By Barton Waring
The Committee on Investment of Employee Benefit Assets' study this year reported that many corporate defined benefit plan sponsors will consider terminating or "freezing" their plans if "mark-to-market" reforms are put in place, suggesting that pension risk would then be too high to bear.
Is this perhaps an overreaction? Defined benefit pensions are wonderful, socially beneficial programs, and a cost-effective means of providing retirement security as a part of a total wage and compensation package. We don't want to lose them. Might there be another side to this "mark-to-market" coin, an opportunity to protect defined benefit plans, strengthening and growing them rather than terminating them?
Smoothing originated years ago, before the development of much of Modern Portfolio Theory, in a well-intentioned effort to reduce risk. But smoothing doesn't make risk go away — it is cosmetic only. We know today better than we did then that risk is expected to accumulate with time, not "revert to the mean"and go away. Since smoothing only protects us when the path of multiyear bad and good returns cancel each other out it won't help during the many periods when they do not self-cancel.
Modern Portfolio Theory teaches us that the real way to reduce risk in the asset and liability context is through hedging the market-related risks of the liabilities with assets having similar market-related risks to the liability's, so as to reduce the net volatility of the pension surplus or deficit.
There is agreement that the liability is mostly bondlike in nature. So the investment policy portfolio with the lowest risk for the funded status of the plan would also be mostly bondlike, looking much like the liability model. One way to accomplish this lowest risk investment position is to establish cash-flow matched or duration matched portfolios. But the lowest risk position isn't necessarily the right investment policy.
As one considers a more aggressive investment policy, mixing in greater proportions of equity, one is reducing the liability hedge and taking on greater net risk. To a point, this can be justified as a fair trade for higher returns. The real decision to be made is how much market-related risk, on the "surplus efficient frontier," should the plan's assets be exposed to, in this search for greater return.
So how does this policy decision relate back to the smoothing concern? You can't hedge the liability with smoothed assets. It is ironic, but today we can see that smoothing and other accounting distortions actually interfere with our ability to clearly see and manage risk.
Today's pension investment policies, averaging more than 70% in equities, are heavily disconnected from the liabilities, and as a result, the sponsor's recent experience of risk has been uncomfortable. Perhaps pension plans should be holding less equity than today, but the response that plans might go to a completely liability-matched policy is also not correct. The right answer will be something in between — but it has to be determined on a market basis, not a smoothed basis. Properly implemented, such an investment policy will be comfortable to the sponsor, which protects the longevity of the plan.
The opportunity is clear: in a market framework we can take advantage of hedging to reduce funded level risk to whatever degree is desired. And when funded level risk is reduced, then by natural extension we reduce the volatility of pension expense and the volatility of pension surplus.
And it is worth noting that an organization wouldn't have to do its accounting and reporting on such a mark-to-market basis — one could manage the plan on such a basis for internal purposes, as some plans do, regardless of the book value methodology. But the reality is that this duality of management and accounting is rare in the pension world.
For this reason, smoothing reforms might facilitate a more accurate and economically useful view by management into the real workings of a given plan, improving the ability of the sponsor to retain and manage the plan over time. You can't manage what you can't see, and we all know that the current system doesn't provide a clear-eyed view into the real status of the plan. Regardless of what we say the numbers are, the economic numbers are the underlying reality, and we will be better off if we manage to them. The liability and the assets are what they are, regardless of what the accounting system says they are: A pound of feathers is not easier to bear than a pound of bricks.
I'm aware that it is a challenging suggestion, given the heat of the accounting and reporting discussion surrounding the marking to market (and other) accounting proposals, to point out that there might be real advantages to managing the plan's risk in a market-related framework. It may not be necessary to change the accounting system for us to change our management approach, but it is necessary that we manage these plans better and changing the accounting might facilitate this healthy change.
But we know one thing for sure: If we moderate the real (market) risk in pension plan investments, the accounting and reporting risk related to the plan will go down also, regardless of whether or not the accounting risk is smoothed or marked to market. Let's protect these plans, and even grow them, with sensible, market-related approaches to risk management that make the sponsor's experience a more pleasant one.
Barton Waring is managing director of Barclays Global Investors, San Francisco.