and so on.

Pension restructuring and adding more alternatives are factors that are changing the governance landscape in numerous ways. For one thing, the need for investigative due diligence and independent valuation services arguably becomes more acute. Second, the regulatory focus on holdings disclosure and compensation paid to service providers could inhibit the use of private funds at the same time that yield-seekers are writing checks.

The "push-pull" dynamic is holding everyone's attention since so much money is at stake.

Public Pension Reform is Seen as Urgent

According to "State Pension Reform, 2009-2011" by Ron Snell (National Conference of State Legislatures, March 2012), all but seven states have made "major changes" in order to lower pension fund obligations. Increasing employee contributions, reducing employer contributions and/or tightening up age and service requirements that dictate when someone can retire are a few of the reforms underway. Modifying how benefits are calculated, offering limited benefits to new employees and replacing defined benefit plans with defined contribution plans are a few of the action steps taken by legislators who worry that there is not enough money to maintain the status quo.

For a state by state listing of the types of retirement plans in place, check out the "Checklist of State DB, DC, and Other Retirement Plans" by Ronald K. Snell (National Conference of State Legislatures, January 2012).

While the pace of change has been noticeably faster in the last few years than ever before, budget reformers still angst about whether various courts will prevent reform by insisting that benefits are guaranteed pursuant to the terms of a given state's constitution and therefore cannot be altered.

Palm Beach Post reporter John Kennedy reports that workers in the Florida Retirement System may not have to add 3 percent to their pensions if the highest court in the state rules that doing so would violate its governing dictates. See "Challenge of Florida's forced pension contribution goes to Supreme Court" (March 16, 2012). In "Pension-deal danger: Vote twist leaves door open to lawsuit," New York Post reporters Fredric U. Dicker and Erik Kriss explain that a new pension tier system, signed into law by Governor Andrew Cuomo on March 16, 2012 may face a legal block by "Senate Democrats or one of the public-employee unions that are trying to fight this." As described in "Untouchable Pensions May Be Tested in California" by Mary Williams Walsh (New York Times, March 16, 2012), cities in the Golden State may be barred from enacting reform because of binding provisions in the state constitution. Whether a financially troubled municipality that files for bankruptcy protection will be subject to federal laws - with state mandates taking a legal back seat - is another "hold your breath" issue.

In "Tea Party Redux: State Pensions in Turmoil" by Susan Mangiero (www.pensionriskmatters.com, July 27, 2006), the question was asked whether taxpayers will "enough." With numerous headlines squarely focused on budget crises related to benefit plan funding, "enough" may not come soon enough for some.

CFOs Fund Pension Plans With Intellectual Property

In "How Creative CFOs are Funding Pension Plans with IP" (Valuation Researcher Alert, June 2011), its authors describe how some Chief Financial Officers are transferring intellectual property assets to their respective pension plans. To add up to 275 million Great British Pounds to its UK defined benefit plans, "TUI Travel PLC is utilizing a partnership arrangement, backed by its Thomson and First Choice brands."

The idea is novel as was Diageo's use of "whiskey" assets to top off its retirement plan funding status. See "Diageo pledges whiskey against pension deficit" by Cecilia Valente, Reuters, July 1, 2010.

As with any "hard to value" security, there is merit in using an independent third party appraiser who can objectively incorporate risk factors in projecting future expected cash flows associated with an intangible asset like a trademark or patent.

Increasingly, expert work with which I am involved has focused on questions about whether an illiquid instrument was properly valued. As I stated during my September 11, 2008 testimony on this topic before the ERISA Advisory Council, bad valuations and related poor policies and procedures can have a costly domino effect because valuation numbers directly impact asset allocation and risk management decisions over time, not to mention fees that are paid to service providers. This is not good news for fiduciaries who are already faced with numerous challenges, each of which puts them squarely in the spotlight of regulators and litigators who see many ERISA plans as needing to do much more in the way of best practices. In the United States, should the U.S. Department of Labor expand its definition of a fiduciary to include appraisers, it may discourage valuation professionals from working with ERISA plans. This itself could be a problem.

U.S. Postal Service Pension Suspends $800 MM Contribution

Let me start out by saying that the persons at my local post office are courteous, helpful and generally terrific people. That said, like most, I was surprised at the news about a suspension of nearly a billion dollars owed to this federal pension plan.

I guest blogged about this issue for CNBC on June 23, 2011. My commentary is reproduced below.

No Pension Checks for the Postman to Deliver?

The mail gets delivered in rain or snow but it might not include pension checks for postal workers. According to a June 22, 2011 press release from the United States Postal Service, it intends to suspend what it owes to its pension plan as a way to “conserve cash and preserve liquidity.” By doing so, it frees up $800 million in cash for the current fiscal year.

This federal plan sponsor is not alone.

In what seems like an unending stream of bad news on the government pension front, countless cities and states are making adjustments to their existing pension and health care plans for retirees.

Two legislative bills in Minnesota would freeze public pensions as of July 1. Following an arbitration, City of Detroit policemen will see smaller payouts. Florida teachers are suing over a new retirement income tax. Congress is seeking more transparency about public pension plan IOUs and has talked about how large scale municipal bankruptcies related to retirement plan liabilities could adversely impact the financial landscape.

While some sources say that the underfunding crisis is improving for states and cities, others angst that the problem is getting worse and that major reforms are needed now. As we head into an election year, politicos are atwitter about the funding gaps associated with entitlements like Social Security and Medicare. Add underfunded public and corporate plans to the mix and things get scary fast.

Some retirement plans are trying to make up for losses by investing in riskier assets. Absent a robust risk management infrastructure, taking on more risk could worsen funding problems later on.

There are solutions but someone has to lead the way. Raising taxes and/or rescinding benefits is unhappy news to voters. More likely to occur is a legislative mandate to pass the retirement plan hot potato onto Corporate America.

Unfortunately, individuals are unlikely to escape unscathed. The tax man cometh almost surely. Joe Q Citizen may end up footing the bill for someone else’s pension plan even if his doesn’t offer one. The gap in funding for entitlements, public plans and personal savings makes for a trifecta with few winners unless material changes are made soon.

