On June 27 in New York, Pensions & Investments hosted a roundtable featuring some of the nation's leading pension strategists discussing the future of defined benefit plans. The participants were M. Barton Waring, managing director and head of the client advisory group at Barclays Global Investors, San Francisco; Peter Chiappinelli, senior vice president of strategic services, Pyramis Global Advisors, Boston; Eve Guernsey, chief executive officer, Americas, of JPMorgan Asset Management, New York; Martin Leibowitz, managing director, Morgan Stanley, New York; Cynthia Steer, chief research strategist and managing director, fixed income, at CRA RogersCasey, Darien, Conn.; and Kurt Winkelmann, managing director and head of global investment strategy at Goldman Sachs Asset Management, New York. Nancy K. Webman, editor of P&I, moderated the discussion.
Pensions & Investments: What do you see for the future of defined benefit plans?
Ms. Guernsey: I think the trend we've begun to see of the freezing of defined benefit plans is going to continue for a lot of the reasons that are very familiar to this group.
Reason No. 1 is, as an employer, it's unclear that it's truly seen as a benefit by employees. Given the turnover rate of the average tenure of employees in most corporations today, waiting around for a defined benefit plan is just no longer in the cards.
Second is that - at least as currently managed - defined benefit plans are extremely expensive.
And third, the benefit that they did represent to corporations is coming to an end as a result of the pending legislation. The ability to use credit, the ability to see it as part of your income, etc., etc. - all of the benefits from a corporate point of view - are going away.
So I think that as the shift from managing defined benefit (plans) as a pool of assets moves more consistently toward managing both assets and liabilities, what we're going to see is a shift toward the CFO paying (more) attention. It's going to be increasingly sort of a corporate finance set of solutions, and I think that, when looked at in that light, freezing plans is going to be a norm.
Mr. Winkelmann: I think it's fair to say that the consensus view is for a continued decline in the number of DB plans. Just to give you a rough statistic, if you look over the last 10- to 15-year period, the percentage of assets in corporate pension plans relative to DC plans has basically declined from 53% to 44%.
Now, I don't want to claim false precision in the numbers, so if you said mid-50s to mid-40s, that might give us a round ballpark (figure).
That said, the pace of change - in our view - has actually slowed down somewhat.
From a corporate perspective, as distinct from a beneficiary perspective the rationale is face forward. First it is the case that the existing rules on smoothing, mark to market and the contribution policy do imply some volatility in corporate accounting statements. Given the kind of reforms that people are talking about, which is to say reducing the smoothing those just exacerbate some of the volatility in the corporate accounting statements.
So our sense is that while these trends in the accounting and regulatory environment are going to change, that's going to exacerbate the issue. Consequently - again, from a corporate perspective - I don't think the situation is particularly rosy for defined benefit plans.
P&I: You were talking about the decline in assets where you said mid-50s to mid-40s compared to DC plans?
Mr. Winkelmann: Yes. The DC plans plus the DB plan assets, and take DBs as a percent of that, that's going to go from the mid-50s to the mid-40s.
P&I: Over what period?
Mr. Winkelmann: Over the last 10, 15 years.
Mr. Chiappinelli: I'm always intrigued and troubled by a question of the future of DB because embedded in that is an assumption there will be this mass behavior in sync, and I think we need to make some very, very clean distinctions between all the different camps.
One cannot generalize about the future of DB.
The first thing we need to do, the first bifurcation, is public behavior vs. corporate behavior. Maybe today we're going to focus on corporate, but let's not forget that two-thirds of the assets are still sitting in public plans.
Corporate plans are clearly on the defensive for all the reasons we're going to talk about a lot today. They're referred to lots of different ways: actors on the stage; boxers in the ring. But there's no doubt that if you are a CFO or a CIO today, you're being asked uncomfortable questions.
Many of these factors aren't even relevant to the public side, so they're not under the same kinds of pressures. The commitment culturally and contractually on the public side is very, very strong to the DB model.
On the corporate side there are some that are clearly under duress, and they're the usual suspects we know about. Certain industries, certain individual companies they are the source of the headline news in your publication and other publications, and of course these are big plans and cover lots of employees. I don't mean at all to dismiss it or minimize it.
