Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

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.

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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.

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Are we there yet?

While traveling to New York City the other day on Metro North, I sat behind a little boy who kept asking his parents the same question that many in the pension field are pondering.

The issue of what end game applies is noteworthy, especially now that Congress has adopted pension reform.

In "Looking for Cash, Congress Finds Some in a Corporate Pension Rule Tweak," New York Times reporter Mary Williams Walsh (June 28, 2012) describes the parts of the just passed highway bill that could force costs upward for American businesses. For one thing, sponsors will be able to stretch out their cash outlays to buoy underfunded defined benefit plans over time. As a result, tax-deductible contributions will be smaller in the next few years, taxable income will be higher and federal tax coffers will go up by an estimated $9.4 billion over the next 10 years." In addition, insurance premiums that companies pay to the Pension Benefit Guaranty Corporation ("PBGC") will be higher to the tune of roughly $10 billion in the coming decade.

The news is troublesome for numerous reasons.

For one thing, employees, retirees, creditors and shareholders are going to find it even more challenging to assess the true cost to companies that offer benefit plans. As a result, they could be in for a nasty surprise later on if reported performance numbers are overly optimistic and mask a large liability that eventually will require cash. Second, the increased PBGC premiums are slated for general revenue which means that incremental dollars may never be available to pay participants of troubled sponsors because they have already been spent elsewhere. Third, using corporate pension plans as a national piggyback to pay for other programs goes against the nature of the trust arrangement that was put in place with the 1974 creation of the Employee Retirement Income Security Act ("ERISA"). Fourth, measuring pension risk and managing it effectively requires those in charge to have a good handle on the economic objectives they are seeking to satisfy. Chief financial officers ("CFO"s) and treasurers could be doing an excellent job of mitigating relevant uncertainties but not be rewarded if capital market participants emphasize accounting numbers that do not capture what is really going on.

Dr. Susan Mangiero, CFA charterholder, certified Financial Risk Manager, Accredited Investment Fiduciary Analyst and author of Pension Risk Management for Pensions, Endowments and Foundations will continue to write about pension risk management. There is a lot more to say.

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As this blogger, Dr. Susan Mangiero, has pointed out repeatedly since the March 2006 inception of www.PensionRiskMatters.com, pension governance counts.

There are numerous ways to quantify the positive impact of governance done well. By extension, the costs of poor pension governance can throw cold water on growth in corprorate earnings and free cash flow. As a result, not only can plan participants suffer but so too can shareholders and creditors should bad employee benefit plan decision-making depress the value of company issued securities.

In a recently issued survey, Towers Watson finds that four out of ten employers "expect to devote more time addressing retirement plan governance issues over the next two years." Reasons cited include the expense of providing benefits, along with more regulatory complexity. Investment volatility was another identified catalyst.

While the in-depth study is not yet published by its sponsor, Towers Watson, it will be interesting to explore later on why more than half of respondents acknowledge the importance of compliance but "only one in four (26%) schedule regular compliance reviews."

Visit www.towerswatson.com/governance-survey for more information.

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I am off to Orlando to address the Florida Public Pension Trustees Association about pension risk management. I will be joined by an esteemed colleague, Dr. Michael Kraten, in a presentation about the fundamentals of enterprise risk management (including the famous COSO cube) and the role of the service provider in creating hedging programs and vetting asset managers who use derivatives. The workshop will include two case studies about foreign currency overlay programs and investing in hedge funds and private equity funds, respectively.

Having addressed the Florida Public Pension Trustees Association ("FPPTA") several times before about pension risk management, I am impressed with its commitment to fiduciary education about investment best practices.

Click here to review the FPPTA agenda for the 2011 summer conference.

