A risk-averse mindset is taking over at many corporate pension funds, and at the same time, plan sponsors are being pushed away from taking a long-term view of their funds' investments.
There are good reasons this change is occurring. Pension funds, long considered a stabilizing influence in the financial markets because they could take a long-term investment view, find their assets and liabilities are becoming increasingly unstable because of volatility in the capital markets driven by hedge funds and other investors, and for corporate sponsors at least, because of possible changes in accounting rules.
The move to pension accounting revisions is reinforcing the desire of corporate pension executives to adopt more conservative asset allocations, which are likely to reduce returns. Although the move would offer less expected volatility, it could result in higher costs, which could lead to more plan terminations at a time sponsors are getting their funds back to fully funded status.
The changes in accounting that would bring more volatility to pension assets and liabilities are coming during a period of great volatility, when pension sponsors — like everyone else —are still reacting to the market meltdown and trying to recover in a weak economy.
With the potential changes, pension executives should reassess their allocation models to see if they are appropriate for the new reality, based on realistic long-term expectations for the U.S. and global economic growth, and are not simply reactions to the recent market collapse.
Corporate sponsors should shift their investments to try to have them do what the long-term investment horizon and accounting rules used to do for them: stabilize returns and eliminate volatility.
Such a move comes with a risk. It would lower expected returns and return assumptions, leading to possibly higher pension contributions and expenses, potentially reducing corporate earnings. But in the long run, it could strengthen the reality of the actual funded status, rather than an appearance in accounting reports. In turn, stronger plans could make freezes and terminations less necessary to maintain competitiveness.
Corporate defined benefit plans are coming under increasing pressure from a variety of fronts, including low interest rates. At the same time, accounting trends, such as the proposal for marking investment gains and losses to market, are pushing some plan sponsors away from taking a long-term focus and higher-risk, higher-return allocations in their investments. Instead, they are being driven toward lower-risk allocation strategies in an effort to mitigate the effects of the resulting volatility in pension contributions and the corresponding harm to corporate earnings.
This shift generally involves increasing fixed-income allocations, including such strategies as liability-driven investment and risk parity leveraging. With that shift come new challenges for corporate sponsors.
Ironically, fund executives are considering these changes just as the equity market seems to be in the midst of a significant rebound. As many plan executives regretted having high equity allocations as they entered the financial market crisis, they might soon regret shifts to higher fixed-income allocations as the current low interest rates seem likely to rise, bringing a new set of risks. They could be swapping the possibility of solid equity returns — the S&P 500 could record its third year in a row of positive double-digit returns, and a total return for 2011 of 23%, according to Goldman Sachs Group Inc. — for relative stability.
If mark-to-market accounting replaces the approach under the current generally accepted accounting principles, it will lead to pressure on corporate pension executives to take less equity and other investment risk in their defined benefit plans, Such a change in pension accounting rules would bring U.S. rules closer to the International Accounting Standards Board rules. (The Financial Accounting Standards Board and the IASB have a collaborative effort under way to improve standards and remove differences. At the same time, the Securities and Exchange Commission has been supportive of convergence to a global accounting standard, promoting projects on the issue.)
Pension funds are powerful instruments in the capital markets but they, in the end, have to operate within them. If the markets and accounting rules cannot get them the stability they would like, they have to try to create it themselves, even at a cost.