This underfunded problem is indeed highly, highly concentrated with a few plans or a few industries.
What's the (adage)? Twenty percent of the guests eat 80% of the hors d'oeuvres. Here it's even more of the case: Five percent of the plans account for somewhere like 50% to 60% of the underfunding. ...
I will agree with the consensus view; no one is starting a new DB plan today. I think we can all just sort of agree upon that. So even if one more plan decides to freeze, the trend is absolutely downward. There is no growth. But I think when we look at either the pace or the number of plans that will do it, we have to make a very, very clear distinction about the future of public plans vs. corporate plans first. And even within the corporate sector, we can isolate which one you're going to have: more radical investment solutions; more dramatic changes in investment strategies; or more radical changes in the benefit policy.
Mr. Waring: Well, I just want to go on record early as being in violent agreement with what everybody else said. I may be a little bit of a Pollyanna on this one, and maybe it's just for purposes of discussion
You know, there is no better way to spread your working life income over your entire life than a defined benefit plan. It's got efficiencies over the defined contribution plan that are remarkably significant. It's not that a defined contribution plan can't be run pretty well, but it can never be run with the benefits and efficiencies I shouldn't say never - (let's say) can't easily be run on the same level of efficiency - as the defined benefit plan.
So I think one thing that we have to imagine is that there might be a time when people wake up and start saying, "Wait a minute, you know, we probably ought to be moving back, the pendulum should be swinging back toward defined benefit plans."
I think portability of defined contribution is way overrated. It's hard for me to imagine very many employers, certainly not as many as they're actually claiming really don't care about their work force feeling portable. Whether it's high tech or whatever, you need your software engineers and your other people, whoever they are, to have some longevity on your work force. There's learning that happens, there's the ability to promote strong people. You need longevity. And a defined benefit plan is kind of explicitly set up as a longevity enhancement device, whereas defined contribution is explicitly set up to enhance portability. So I think, again, as the benefit world matures and kind of gets a better handle on both defined benefit and defined contribution, the relative weight and importance of DB is something that can only be realized over the long term.
You know, one of the comments that you often hear, and Eve mentioned a minute ago, is that these plans are costly and risky. It probably is true that they're costly, and certainly the experience has been that they're risky, but, you know, they don't have to be.
The accounting isn't going to change that. The accounting treatment doesn't make them more risky or more costly if we go mark to market. They already are as costly and as risky as they're going to be; and that cost is purely a function of the benefit promise.
There's a lot of misunderstanding that somehow the cost is going to change with different accounting treatments, or you can manage costs through the accounting somewhat. You can't manage cost. You can sometimes postpone it and defer it into different periods, but the present value of your future normal costs for giving those benefits is the amount of the present value of the benefits, and it can't be any other way.
You know, the risk and the way that we've been managing plans using smoothing on the liabilities is different than what's going on in the assets. There's no way to get rid of the risk in investment plans. There's no asset you can invest in to escape liabilities. Mark to market actually gives us opportunities to invest in things that you can hedge a liability with, because as soon as that liability is smooth, you can start managing it out and then, in fact, you can start thinking about exactly how to control how much risk you take.
Most of the risk, it turns out is investment mismatch risk. Of course, if we have any amount of bonds in 30% of our portfolio, it's going to be highly risky against these very long duration pension liabilities. And of course if we have 70% equities, it's going to be very risky against our bondlike liability portfolio - those are known risks. We see them coming; we know those are risky.
There are ways to control risks by controlling the investment policy ... but it requires mark to market. You can't actually do it without mark to market and looking through at the underlying economic accounting, if you will.
So I think there's hope for DB plans. The near-term trend - which has had us coming down from somewhere in the neighborhood of 50% of the work force covered by DB plans maybe 30 years ago today it's only about 22% - that's likely to continue for a while. But the death of defined benefit plans has been exaggerated.
Ms. Steer: Well, I feel a little bit wistful, you know, when we talk about the death now for DB plans. Like Barton and Peter, I feel very much that it's an efficient mechanism, and I believe very much in the DB side of the house. I also think we have, as an industry, for the last 15 years not invested enough on the education of the DB side and in fact all our lawyers for many years told us we couldn't. We have a lot of catching up to do.