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While on a "sort of" vacation at a health spa in Arizona, this blog's author has treated herself to some "fun" reading, in between exercise classes and tending to business. As such, I came across an article in the Science Times section of the New York Times that I would have ordinarily set aside. Written about perception and reality, it seems to perfectly capture current happenings in pension land. Coincidentally, its August 21 publication date was the same day I fielded an invitation from CNBC to address whether pensions are taking on too much investment risk, where one goes to unearth information about pension investments and whether there is anything a plan participant or shareholder/taxpayer can do about "excess" pension risk. Unable to coordinate schedules, I will not appear on August 22. However, I encourage readers to download the Squawk Box video of the segment about pension risk. It promises to be interesting and timely.

Let me connect a few dots.

According to George Johnson, author of the aforementioned article, "Sleights of Mind," magicians succeed by exploiting what are described as cognitive illusions - "disguising one action as another, implying data that isn't there, taking advantage of how the brain fills in gaps." According to The Amazing Randi, this means that assumptions are often mistaken for facts.  Courtesy of the Visual Cognition Laboratory at the University of Illinois, a short video illustrates that observation skills are mixed. Only a few audience members who watch a film of basketball players - and then count how many times a particular team (categorized by shirt color) scores - ever notice the man in a gorilla suit walking on stage. (By the way, did you know that there is such a thing as National Gorilla Suit Day? Click here to learn more.)  

How this relates to pension risk is as follows. We know that billions of pension dollars are moving into derivatives, hedge funds, private equity funds, commodity pools, infrastructure, real estate investment trusts and so on. We know that some of these funds invest in economic interests that are "hard to value." We know that not every fund has a solid risk management policy. (Current newspaper headlines make that point abundantly clear.) We know that not every pension fiduciary has a finance background, let alone investment expertise. We know that finding out about a pension fund's holdings and liability risk drivers is often difficult. Form 5500 reports filed by ERISA funds are stale and overly general. Public funds might provide some information online or in response to the Freedom of Information Act but likely not on a frequent enough basis. Even financial footnotes are notorious for what they don't say about pension risk (on both the asset and liability side). It's rare if we even know who is making multi-million decisions about employee benefit plans, let alone be able to review their resume to gauge "suitable" knowledge and experience. We've blogged many times about meaningful disclosure, or more precisely, lack thereof. Click here to access past posts on this topic.

In a soon-to-be released survey about pension risk (co-developed by Pension Governance, LLC and the Society of Actuaries), there is clear evidence that pension fiduciaries perceive that they are doing a great job of vetting external managers with respect to risk management at the same time that the questions they profess to ask are overly simplistic. (Look for the executive summary to be released in mid-September.) Our forthcoming www.pensionlitigationdata.com clearly indicates a surge in allegations of breach on the part of the investment fiduciary(ies).  Coincidence? Maybe not.

If the Fed and international central bankers are unable to quell investors' fears, we move into a recession and/or different asset classes get hit hard in terms of price volatility, life is going to be very tough for plan sponsors. Poor practices will likely come to light as large losses occur. Risk is truly a four-letter word. Absence of a rigorous risk identification, measurement and management system (policies, procedures, operations) will leave little room for defense.

 We are going to write much more on this topic in coming months. It's too important to ignore.

P.S. The nice photo comes to readers from the National Zoo.

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Are derivative instruments a recipe for disaster, an integral part of effective investment management or something in between? As explained in "Derivatives: The $270 Trillion Gorilla", meteoric growth around the world speaks volumes. At the same time, the incremental risks are real and cannot be dismissed.

Financial News reporter Renee Schultes writes that few fund managers "have the operational infrastructure and expertise to trade outside the listed and less-liquid listed derivatives market." (See "Managers struggle with OTC derivatives trading", Financial News, September 25, 2006.) Financial Times journalists Paul J. Davies, Gillian Tett and Saskia Scholtes chronicle efforts to address operational issues related to derivatives. (See "Derivatives dealers' tough match", Financial Times, September 25, 2006.)