Note to Readers:

Cows, Elephants and Pensions

In addition to a few days of productive meetings in London, I had the pleasure of seeing brightly colored elephant statues throughout the greater environs of the city. Apparently, these "for sale" collectibles are meant to draw attention to the plight of the Asian elephant. Click here to view some of the 250+ pachyderms on display through the end of June 2010. Several years ago, 3D bovines of all stripes and sizes were all the rage, appearing in New York, Tokyo, London and many other cities throughout the world. Grabbing the attention of tourists and neighbors alike, the Cow Parade was able to auction off the cows to benefit local charities.

After reading the scary projections in "Funded Status Takes a Beating" (Pension Thema, Deutsche Bank, June 2010), I wonder if we need some version of Piggybanks on Parade to accelerate the long overdue focus on financial pain in the boardroom. Authors John Haugh and Ken Akoundi project an "aggregate S&P 500 pension deficit of $325 billion" by mid year 2010 and an "aggregate funded status of 78%." Notwithstanding the economics associated with each benefit scheme and absent a pro-active risk management approach to stem further damage, funding problems can easily spell trouble for shareholders too. Topping off plans as mandated by law requires cash that could otherwise be diverted to positive net present value projects.

Who wants a porcine statue in their living room as a visible reminder that pensionland has issues that impact us all? Raise your hand.

Gordon Gekko and Over Funded Pensions

Talk about a blast from the past. As I prepared dinner this weekend, I caught bits and pieces of Wall Street. According to this film that won Michael Douglas an Oscar for his portrayal of Gordon Gekko, "Greed is Good," bad companies deserve to be destroyed and employees are collateral damage. What particularly caught my attention was the reference to an overfunded pension that., post corporate break up, would net this arbitrageur over $60 million in cash.

Wow - have things changed.

In "5 years of corporate funding gains gone" (June 1, 2009), Pensions & Investments reporter Rob Kozlowski reports that the "top 100 U.S. corporate pension plans saw their funded status drop by nearly 30 percentage points in 2008." In dollar terms, the plans reported a deficit of nearly $200 billion compared to a surplus in excess of $111 billion in 2007.

The fallout is no doubt painful for plan sponsors and participants alike. What will be interesting to watch is the plethora of new products being developed to help address funding gaps and better manage plan risk.

Editor's Note: A sequel to Wall Street is under way. I'll buy the popcorn for that movie! Sounds intriguing. Click to read more.

Hedge Fund Haven Gets Double Whammy from Pension Plan and New Regulations

According to "Taxpayers may pay for pension shortfall" by Neil Vigdor (Greenwich Time - March 1, 2009), prosperity for this lovely Connecticut may soon be a distant memory. A recent meeting of town officials revealed that "the town's pension fund has lost nearly 24 percent, more than $100 million, since last year. Continued deterioration in the equity markets could lead to a $16+ million contribution in short order. Layoffs of public workers have already begun with more likely to come. Though some employees are being directed to 401(k) plans in lieu of the traditional defined benefit plan, municipal woes are a huge headache.

Making matters worse, Greenwich - the home of more than a few major hedge funds - may soon be slapped with onerous compliance costs if Nutmeg state legislators have their way. Hartford Business Journal reporter Greg Bordonaro writes that three bills could potentially roil an already challenged industry. One bill would prohibit investments in hedge funds for individuals (institutions) with less than $2.5 ($5.0) million in assets. Another proposed rule would force additional transparency for any hedge fund that take pension assets. Only time will tell if lawmakers get their way. Earlier attempts at state mandates were rebuffed, fearing that the state would lose tax revenue from wealthy hedge fund managers. However, choppy markets make alternatives a ripe target for attack. Should compliance costs soar, Greenwich town leaders will have more to worry about than pension deficits. As hedge fund attorney John Brunjes says, "It's a highly competitive business, so it would take very little in terms of regulation for hedge fund managers to consider doing business elsewhere." Click to read "Lawmakers Propose Stiff Hedge Fund Oversight.

What's interesting is that equity-related losses are tempting plan sponsors to accelerate their allocation to strategies that lure with the potential of higher returns. Whether doubling up makes sense is a topic for another day. However, alpha-seeking institutions may have nowhere to go if new rules depress expected returns by increasing costs. The counter argument is that regulations are long overdue. No doubt it will be an interesting year for hedgies.

History Repeating Itself or a New Start in 2009?

Philosopher George Santayana once said that "Those who cannot remember the past are condemned to repeat it." If Nikolai Kondratiev were still alive, he might agree. An advocate of  long duration boom-bust periods, this Russian economist is credited for giving life to what is oft-described as a Kondratieff wave. His study of  American, English and French prices and interest rates from the 18th century led him to believe that an economic cycle is likely to repeat every 60 years, occuring as four distinct phases (inflationary growth, recessionary stagflation, mild growth and then depression). Click here and here for an interesting overview of Kondratieff's theories, applied to modern times.

As we launch into a new year, full of hope for a respite from what can only be described as a roller-coaster horrible, one wonders what lessons will be learned and acted upon. The Pension Governance team, not surprisingly, votes for a renewed (or for some organizations, a de novo) emphasis on enterprise risk management wherein plan sponsors hunker down to identify and properly measure the alphabet soup of nasties that can roil either a defined contribution or defined benefit plan. As I wrote several years ago, "Risk comes in many forms and ignoring it, while emphasizing returns, makes little sense." Click to read "Pension Risk Management: Necessary and Desirable" (Journal of Compensation Benefits, March/April 2006),

Importantly, a holistic risk management process must go well beyond benchmarking against point-in-time numbers alone. A June 9, 2008 article proves this point with respect to traditional pension plans. In "Surplus hits $111 billion," Pensions & Investments writer Rob Kozlowski chronicles a two-year rise in excess funding for the top 100 U.S. corporate schemes. Just six months later, Barrons reporter Dimitra Defotis cites a Credit Suisse report that has S&P 500 companies facing a "pension deficit of at least $200 billion," the "largest shortfall since 2002, when pension liabilities exceeded assets by a record-setting $218 billion in the aftermath of the dot-com bust." See "The Math Doesn't Add Up" (December 8, 2008). Owners of defined contribution plans are taking it on the chin as well. As USA Today reporter Christine Dugas lays out, more companies are dropping the 401(k) match at the same that plan participants have been hit with large negative returns. See "401(k) losses: Older investors' retirement funds hit hard" (October 31, 2008).