But what I think is interesting is that we are here partly, not just because of interest rates, but because of contribution holidays. I would just like to put for the record that No. 1 on the corporate side of the house, the reason we're here is the IRS did not allow us to take tax deductions on contributions through the '90s and it was uneconomic for major corporations to make those contributions; we would be a lot better off had that reality not been in place.
But on the public plan side, it is startlingly different. The funding reality of those plans who made contributions during the '90s and those who didn't, and the state legislatures or the city legislatures who had contribution holidays, have a much different funding reality than the ones who didn't. Those who had contributions during the '90s and early 2000 probably have, you know, a 95% to 100% funding level at this point.
So, you know, I am wistful. It's a good, efficient mechanism.
I also think we have examples around the world where hybrids will work I would like to be a little more optimistic that maybe some day when we get through this and we understand what we're doing better, that there will be a new DB plan.
Mr. Leibowitz: Well, it's kind of nice actually sitting here like a poker game and everyone else is declared. But I guess in fairness I should confess that up to a couple of years ago I was involved in running the biggest DC plan around ... But even then, and still now, I feel wistful: that's a great word. DB plans are, you know, wonderfully ideal for beneficiaries. And the character of DB plans is not easily reproduced in DC plans for a lot of reasons.
Some of my best friends are DB pension plans, but I think they do have problems and I think they are an endangered species. It is true that there probably still is asset growth, in fact even in the governmental plans and let's not forget that, but they also are under stress.
Barton is absolutely correct. It's not a question of the accounting or even the regulation, which just adds fuel to the fire, but the problems are endemic in the economics. It is a big promise. A couple of things which perhaps do deserve mention is that it's a particularly big promise in an environment where people are living much longer, where there is a fundamental uncertainty as to how long they're going to live, and where the compounding issues of health care interact with that.
The other issue, which is I think particularly important in this country, is the issue of inflation. Our plans are typically nominally based. One of (Barton's) papers has pointed out that there is a strong real rate characteristic to the projected liability, but the terminal payments are almost always, these days, without any inflation adjustment or certainly any material inflation adjustment. And while we tend to live in a world of low inflation, we are talking about the next 30, 40 years.
In some ways these issues interact, because one of the ways to deal with excessive nominal liabilities is inflation. It is not like the government itself is free of such liabilities, just to go back to the health-care issue. So I think we've got big problems with DB plans. I don't share the optimism that there will be resurgence. Frankly, I wish I did.
Ms. Steer: I wish I did, too.
Mr. Leibowitz: I think that in terms of a constructive way of dealing with things, it's important to turn to DC plans and try to find ways of making them viable, and try to inject many of the good features of DB plans into the framework.
P&I: How can a corporation use mark-to-market accounting to its advantage? Will mark-to-market accounting actually enhance the surplus in a corporate defined benefit plan?
Ms. Steer: It sort of strips down to reality ... I mean, you really know what you have got. But do many of us manage on a cash basis? I don't know that many of us manage on a cash basis. So it's just another reality.
Mr. Winkelmann: I think Martin actually said it correctly: The true economics are mark to market, and the accounting isn't going to change that.
So the fact that there is this smoothing, the fact that we might not necessarily use market discount rates I mean, they're there, but the true economic picture is mark to market. So I think the real question is: Suppose we do mark to market, what kind of impact is that going to have on the way analysts think about the companies.
And I was just talking with Barton yesterday on precisely this issue, and he made the point, look, if you go back five years ago when people weren't paying much attention and you talk mark to market, they wouldn't have had an impact. But at this point people are paying attention, they're paying attention to what the discount rate assumptions are, so could we have an impact on market pricing if we move to mark to market? Possibly. But as a quasi efficient-markets kind of guy I would say people are already talking about it, so I think it's just not that big of a deal.
Mr. Leibowitz: I guess the question when you have different parties involved (is) when there is an underlying reality, it's important that people see the underlying reality, and if some people think other people are not seeing (that) reality, you can have that effect, that inappropriate effect
Mr. Winkelmann: I think that's right. The question is to what extent is everybody paying attention, really paying attention.
