CIOs face a call to action summoned by a new paradigm of pension fund management brought about by the most significant changes to pension plans since the enactment of ERISA, the adoption of FAS 158 and the Pension Protection Act.
Chief investment officers have to understand the implications of this paradigm and rethink their approaches to risk and asset allocation. Doing so effectively can strengthen the financial well-being of both the corporation and the pension plan. It will require embracing new tools for defining, measuring and managing risk and implementing customized asset allocations.
Under the Financial Accounting Standard 158 environment requiring a pension plan’s underfunding or overfunding to be on the corporate balance sheet, short-term swings in the financial markets will have a direct effect on the corporation’s risk exposure. Pension plans will be transformed from off-balance sheet operations with results smoothed over many years to large consolidated corporate business units with high potential short-term volatility. This transformation brings the plan to center stage for senior management and places it in direct competition with the sponsor’s core businesses for risk and resource allocations.
As a result, CIOs, in addressing pension plan asset allocation issues, must first assess the plan’s upstream effects on the sponsor and then align the plan’s risk profile with the corporation’s ability to absorb risk in the short and long term.
Traditional assessments of pension risk such as volatility of returns and surplus do not provide chief financial officers, treasurers and CIOs with actionable information. For example, it is difficult to assess whether an expected return of 7% and a standard deviation of 10% is appropriate for either the plan or its sponsor. Similarly, surplus volatility provides some insight as to the potential impact of the pension portfolio’s allocation on the plan, but does not explain its upstream impact on the corporation. CIOs must translate the pension lexicon into a language relevant for corporate decision-making. Three corporate finance-based metrics we developed go a long way toward accomplishing this goal.
Shareholder equity at risk: This measure defines risk in terms of FAS 158. For every asset allocation, it is possible to calculate the potential impact on shareholders’ equity. Shareholder equity at risk represents the difference between the impact of the expected and the worst-case scenarios. If senior management expected that given the plan’s asset allocation, the corporation would experience a $100 million increase in shareholder equity during the year, and in the worst-case scenario, a $600 million decrease, the risk would be $700 million. Unlike standard deviation of returns or surplus volatility, shareholder equity at risk is a meaningful risk measure that enables the CIO and CFO to assess whether the plan’s risk level is appropriate (in light of the corporation’s overall risk profile) or whether it needs to be adjusted.
Cash flow at risk: This defines risk in terms of contribution requirements under the Pension Protection Act. Cash flow at risk represents the difference between the expected level of contributions and a worst-case scenario for a given portfolio allocation.
Earnings at risk: The third measure defines risk in terms of the potential impact of the pension plan on corporate earnings. Earnings at risk represents the difference between the corporation’s expected level of pension expense and a worst case, measured for the same portfolio allocation.
The use of these risk measures facilitates the identification of an asset allocation that delivers the desired level of returns on plan assets within acceptable levels of corporate risk.
The greater transparency of pension risk under the Pension Protection Act and FAS 158 will cause many CFOs and CIOs to extend risk management techniques — such as those used in hedging interest rate exposure — to the pension plan from the corporation. While these concepts might be new to many pension plans, corporate treasury teams have been successfully hedging interest rate and other corporate balance sheet risk exposures for more than 20 years.
With the needs of the plan and the corporation so closely aligned, the plan’s asset allocation must be based on a customized solution that reflects both corporate factors (e.g. industry, financial strength, tax strategy and plan size relative to the balance sheet) as well as plan-based factors (e.g., the nature and growth rate of its liabilities and funded status). Consideration of both sets of factors facilitates the assessment of important trade-offs between risk control, investment results and the financial impact of the plan on the corporation, and ensures that the total risk of the plan’s investment policy is aligned with the corporation’s capacity for absorbing risk in terms of shareholder equity, earnings and cash flow. The result is a customized, rather than a one-size-fits-all 70/30, asset allocation.
The heavy concentration of equities within most pension plans represents a large risk exposure to both the plan and shareholders. Reducing a plan’s long-only equity stake, and funding a wide range of beta and alpha sources that can generate returns with low correlation to equities and each other, is the winning approach to reducing the volatility of the plan’s surplus. Within the next five years, we believe the typical final-pay pension plan will have from 25% to 35% of its assets invested in non-traditional asset classes, vs. about 8% today.
Never have the skills and experience of the CIO been more critical than they are now in implementing this approach, maintaining the viability of the DB plan and managing the plan to meet the dual objectives of enhancing shareholder value and ensuring participant benefit security.
William McHugh is group head of the strategic investment advisory group of JPMorgan Asset Management, New York.