Questions abound, though not directed to any particular plan or organization. What could have been done differently to minimize the ill-effects of a systemic meltdown? What was the role of intermediaries in terms of advice-giving? Was there proper diversification? Was too much latitude given to asset managers? Was scant attention paid to risks relating to internal controls, valuation and restrictions on being able to liquidate particular holdings? Were investments in some cases not truly suitable for beneficiaries?

If New Year's Day marks an opportunity for a fresh look at life, why not make 2009 the year of the comprehensive pension risk manager?

Cracks in the Pension Safety Net System?

According to two separate news accounts, cracks may be appearing in the pension back-up systems for the United States and UK, respectively. Already jittery taxpayers may look at these warnings with heightened alarm.

In "Pension Agency Sounds Alarm on Big Three," Wall Street Journal reporter John D. Stoll (November 28, 2008) writes that the Pension Benefit Guaranty Corporation ("PBGC") is worried that large automakers may offer early retirement or buyout deals to some plan participants, at the expense of those who remain. Stoll adds that a year-end accounting by General Motors ("GM") has its pension plans "overfunded by $18.8 billion," but recently reported that "its plan for hourly workers was underfunded by $500 million because of restructuring expenses." The Toronto Star suggests funding woes for GM's Canadian pension plan. (See "GM Canada's pension plan troubled before market collapse" by James Daw, November 15, 2008.)

In "Pension lifeboat may be sunk by wave of firms being liquidated" (November 28, 2008), Phillip Inman and Simon Bowers - reporters for The Guardian - write that "The Pension Protection Fund (PPF), which has already rescued more than 66 retirement schemes, may be forced to increase its levy on profitable companies to boost its finances or risk a government bail-out if more companies go bust." With the collapse of Woolworths and other troubled companies, this UK counterpart of sorts to the PBGC may find itself in a postion of having to pay out more each year than it takes in.

This day after American Thanksgiving, known as "Black Friday" for shopping jaunts, may be the day the bell tolled for two of the world's largest concentrations of private pension schemes.

Editor's Note: On November 17, 2008, a PBGC press release describes a reduction in its deficit as a snapshot number, influenced by events that may not repeat themselves.

<< The PBGC’s insurance program for single-employer pension plans reported a deficit of $10.7 billion, a $2.4 billion improvement over last year’s $13.1 billion shortfall. The deficit of the insurance program for multiemployer pension plans was cut in half to $473 million, a $482 million improvement from the $955 million deficit reported a year earlier. 'The PBGC’s lower deficit is good news, although it is important to remember that the deficit number is only a snapshot of where we stood on September 30,' said Director Charles E.F. Millard. 'Successful negotiations with companies in bankruptcy protected workers’ pensions and sliced hundreds of millions of dollars in liabilities off our books.  Favorable interest rate changes reduced liabilities, and our careful stewardship of the PBGC’s investments limited losses to 6.5 percent of assets. Although the current turbulence in our economy will mean a challenging environment in 2009, the PBGC has the resources to meet its commitments to America's retirees for many years to come.' The decline in the deficit in the single-employer program was primarily due to a $7.6 billion actuarial credit from a favorable change in interest factors, $1.4 billion in premium income, credits of $826 million from completed and probable terminations and $649 million in favorable actuarial adjustments. These amounts were offset by investment losses of $4.2 billion and a $3.4 billion actuarial charge due to passage of time. Total return on invested funds was -6.5 percent. > 

Troubled Pensions - CNN Money Interview

Click here to view "Troubled Pensions," an interview I gave to CNN Money anchor Poppy Harlow on November 24, 2008. (The piece aired on November 26, 2008.) The roughly five minute discussion centered on four questions, including:

  • Is Congressional reform of the Pension Protection Act of 2006 needed or should plan sponsors be forced to top off underfunded plans?
  • Will the Pension Benefit Guaranty Corporation be able to handle traditional plans of ailing auto manufacturers?
  • Will plan sponsors be tempted to assume more investment risk in order to make up for current losses?
  • Is pension litigation on the rise?

UK Pensions in the Red

According to "Red alert for pension plans," The Scotsman reporter Teresa Hunter enlightens readers about mammoth losses for pensions run by some of the UK's biggest 100 companies (August 10, 2008).  Describing the 41 billion pound sterling hit as "the largest downward swing since the dotcom bust six years ago," Hunter shocks by comparing the current status quo to a 12 billion GBP (Great British Pounds) surplus only 12 months ago. A collective infusion of 40 billion GBP and a reduction of "risk by cutting their exposure to the stock market from 59% to 53%" has done little to stem the tide. Recession, additional regulatory mandates, anemic stock market returns, new accounting rules (such as FRS 17 and/or IAS 19) and extended lifespans promise more pain.

Putting things in context, the reported loss is roughly 78 billion U.S. dollars (based on an August 8, 2008 GBP/USD exchange rate as reported by Oanda.com). Some significant takeaways from the 2008 report, published by actuarial firm, Lane Clark & Peacock, are telling:

  • Like the United States experience, many British firms no longer offer traditional benefits to new employees.
  • The pension IOUs for some plan sponsors exceed their respective market capitalization. (British Airways, BT and British Energy Group are examples.)
  • Conflicts of interest arise between shareholders who seek improved pension plan expense managment versus plan participants who want more benefits (or at least do not want benefits to be cut).
  • Trustees take a longer-term perspective than shareholders, often putting them at odds with respect to risk-taking.
  • Accounting reports vary because of company-specific inputs that likewise vary such as discount rate, expected asset portfolio rate of return and longevity assumptions.
  • Some companies do not use derivatives to manage risk, hoping for an improved funding situation in "due course" and/or wanting to avoid negotiating asset allocation with trustees (who have "unilateral control").
  • "Most trustees are not investment experts" and require additional training before making a decision about swaps, pension buyouts and/or change in investment policy.