Mr. Leibowitz: Yes, on both the corporate as well as the public market.
Ms. Steer: I think the possible tragedy, however, in a mark-to-market environment, unlike the smoothing market, (is) the governance of the plan becomes much more short-term focused. I keep seeing us look at short-term performance a lot more when we have long-term pools of capital, we have a long-term balance sheet issue, we have a long-term income statement issue.
And I'm old enough to remember the transition from FASB 8 to FASB 52, which is the transition where all of foreign exchange gains and losses came right into the income statement and then there was more of a smoothing on FASB 52. And this is such a long-term issue; it's not a dissimilar kind of issue. I just hope our governance sort of modifies but doesn't change radically.
Mr. Winkelmann: I think mark to market is going to bring into very clear relief, let me get this right it will make very clear some of the points Barton raised about the interest rate mismatch, where the risks are in the plan. So I think it actually has the potential to shift our investment policy toward a long-term focus. You can call me optimistic .
Ms. Guernsey: I think that's possible, but maybe the answer lies in the middle of what everybody said. If you do have that sharp view of the true economic reality, it could, for a healthy plan, promote a healthier investment environment, healthier investment plan. But I think for those that are less healthy, it will hasten the freezing of those plans.
Ms. Steer: But I think it will do a disconnect between cash flow and spending policy on the downside. I think you're going to have more focus on, OK, not total return but (rather), how am I going to pay for the benefit in four years. The actuarial flaw, as we have thought about DB plans, is the indifference in the short end about how you pay the benefits, you know, vs. the long-term total return.
Mr. Waring: But that's where you guys get reconciled. The long-term is reconciled by what Kurt's saying, once you get past that flaw and start seeing what's really going on.
Ms. Steer: And that's what is a better thing.
Mr. Chiappinelli: I'm not sure if I'm agreeing with them or disagreeing with you ... but I think also the CFO or CIO function will go through a materiality exercise. It's not just "Oh, mark to market, this screws up everything on my financial statements." It's immaterial.
Look, a business has volatility in all of its inputs. This is the nature of what they do. If you're Starbucks and you are dealing with volatile coffee prices, you're dealing with volatile coffee prices. It's your decision (on) what's your hedging strategy on coffee bean prices, if any. ... But it's a decision, it's an economic decision and you can do it; you can partially do it or you can do it the whole way. It's a pure economic decision.
All this has done is (taken) your labor costs and your pension costs and corrected your balance sheet impact, which is different from the day-to-day coffee prices.
I get that it's a long-term liability, but if it's not a major component, if it's not a material driver of your costs it can be a billion-dollar plan, it can be a $2 billion plan, but relative to a sizable debt structure, relative to a very large market cap I mean, you've got oil companies that are not sweating bullets over this. They have big plans, but it is not, on a relative basis, a material driver of the cost structure.
Mr. Leibowitz: However, Peter, I think there is a correlation between large, labor-intense organizations, which are understandably stressed in this global environment, and having large plans which have become larger with the course of time and markets that have not.
Mr. Chiappinelli: Absolutely.
Mr. Leibowitz: I think what you are saying is true for some companies, where it's, you know, a peanut vs. the elephant itself. But in other cases it is a sufficient-size elephant and one which the organizations are not comfortable viewing as part of their regular flow of business, (and) it is going to be a problem, in some ways quite apart from how well-funded it may or may not be at a different point in time. The volatilities there will require all the parties involved to have comfort that everyone is seeing through to the underlying economics the right way. And that's a tall order.
Ms. Steer: Marty, I would also like to bring up your point about inflation, because for the first time in 25 years we have changing yield curves, we have changing inflation, we have changing foreign exchange rates and we don't have a central bank of one. So we're laying this very complex problem onto balance sheets in a globalized world where you have got the possibility of inflationary erosion coming into the balance sheet; it's a more complex kind of problem.