New accounting rules and regulations encourage a paradigm shift that emphasizes risk analysis. Liability-driven investing is the new "it" topic and, by extension, derivatives are getting a serious look by public and ERISA pension fiduciaries alike. Money managers use derivative instruments as well for a variety of reasons such as transforming cash flows, leveraging exposure to a particular asset class or hedging. The Towers Group, a research and consulting firm, reports that "buy-side derivatives usage" is expected to "explode, bolstered by the shift to electronic trading, search for alpha, and more accommodating regulations (such as changes to ERISA and the adoption of the Prudent Investor Rule), which allows derivatives usage in pension funds and institutional money management." (See "Growth in Derivatives to Have Profound Impact on Wall Street Firms", September 18, 2006.)

The ultimate question is whether the expected benefits outweigh the costs. I wrote an entire book on this topic. Written for fiduciaries and related parties, Risk Management for Pension Funds, Endowments, and Foundations is a primer about the risks and benefits of derivatives and, more broadly, risk identification, measurement and control. I could easily write a second book about the topic. There is so much to say.

That is why subsequent posts will address the topic of derivatives, and the fiduciary implications of their use.

For those who want to read more, here are links to earlier blog posts and some articles I've written about risk management.

1. "Derivatives Get the Blame"

2. "Operational Risk and Derivatives"

3. "Derivatives Valuation: One Size Does Not Fit All"

4. "Pension Risk Management: What We Don't Know Can Hurt"

5. "Five Keys to Risk and Risk Management"

You can find lots more by going to our online library. You may also be interested in receiving our complimentary ezine about risk and valuation. Click here to sign up. (A link to our privacy policy is at the same URL.)

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The just released pension fund asset management guidelines, courtesy of OECD (Organisation for Economic Co-operation and Development), state that "legal provisions should address the use of derivatives and other similar commitments, taking into account both their utility and the risks of their inappropriate use".

I will devote considerable time to the topic of derivatives and pensions in this blog. For now, I will make a few introductory comments to hopefully whet your appetite.

1. Derivatives can be used in a variety of ways to manage assets and/or liabilities and for both defined contribution and defined benefit plans (though there are significant differences with respect to strategy, risk assessment, accounting treatment and so on). I have written a lot about this topic, including a book and countless articles, and there is still much more to say. Identifying, measuring and managing risk is a cornerstone of being a good investment fiduciary.

2. The derivatives market is huge. According to the Bank for International Settlements, outstanding over-the-counter derivatives contracts (in terms of notional amounts) exceeded $270 trillion when estimated in June 2005. Think about it. In comparision, the U.S. national debt tally is approximately $8.36 trillion. Estimated 2005 gross world product is $59.38 trillion. The global derivatives market is the proverbial 200 pound gorilla of the financial world. It is worthwhile understanding why this market continues to grow. (Stay tuned!)

3. Derivatives are contracts that "derive" their value from the value of an underlying security, commodity, index or other type of instrument. For example, the value of a gold derivatives contract depends on the price of cash gold. (Derivatives valuation is a broad topic and will be addressed in other postings.)

4. The term "financial risk management" typically refers to the use of derivatives in some fashion (though this is not always the case).

5. Pension fiduciaries who ignore derivatives, especially if the Investment Policy Statement restricts their use, may want to rethink their stance. They should know that financial performance is impacted by the price behavior of derivative instruments if they have allocated monies to: (a) hedge funds or mutual funds that employ derivatives (b) asset-backed securities such as mortgage-backed bonds or collateral default obligations (c) convertible bonds (d) callable bonds (e) currency sharing agreements (f) private equity with warrant arrangements (g) contingencies of any type and the list goes on.

6. Derivatives, used improperly, can wreak havoc. Much more will be said about the identification and measurement of risk, how to determine appropriate use and a host of other critical MUST KNOW elements of the decision-making process.

7. The issue of a fiduciary duty to hedge is an ongoing and interesting legal question.

8. Financial engineering opens the door wide to a variety of new investment opportunities for pension funds. Fiduciaries must know (or learn) how to evaluate each opportunity. Outsourcing does not eliminate the fiduciary's duty to monitor.

9. Using derivatives is seldom a one-time event but instead requires a commitment to evaluate economic efficacy on an ongoing basis.

10. Creating a risk management process is just the beginning. I will address the Five C Approach(SM) as a way to assist fiduciaries.

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