In the spirit of The World is Flat by Thomas L. Friedman, it is pretty clear that members of the global retirement fiduciary community share most of the same concerns and economic realities. There are few countries that are immune to the panopoly of factors that result in higher costs.

Editor's Notes:

Measuring Pension Liabilities: Atlas Had It Easy

According to New York Times reporter Mary Walsh, some defined benefit plan liability measurements are being called into question. Pressure to pretty up numbers or the use of older methods that don't reflect economic reality are two potential pitfalls. According to "Actuaries Scrutinized on Pensions" (May 21, 2007), New York actuary Jeremy Gold is credited for encouraging a reality check. If true that defined benefit liabilities are routinely undervalued (as some believe), the inevitable result is an added burden on taxpayers and/or recipients of municipal largesse when bills come due.

Making matters worse, lowball estimates of retirement plan IOUs can lead to expensive new benefits and/or an inappropriate investment policy. Walsh cites Alaska, New York and Texas as a few of the states with actuarial "issues." Unlike private plans, critics suggest that lax rules for public plans open the door to potential abuse.

This blog's author adds that a disconnect between actuarial numbers and economic assessments of promises to keep is no more disturbing than a gap between artificial accounting reports and the  "real" liability. This is not to say that actuarial or accounting numbers are inherently skewed. Such a statement would be a gross and unfair indictment of hard-working actuaries and CPAs who are careful to avoid relying on unrealistic assumptions or refuse to succumb to political pressures.

The main message is that investment fiduciaries have no chance of realizing a "good" outcome if they start with imprecise numbers. Greek hero Atlas may have the easier task.

Editor's Note:

1. Check out "Will the Real Pension Deficit Please Stand Up?" (June 22, 2006).

2. Click to read "Pension Actuary's Guide to Financial Economics" by Jeremy Gold et al, published by the Society of Actuaries and the Academy of Actuaries in 2006.

Warren Buffett on Pensions - Crazy Assumptions?

In case you missed it, the Oracle of Omaha, Mr. Warren Buffett opined on the less than sanguine state of pension reporting. In his 2007 Letter to the Shareholders, this famed CEO of Berkshire Hathaway Inc. made the following comments about corporate and public pension finance. His comments echo our concern (a repeated favorite topic of this blog) about the black box we currently call pension reporting is going to rear its ugly head in a horribly painful way. What we don't know is going to really hurt. Shareholders, beneficiaries and taxpayers, are on the hook at the same time that Medicare and Social Security (and international equivalents) are in deep trouble.

We concur Sir!

For more than a few plans, the sky is falling. Unfortunately, we don't have a way to gauge when and by how much. Is this anyway to run things?

Excerpted from "Warren Buffett's Letters To Berkshire Shareholders
Updated February 29, 2008" - 2007 Letter:

<< Fanciful Figures – How Public Companies Juice Earnings
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington
need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting.

An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.

After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value.

A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for.

It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market. 

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. 

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the
20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and highpriced managers (“helpers”).

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

Some companies have pension plans in Europe as well as in the U.S. and, in their accounting,
almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them
report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire. After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep. >>

The Case of the Mistaken Jellybean and Pension Food for Thought

      
                                                                 

When I was a little girl, the spring holidays were a big deal. My sister and I would spend hours in search of hidden jellybeans and chocolate eggs. My favorite flavor was licorice and, once found, I would indulge. One year, to my delight, I found what I thought was a black jellybean. Luckily, upon closer inspection, I realized it was a gift from the cat (and of course I threw it away).

So what's the moral of the story for plan sponsors?

Look closely and act wisely.  What looks like a bonus could be a nasty surprise in disguise.

More specifically, sponsors who only look at the positive impact of short-term market conditions on funding status, without addressing long-term structural issues, miss the mark. What looks like a favored treat (relief from having to do anything now as long as nominal numbers "look good") could turn out to be just the opposite (a situation left untouched until it's too late to take corrective action in a cost-effective manner).

An examination of the short-term versus long-term also begs the question. Should the funding of benefit plans be considered strategic or tactical? Those organizations that address risk management on an enterprise basis are starting to more fully incorporate the cost and design of benefit programs as part of their planning. Unfortunately, there is evidence that things remain in disrepair.

"Corporate Directors May Not Be Providing Sufficiently Robust Enterprise Risk Oversight," published by the Conference Board in conjunction with the McKinsey & Company and KPMG's Audit Committee Institute, states that "Corporate directors could find themselves exposed to liability if they fail to keep pace with evolving best practices in enterprise risk management (ERM)." The study also found that "While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile." Click here to read our prior blog post about Enterprise Risk Management entitled "Enterprise Risk Management in the Boardroom."

Enjoy what April has to offer but don't get lulled into false security.

New Fiction Book Advocates Radical Solution to Pension Crisis



If you read Thank You For Smoking (and/or saw the video), you understand Christopher Buckley 's ability to put things in perspective with humor. With his new book Boomsday, he seems to have done it again. The plot takes generational warfare to new heights. According to the book description on Amazon.com, escalating Social Security expenses compel "Cassandra Devine, a charismatic 29-year-old blogger and member of Generation Whatever" to suggest that "Baby Boomers be given government incentives to kill themselves by age 75." As you can imagine, the book is creating controversy. Click here to read more.

We've written extensively about the looming financial crisis due to increased lifespans. Click on the Demographics folder to access previously published posts (on the left hand side of the home page of this blog.)

Living longer if you are healthy, and have economics means, sounds like fun. Who wouldn't want to take a course in the classics or travel the high seas with family and friends? Unfortunately, for the younger folks who will be forced to foot the bill through higher taxes, things are not quite so grand. This is not to put blame on senior citizens. (Let's face it. We're all heading in that direction.) Unfunded benefits have never been a good idea.