Mr. Leibowitz: You just mentioned one thing, which I think is very important, that I missed. Let me just emphasize it: globalization. We in the U.S. have a relatively unique situation to the extent that there is far more dependence upon employee-based type of retirement arrangements than in other countries with whom we compete
Mr. Waring: I think my answer is simply the one that I gave in the op-ed that I did for P&I (Oct. 4, 2004), and that basically was if you want to manage these plans so they aren't too costly and they aren't too risky, then you have to have mark to market.
You know, basically all of the affected parties here - whether it's labor, whether it's management, whether it's the regulators - all of them are having a hard time seeing the problem with non-mark-to-market accounting. Basically I think it's going to make management's job easier in terms of controlling risks and costs. It's going to make the laborer's job easier in terms of understanding what they've got and negotiating benefits. It's going to make the regulator's job easier.
As a matter of fact, I think all of the interests come together with one version of accounting instead of the three or four versions we have right now, if we go to complete mark to market. And I don't mean just changing the discount rate. I mean mark to market all the way through to changing the distribution calculation - far more than what people talked about. When you hear some of the actuaries saying "Hey, we are all financial conduits now" and all they've done is change how they think about the discount rate they haven't changed how they think about income and expense, they haven't changed how they think about calculating contributions - all those things will be improved to the benefit of everybody. Everybody will be better off with mark to market.
That's, I know, a totally contra-opinion to what our friends out there in sponsorland have as their first reaction. However, when they hear that, they listen. It's an interesting and worthy argument to them, even though it is contra to the position they are taking so far. Even CIEBA (the Committee on Investment of Employee Benefit Assets) wants to hear that view.
Mr. Leibowitz: Barton, do you have concerns that it might be a very tough transition?
Mr. Waring: To mark to market?
Mr. Leibowitz: No. If we were to have mark to market, a tough transition to a nirvana of everyone looking at fundamental economics and reacting to it in an appropriate way rather than, you know, in a paranoid or overwrought way.
Mr. Waring: Well, yes, I think that it might well be a tough transition. Nobody likes change. But several things will have to happen. I mean, the actuarial and the accounting communities will have to get up to speed (on the fact) that it's a non-trivial task. The whole notion of how to refocus the investment policy efforts so the long term is still taken care of You know, there's a bunch of follow-on effects that people will have to learn, and those of us that spend way too much of our lives with our heads so deep in this problem that it almost appears simple to us may sometimes fail to appreciate people who have real jobs - and this is a small part of their life - how quickly they're going to catch on and have it all make sense to them.
Ms. Steer: But, frankly, one size doesn't fit all. Those corporations whose treasury and pension areas have not been separated for a decade are going to have a much easier time I mean it could, in an off sense, spell the death of the separate investment management company at the corporate level. You have got to have such an integrated function. ...
What I think is very interesting, if I were to look at organizational charts, is that the function of treasurer of a corporation, which generally sometimes had an equal - the CIO of the pension fund was sort of on an equal level - that function of treasurer has just gone up because that's where the hedging functions are, that's where the global integration is.
So that's become a much more complex job relative to the CFO job right now. And it's going to be interesting how this evolves.
Mr. Waring: Certainly any CIO that thinks his job is just a big manager has a new vision coming.
Mr. Chiappinelli: I tell you, I really feel for the plan sponsor community. These are bright, intelligent, hard-working folks. Many of them didn't get their MBA in finance, they don't have their CFAs, don't spend their days and nights thinking about this. They have regular day jobs and so they've asked the firms that are sitting around this table for help; they have hired consultants, they have hired all sorts of experts. Many of them, a whole generation of them, have just been trained on CAPM (capital asset pricing model) and efficient frontier, and now they feel comfortable talking this language and feel like they've finally got it.
And now ... talk of (liability-driven investing) and talk about different risk metrics, although that may end up being the right way to think about it, it's a change. It's rewriting the rule books and what defines a successful plan. It's what they're going to have to report to their boards on: Did we make it or not. That whole metric has been (changed) or is about to change.
And I feel for them because they just got up to speed on CAPM, and now we're changing the risk factor that they're going to be judged against.
It may be the right thing to be doing, but
P&I: Other than Salomon's (latest figure of) $50 billion in underfunding (for the pension plans in the S&P 500), does anybody have any other number they want to throw in on the latest size of the underfunding?