Sharp swings in funding levels from large surpluses to large deficits, combined with new accounting and regulatory requirements, have prompted a major debate about the appropriate strategy and perspective for managing pension plan assets. This debate will intensify as plans with funding shortfalls are now required, under FASB 158, to reflect these shortfalls on their balance sheets. Thus, corporations with underfunded plans have experienced a hit to shareholder equity this year.
The debate will center on risk; specifically, the appropriate risk to measure and manage and the appropriate time frame. Currently, plan sponsors focus on the asset mix to meet long-term investment return objectives subject to predetermined risk tolerances. Ironically, most plans have very similar asset configurations despite very different liability profiles and very different company dynamics and circumstances. The focus is long-term. The operating assumption is that equities will outperform bonds over the long term and, as such, substantial holdings in equities are warranted.
In a so-called “liability-driven investment” construct, the focus shifts dramatically to one of managing the surplus — the difference between the fair value of plan assets relative to projected plan benefits. The time horizon is much shorter and is determined primarily by accounting and regulatory considerations. Under this construct, the dominant variable is changing interest rates, which affect the valuations of both assets and liabilities. Liability valuations are particularly sensitive to interest rate fluctuations because interest rates are used as the basis for discounting pension plan obligations. Thus, changes in the level of interest rates can result in pronounced changes in the value of pension plan liabilities and plan funding levels.
Interest rate risk, and its impact on surplus or funding risk, was dramatically illustrated in the period from 2000 to 2002. Rates on high-quality corporate bonds — which are referenced for discounting liabilities — declined sharply. This resulted in a massive increase in the present value of plan liabilities and a shift in the funding status of many plans to deficit from surplus. The collapse in equities over this same period compounded the problem. According to the Treasury Department, unfunded pension plan liabilities increased by $286 billion, to $450 billion, between 2000 and 2005.
Within both constructs, the funding of plan liabilities drives the investment framework, but the time horizons are different.
The new regime — defined by the promulgation of the Pension Protection Act on Aug. 17, and the adoption of FASB 158 on Sept. 29 — has effectively compressed the time frame that plan sponsors operate in. Under the old regime, plan sponsors could take a long-term perspective. They could afford to focus on asset classes with higher expected return and virtually ignore the mismatch between asset and liability durations. Funding shortfalls were only recorded in footnotes to the balance sheet and obfuscated by the treatment of credit balances.
Now, with the compression in smoothing periods for asset and liability valuations and the requirement that funding shortfalls be reflected in the balance sheet on a current basis, plan sponsors will, of necessity, be more sensitive to the mismatch between assets and liabilities and the funding volatility that this generates.
The risk equation has changed, but not because plan sponsors have lost confidence in their asset portfolio configurations and their ability to generate solid long-term returns to fund pension plan liabilities. Instead, it has changed because of the shorter timeframes imposed by new accounting and regulatory requirements.
What is appropriate for one plan is not necessarily appropriate for another. It is all about risk tolerances. A corporate sponsor that has a large plan relative to the size of the corporation and little or no tolerance for pension-plan-driven volatility in the balance sheet will likely move to a fairly precise asset-liability duration match. A corporation that has a small plan relative to market capitalization and a reasonable tolerance for balance-sheet volatility can afford to have a fairly high exposure to riskier assets such as equities, even within a “surplus optimization” framework. It’s all about risk tolerance.
A shift in plan sponsor focus, even by degrees, will necessitate a pronounced change in perspective and strategy. Along the compendium between the current norm of total return management to surplus management, there are many gradations. The degree of movement toward managing the surplus will be driven by many factors, including a plan’s funding status, the financial health of the company, the corporation’s sensitivity to balance sheet volatility, the need to maintain specific credit ratings for funding purposes, peer group norms, and the size of the plan relative to the size of the corporation.
Taylor is managing director, fixed income, at Principal Global Investors, Des Moines, Iowa.