If you don't mind some dismal reality with your coffee, check out The Coming Generational Storm: What You Need to Know about America's Economic Future by Laurence J. Kotlikoff and Scott Burns or Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It  by Peter G. Peterson.

The questions remain. Who has the power to solve what many believe is an imminent retirement system meltdown (including Social Security and Medicare)? What precludes them from doing something now? What is the consequence of playing ostrich, ignoring red flags and staying with the status quo? Take our 2 minute "Pension Crisis" survey and tell us what you think. Click here to start.

This post is written the day after April 1 by design. This is no April Fool's Day gag. Crushing "pay as you go" programs are here to stay until courageous leaders step up to the plate and take action or economies around the world implode.

Pension Regulation - Driving Under the Influence of a Muffin



I live in a lovely town of about 18,000 people. Thankfully, there is little crime other than an occasional act of mailbox vandalism or the theft of holiday inflatables. Credit good-hearted people and a vigilant police force, especially it seems, when it comes to driving. I know this firsthand because I was pulled over the other day for DUIM (driving under the influence of a muffin, blueberry in this case). Apparently, I was swerving slightly to the right even as I drove a cautious twenty-five miles per hour. When I rolled down my window to say hello, the police officer saw the muffin, gave me a warning not to eat while driving and said he was on the lookout for DUI's (driving under the influence). After I thanked him, a bit shaken for the experience, I got to thinking.

Can rules be too rigid and what happens when you cross the line ever so slightly?

These thoughts are not unique to me. The topic du jour in financial policy circles is whether regulation is too heavy-handed and thereby impedes capital market innovation. Just last week, wonk wizard and New York Times columnist Ben Stein queried the wisdom of the so-called Paulson Committee in seeking to redress the "onerous" audit standards attached to Sarbanes-Oxley. (See "So Many Millions, So Little Body Armor", January 7, 2007)

Citing a plethora of option problems on Corporate Boulevard, he asks: "Isn't backdating precisely an example of a failure of internal controls? Haven't we just found out that internal controls are far too lax, not too strict?"

The same question, applied to benefit plan governance, is apt. At a whopping 908 pages, the Pension Protection Act of 2006 has spawned a new industry to decipher the nooks and crannies of this far from simple regulation. Too soon to assess the fallout, one ponders. Could it be too much? If so, what can take its place?

I'm a big believer in industry self-regulation but that begs yet another question. Who represents the "pension industry" and do the players speak with one voice? Arguably, HR has a different perspective than Audit or Treasury. Without a unified world view about what pension governance means, it's hard to imagine a system without mandatory regulation.

Free marketeers will say this is troublesome. The regulatory burden is far from trivial. Real dollars are redirected to activities that may not reap rewards. Perverse incentives arise and the law of unintended consequences results. Look what happened in the UK. In the aftermath of FRS 17, a large number of companies terminated defined benefit plans as quickly as possible.

Then there is the issue of compliance. Many suggest that pension regulatory changes are outpacing the industry's ability to keep up. Does this put a fiduciary in harm's way (the equivalent of swerving slightly while eating a muffin)? You think you're doing the right thing but get "pulled over" nonetheless. How can a decision-maker protect herself (himself) from mounting personal and professional liability?

Here's to pension governance solutions - the sooner the better!

Pension Disclosure and SEC Sanction



According to its website, the SEC sanctioned the City of San Diego "for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003."

The SEC-issued Order "finds that the city failed to disclose that the city's unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city's liability for retiree health care was another estimated $1.1 billion.

According to the Order, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. The Order further finds that the city knew or was reckless in not knowing that its disclosures were materially misleading."

The Order makes for fascinating reading. For one thing, an eight percent assumed rate of return on investments was used "without regard to its actual historical rate of return." Some increased benefits were treated as contingent liabilities that were not reflected in certain liability calculations.

Some general observations ensue.

1. Assuming no fraud, a plan's actuarial report should be read in conjunction with any other disclosures about a plan. To the extent that there are differences, responsible fiduciaries must ask hard questions in order to reconcile the "tale of two pensions."

2. This is unlikely to be the last event of its kind. Does this put additional pressure on rating agencies and other watchdog groups to identify potential red flags before the fact, to the extent possible?

3. What is the future of public plan pension and health care benefits? Courtesy of Sean McShea, president of Ryan Labs, a recent Economist article about Other Post-Employment Benefits ("OPEB") augurs poorly for taxpayers in states adversely affected by a new government accounting decree. "Going into effect on December 15, the rule requires municipal government employers to "treat their health-care promises to workers the same way they already handle their pension obligations: by reporting on the total size of their future commitment, instead of just this year's cost." (See "The known unknowns, Economist, November 16, 2006)

4. The size of the liability is important as is the rate of growth in the liability, netted against the expected change in asset performance.

5. Plans in crisis will be tempted to reach for higher expected returns. Identifying and evaluating incremental risk is essential. A bad choice could exacerbate an already grave situation.

With Thanksgiving in the U.S. only a few days away, we'll have to think long and hard about why we are grateful in benefits land.

Pension Fiduciary Liability - Busy Times Ahead



The life of a pension fiduciary is no bowl of cherries. As I wrote on May 16 of this year, I parenthetically asked why anyone would want to be a fiduciary. Their job is critical to the process but less than easy.

"Often the pay is bad and the hours are long. (Individuals seldom receive any additional compensation at the same time that they are asked to assume significant responsibilities that put them directly in the 'line of fiduciary fire.') One might say it's like being asked to constantly eat your peas without any hope of ever getting dessert." (Click here if you want to read the entire post entitled "Who Wants to be a Fiduciary Anyhow?")

In "Liability of plan fiduciaries a still-growing concern", journalist Marion Davis (Providence Business News, November 11, 2006) writes that, post-Enron, employers are more aware of their fiduciary duties to "manage the plan honestly" and to "manage it reasonably well and provide accurate and complete information to participants."

She cites attorney Richard D. Hoffman with Nixon Peabody as saying that "he has seen a growing number of employers buy insurance to protect themselves from ERISA claims" at the same time that the "number of claims has increased as well" and "plantiffs have become more sophisticated."

Issues such as fees are just the tip of the iceberg. The Pension Protection Act of 2006 adddresses valuation and a cornucopia of investment-related issues such as qualified alternatives for 401(K) plan participants. The article quotes attorney David C. Morganelli with Partridge, Snow & Hahn as recognizing a heightened awareness of what is at stake, adding that "lawyers such as himself have been answering an increasing number of questions about obligations and liabilities under that law and under ERISA."

In January 2007, our sister company, Pension Governance, LLC, will be unveiling a searchable pension litigation database, along with regular updates about trends and highlighted cases as pertains to financial issues. We started on the database over ten months ago and quickly realized that the volume of cases to be analyzed and catalogued dwarfed our original expectations.

The good news is that there are many things that can be done upfront to mitigate fiduciary risk. The questions for pension fiduciaries are threefold. Are they fully aware of all relevant risks? Do they know what has to be done? Are they ready to move forward?

We'd love to give you our take. Email us if you want to be notified of the pension litigation database launch and/or would like to get our thoughts about the challenges that loom ahead.

Editor's Note:
Please be reminded that we do not provide accounting, investment or legal advice. We provide independent research and analysis to pension fiduciaries and/or their attorneys in the areas of financial risk, derivatives, valuation, fee economics, disclosure best practices, questions of suitability and prudential process as relates to financial/economic issues. In addition, we offer training and consultation to boards, investment committees, trustees, regulators and pension-focused money managers in the areas of financial risk and valuation.

Mice, Red Wine and Escalating Health Care Costs



New York Times reporter Nicholas Wade describes research by the Harvard Medical School and the National Institute of Aging that could be a boon for vintners worldwide. Using experimental mice, scientists allege possible benefits of a "natural substance found in red wine, known as resveratrol". One group of furry creatures, fed a high-fat diet, accompanied with daily doses of resveratrol, gained weight but did not experience signs of medical problems and, "even more striking, the substance sharply extended the mice's lifetimes."

Wade describes a second gateway to expanded years - put the cupcakes away. Research done since 1935 shows that "mice fed a calorically restricted diet - one with all necessary vitamins and nutrients but 40 percent fewer calories - live up to 50 percent longer than mice on ordinary diets."

Elsewhere, Medicinenet.com quotes Mark Mattson, Ph.D and chief of the Laboratory of Neurosciences at the National Institute on Aging as likewise extolling the benefits of this approach.

"First, it reduces free radical production, or the production of highly damaging forms of oxygen, and the second is that calorie restriction increases the resistance of cells to stress. We think that both of these are important in protecting against a number of different diseases that have a negative impact on life span, such as cardiovascular diseases and cancer."

If you're panting to try cold kale soup and other goodies (similar to what my husband eats), click here to visit the site of the Calorie Restricted Society for more information.

Lest you are asking what this has to do with benefits, many experts now describe pension "problems" as tiny compared to a looming health care crisis - one that could wreak financial havoc across companies, big and small. So while the prospect of living longer is an amazing gift for many, there is a real cost of providing medical services to retirees. In some cases, post-employment exceeds work span by a significant amount.

At my request, Mr. Robert James Cimasi, president of Health Capital Consultants and author of The U.S. Healthcare Certificate of Need Sourcebook and countless articles and speeches, describes the situation this way.

"The US Healthcare Delivery System is facing what is perhaps its greatest challenge in the expected demand for increased health services from the aging of the baby-boom generation, the fastest-growing segment of the population. With the over 65 years old portion of the US population expected to increase from 20 million in 1970 to 69.4 million in 2030, the entire system by which healthcare services are dispensed in the U.S. is subject to radical change in the next two decades. As healthcare costs continue to rise faster than inflation in the overall economy, driven by advances in technology and treatment (as well as the growing baby-boomer population), pressures to reduce costs will result in a changed paradigm for healthcare delivery, most likely leading to some form of healthcare rationing. The potential result is that the quality of care received will depend increasingly on the individual's ability to pay.

One example of this trend is the accelerating movement from the traditional U.S. health coverage system of 'defined benefits' (where employers provide a package of defined benefits to their employees) to a system of 'defined contributions' (where employers contribute a set amount and then require employees to decide how much of their health benefit dollars to spend by selecting from a range of benefit plans), which is being driven by employers seeking to limit their exposure to what has become double-digit health insurance premium rate increases. These arrangements represent a fundamental shifting of the financial risk of health coverage from the employer to employees, whereby employers can limit their contributions, while employees must contribute increasing amounts of their own money to pay for health insurance cost increases in attempting to maintain the same level and quality of health care for themselves and their families.

This 'sea-change' in the U.S. Healthcare Delivery System presents both challenges and opportunities for the investment community, based to a great degree on the scope of their understanding of the risks related to these fundamental underlying factors."

For additional information, visit the HCC website library.

Other online resources that may be of interest are listed below.

1. National Center for Policy Analysis Health Care Economics

2. About.com Health Care Economics

3. Council on Health Care Economics and Policy

4. U.S. National Library of Medicine Health Care Economics

Freezing Pensions: Brrr!



Talking about defined benefit plans is a little like listening to the Beatles.

You say yes, I say no.
You say stop and I say go go go, oh no.
You say goodbye and I say hello
Hello hello
I don't know why you say goodbye, I say hello
Hello hello
I don't know why you say goodbye, I say hello.


While some advocate their use as a means to attract and retain employees, others intimate their inevitable demise. Either way, one thing is certain. More and more companies seem to favor plan freezes in order to cut costs.

Dow Jones Newswire reporter Steven D. Jones points out that the newly enacted Pension Protection Act of 2006 encourages freezes by compelling companies to fully fund their obligations within a prescribed period of time.

Whether a freeze is "soft" and shuts out new entrants or "hard" and also halts benefits from further accruing, current retirees are not typically impacted. On the other hand, people in the system could end up with less money when benefits are tied to time in the plan.

Even when companies are flush with cash, freezing may make sense. Retiree longevity comes with a hefty pricetag in terms of funded benefits. Moreover, forthcoming accounting rules will force disclosure of pension obligations onto the balance sheet, an unwelcome event for some, especially if it leads to loan covenant breach.

Even writing from a few sunny vacation days in Arizona, this author has to admit that the pension climate sometimes seems downright Arctic.

Jacket anyone?

PBGC Data Book Paints Grim Picture

In its newly released "Pension Insurance Data Book", the Pension Benefit Guaranty Corporation (PBGC) continues to show about a $23 billion deficit, adding that "typically, the plans trusteed by the PBGC are only about 50 percent funded on a termination basis. Very few of the claims against the agency (only 1.5 percent) come from plans that are at least 75 percent funded."

By way of background, the "PBGC is a federal corporation created by the Employee Retirement Income Security Act of 1974 to guarantee payment of basic pension benefits earned by workers. Its two insurance programs cover 44 million American workers and retirees participating in over 30,000 private-sector defined benefit pension plans, including some 1,600 multiemployer plans. The agency receives no funds from general tax revenues. Operations are financed largely by insurance premiums paid by companies that sponsor pension plans and by investment returns."

Could it get any worse?

Pension Truth Telling


Wikipedia describes the Rashomon Effect, named after the 1950 classic movie, as the proper way to describe any situation "wherein the truth of an event becomes difficult to verify due to the conflicting accounts of different witnesses."

And so one wonders if the Rashomon Effect pervades in pensionland. After all, it seems that every day brings new headlines with gloomy news about pension losses. Can it all be bad?

Whether a pension crisis is upon us is an excellent question. Solving a problem is impossible without acknowledging its existence.

These thoughts arose a few days ago when a blog reader sent the following anonymous note:

Government plans are not covered by ERISA for sound constitutional reasons, state sovereignty, the 10th Amendment, etc. Take a closer look and you will see that most plans are soundly managed. They are also subject to multiple levels of state oversight. Don't buy the hype.

Importantly, one might have penned something similar about ERISA funds regarding what we read and hear. The focus of the newly passed Pension Protection Act of 2006 in all of its 907 page glory, and now awaiting Presidential approval, company pension headlines are often negative, replete with references to losses, rescinded benefits and/or impact on employee morale.

The National Association of State Retirement Administrators ("NASRA") has written extensively in support of municipal pension plan management. To illustrate, in an August 2, 2006 letter to federal lawmakers, they and other signatories wrote about the misperceptions of public pension finance and the benefits of a study by the Government Accountability Office to set the record straight.

There are fundamental differences between governments and businesses that result in critical distinctions between plans in each sector and the way in which they are accounted for and measured. These distinctions are often unknown or misunderstood.

Public plans are in sound financial condition and State and local governments take seriously their responsibility for paying promised benefits to their employees and retirees. Comprehensive State and local laws, and significant public accountability and scrutiny, provide rigorous and transparent regulation of public plans and have resulted in strong funding rules and levels. Public plans are backed by the full faith and credit of State and local governments. Additionally, a public plan participant's accrued level of benefits and future accruals typically are protected by state constitutions, statutes, or case law that prohibits the elimination or diminution of a retirement benefit, providing far greater protections than what is provided by ERISA or PBGC.

State and local retirement plan assets are professionally-managed and provide valuable long-term capital for the nation's financial markets. The $2.8 trillion held in plan portfolios are an important source of stability for the marketplace and are designed to withstand short-term fluctuations while still providing optimal growth potential.

The bulk of public pension funding is not shouldered by taxpayers.

The vast majority of public plan funding comes from investment income.


This author concurs that shedding more light on the financial health of public plans is a great idea. Ditto for ERISA funds.

Finger pointing is futile. Taxpayers, shareholders and plan participants just want to know what impacts their wallets.

1. Can I afford to retire?

2. Will my benefits be limited or, worse yet, pulled away once I've retired?

3. Will my taxes go up?

4. Will my equity investment fall in value because of a company pension problem?

Reasonable people want answers now, not later on when it's too late to do anything to salvage their financial stake. As mentioned many times before, a real dilemma is information - old, incomplete and/or difficult to interpret. (Click here to read "Will the Real Pension Deficit Please Stand Up?")

How can we get closer to the truth and then use it productively?

California Dreaming: Pension Bill Fails



A recent legislative attempt in California has apparently caused quite a stir. Assembly Bill (AB) 2122 sought to preclude companies from paying dividends to shareholders before satisfying pension obligations and to "make directors and officers of a corporation jointly and severally liable for improper distributions" under certain circumstances.

Refer to the July 13, 2006 post entitled "Dividends, Pensions and California Chaos".

Blogger Jerry Kalish provides a novel suggestion.

The proposed bill - and the politics behind it - conveniently ignores the massive unfunded pension liabilities in California, e.g, the California State Teachers' Retirement System faces a $24 billion unfunded pension liability.

But we got them beat in my home state of Illinois which at $35 billion has the largest unfunded pension obligation in the country. The Fitch Rating service released a "negative outlook" for Illinois finances - one of only three negative outlooks issued by the rating service in its review of the states. The other two? Louisiana dealing with the aftermath of Hurricanes Katrina and Rita and Michigan dealing with massive problems in the automobile industry.

Um! Should there should be a law that no more salary increases occur for state legislators until pension liabilities are met?


So where does this attempt stand now?

According to the website that tracks California legislation, the bill failed passage on June 22, 2006 with "reconsideration granted".

While laudable to encourage prudent pension funding, there are a host of problems associated with this type of reform.

Is Milton Friedman right when he said that "the government solution to a problem is usually as bad as the problem" and that "there's no such thing as a free lunch?" Notwithstanding the law of unintended consequences, empirically validated time and time again, there are a variety of better, and arguably more efficient and cost-effective ways to solve the pension "crisis" than putting state legislators in charge of a company's capital structure.

Bye Bye Equities



The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

Air Miles to Fund Pension Shortfall



The Independent reports that "British Airways is mulling the sale of its Air Miles customer loyalty scheme to help fill a pensions deficit that could be twice as big as first thought".

A novel concept, perhaps U.S. carriers will follow suit. How it will work specifically is not yet publicly known. It is reported that British Airways would receive up to 200 million British pounds "and provide flights in return" as part of a "complex transaction".

How the deal is priced will be of particular interest to many. Since airlines often employ discriminatory pricing, what exact flights should be bartered (in terms of revenue generation possibilities)? What are the tax implications? Is this the best way to finance the pension shortfall? What is the likely shareholder reaction? How will frequent fliers be impacted?

If it works for the airlines, what about the credit card companies and other industries that regularly employ reward programs to augment market share and plump up the bottom line?

Will the Real Pension Deficit Please Stand Up?

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?

Increased Liability for Fiduciaries, Trustees and Plan Sponsors?



Fiduciary liability is serious stuff. As earlier discussed, ERISA litigation statistics suggest a precipitous increase, especially with respect to issues of fiduciary breach. (See "Pension Lawsuits".)

According to Reish Luftman Reicher & Cohen attorney Joe Faucher, ERISA fiduciary liability can apply "when the plan expressly designates a person as a fiduciary, generally as the plan administrator, plan trustee, or member of an administrative committee". It is also relevant when "a manager performs a function that ERISA deems a fiduciary function". Examples include the following:

1. Influence or control "over the management of the plan or any authority or control over management or disposition of the plan assets"
2. Provision of investment advice in exchange for a fee
3. Discretionary authority as regards plan administration

On June 13, Greenberg Traurig attorney and Chairman of the Employee Benefits Group, Jeffrey D. Mamorsky, will be joined by Rhonda Prussack, Fiduciary Liability Product Manager for the National Union Fire Insurance Company and IRS Senior Employee Plans Examiner and Large Case Reviewer, Randy G. Sammons.

The topics?

1. Trends in Litigation
2. Regulatory Environment
3. IRS Audit Initiatives
4. Prescriptive Techniques to Avoid Litigation

Is a new wave of trouble about to crash around us?

With an increased focus on compliance, governance and best practices, we're likely to hear much more about fiduciary breach. Keep in mind that even service providers such as CPAs, money managers and consultants are vulnerable, personally and professionally. (The author is neither an attorney nor CPA. Readers are urged to seek advice from appropriate professionals as to whether they are fiduciaries to a plan and what that entails.)

Though not a panacea for eliminating oversight duties, outsourcing is gaining in popularity. Independent Fiduciary Services CEO Samuel (Skip) Halpern provides some compelling reasons as to why and when to seek help in the form of an independent fiduciary.

Look for much more on this topic in coming months!

Pension Accounting: Catalyst for Change?

I have long wondered when people would really start to pay attention to what some describe as the "pension perfect storm". Could new accounting rules be the catalyst for change? Just recently, the Financial Accounting Standards Board unveiled the first of several changes in how companies will have to portray pension fund finances. Arguably long overdue, a company will need to recognize "the overfunded or underfunded status of defined benefit postretirement plans as an asset or a liability in the statement of financial position". A second phase of this multi-year project will impact reported earnings.

What lies ahead?

If past is prologue, a change in the way financial statements are assembled will have a material influence on corporate behavior. Consider FAS 133, the mammoth rule book for derivative instrument accounting. Not long after it took effect, more than a few companies cut back on the use of derivatives, citing FAS 133 compliance as overly complex and time-consuming. Reducing speculative positions is one thing. Abstaining from the use of derivatives to mitigate interest rate, commodity, currency or equity risk is another thing altogether. Following the promulgation of FRS 17 in the UK several years ago, the National Association of Pension Funds "found that more than three quarters of companies offering final salary pension schemes were less likely to do so because of the new accounting standard".

In both cases, the law of unintended consequences prevailed. Instead of promoting transparency, new accounting rules encouraged outcomes that were contrary to the original intent. Does this mean that additional companies will shed their defined benefit plans rather than report "bad" numbers? (Note that freezing or terminating a plan has both an accounting and economic impact so the choice is not as straightforward as it may seem.)

Am I saying that accounting reform is bad? Not all all. I think the marketplace is desperate for more and better information. Will that ensue with FASB initiatives? It's too soon to say. Final rules are months away. (Subsequent postings will dive deep into the issue of pension information and the lack thereof. Suffice it to say, there is so much about pension assets and liabilities that remains a mystery.)

Will the new accounting requirements improve pension economics? Will shareholders have a better understanding of the true cost of providing post-retirement benefits and the related impact on dividends, earnings and flexibility? Will employees and retirees feel more or less comfortable that defined benefit plan promises will be kept? Will taxpayers worry that a federal bailout looms large as post-implementation numbers surface? Will reported figures square with actuarial or statutory assessments?

Notwithstanding a plethora of unanswered questions, I'm betting on FASB to mix things up. After all, the pension issue impacts the lives of nearly every adult in the U.S. (and abroad), either as investor, employee and/or taxpayer. When accounting rules change, so too do people's actions.

Is There a Pension Crisis?

People are living longer, requiring even more in the bank to pay bills once they quit working. Studies consistently show that most people are saving very little and are not financially prepared to retire any time soon. Social Security trustees project costs to exceed tax revenues as early as 2017 and are urging reform. This is particularly compelling now that only three workers pay taxes into the system to support each existing beneficiary, compared to the original sixteen persons at inception.

Last summer, the U.S. Government Accountability Office released a study citing the largest ever deficit of $23.3 billion for the Pension Benefit Guaranty Corporation, a single-employer insurer that protects the retirement incomes of more than 40 million American workers in excess of 30,000 defined benefit pension plans. Executive director, Bradley Belt, stated that "financially troubled companies have shortchanged their pension promises by nearly $100 billion, putting workers, responsible companies and taxpayers at risk." In July, Standard & Poor's reported that defined benefit plans for 364 of the S&P 500 Index member companies remain under-funded by $165 billion. Public pension plans are struggling too. National Association of State Retirement Administrators statistics indicate a $300 billion aggregate pension shortfall for the largest state and city plans.

What do you think about the current retirement situation? Choppy waters or calm seas?

Take our five question survey and see what others think too.