Unlike the U.K., which usually has a board of trustees operating independently of the sponsoring company, trustees with the main fiduciary duties within U.S. corporate DB funds generally are employees of the organization. The arrangement makes it easier for sponsors to be aware of pension funding risks, but more difficult to separate the interests of the pension fund from that of the company, managers said.
Nevertheless, fund executives in the U.S. are making a more concerted attempt to take into account the company's pension funding policy when charting the investment program, said Peter Austin, Boston-based executive director of BNY Mellon Pension Services, a division of BNY Mellon Asset Management.
These efforts are essential as solvency levels are improving and sponsors want to lock in those gains. “It reinforces the need to establish a more comprehensive program to improve the funded status” of pension funds, Mr. Austin added. According to data provided by BNY Mellon, the funding ratio of a typical U.S. defined benefit fund rose to 88.5% at the end of March compared with a low of 71.3% in August 2010.
“If a pension fund is underfunded and the sponsor is financially weak, then (trustees) need to give a lot of thought to protecting the pension plan,” said Charles Baillie, managing director and global co-head of global portfolio solutions at Goldman Sachs Group Inc., based in London, referring to the higher risk that a weak sponsor might be unable to make additional contributions if funding levels drop. Others added that sponsor risk also increases as the size of the pension fund becomes larger relative to the sponsor's market capitalization. Mr. Moore of PIMCO said several pension funds of brokerages are shifting assets to bonds from equities in a countercyclical move to the sponsor's own earnings expectations. “A number are well north of 60% (invested in fixed income) and plan to be fully invested (in fixed income) within the next three years,” Mr. Moore said. He declined to name the clients.
About a dozen U.S. and U.K. pension funds contacted for the story either declined to comment or did not respond to interview requests to address sponsor risk in their investment portfolios.
LDI is “one way of skinning a cat in terms of managing sponsor risk,” Mr. Baillie said. “By immunizing against interest-rate risk and inflation risk, for example, (pension fund executives) don't need to depend as much on sponsor contributions. It's a form of insurance that's not negatively viewed by the company.”
However, traditional LDI looks at the liabilities relative to the assets of a pension fund, but looks at it in isolation of the sponsor, said Lionel Martellini, scientific director of EDHEC-Risk Institute and professor of finance at the EDHEC Business School based in Nice, France. “What is needed is to also consider the risk the sponsor poses” on the pension investment portfolio.
Pension executives are going beyond LDI, for example, by managing the equity tail risk in the investment portfolio, “which makes sense given the financial performance of most sponsors is positively correlated to the stock market,” Mr. Baillie added.
Another way that pension executives are considering sponsor risk is to make investment decisions that are either uncorrelated or negatively correlated with the company's performance. According to the EDHEC report, under certain circumstances, pension fund executives could consider shorting the company's stock or buy credit default swaps.
“In some cases ... an out-of-the-money put option on the shares of the sponsor, for instance, could alleviate the burden for both parties (the sponsor could see its capital injections limited when its share price plunges, and the pension fund would have partial protection from sponsor risk,” according to the report, which was supported by AXA Investment Managers. AXA IM sponsors the EDHEC-Risk/AXA Investment Managers research chair on regulation and institutional investment.
Managers and consultants say such hedging solutions can be expensive and could send a negative signal to the market about the company sponsoring the fund. According to the EDHEC report, one of the main reasons for not incorporating sponsor risk into the investment portfolio is that it might be perceived as a hostile move toward the sponsor. However, according to the report, “sponsors would clearly welcome having reduced contributions rather than increased contributions to the pension fund when their financial health degrades.”
Another reason for not tackling sponsor risk is the presence of pension fund insurance such as the Pension Benefit Guaranty Corp. in the U.S. and the Pension Protection Fund in the U.K., according to the EDHEC report.
But fund executives are moving in the right direction, experts said.
“What I have seen recently is a less direct move to protect the plan,” Mr. Baillie said. “For example, if you're a bank, you might remove the financial component from any indices in which you invest.”
Mr. Gillespie of Towers Watson added that “most trustees avoid sponsor-related investments; regulations limit this to 5% of the scheme's assets” in the U.K. and 10% in the U.S. On top of that, some groups of trustees avoid specific assets to provide “an additional level of security” in reducing the correlation between the investment portfolio and the sponsor's earnings sources, he said. Some pension funds with sponsoring companies that are heavy buyers of commodities have implemented an overweight position on commodities investments within the investment portfolio in an attempt to offset the potential effects of higher raw material prices on company earnings.
“It wasn't that long ago when pension funds had a substantial share of the pension plan assets invested in the sponsoring company,” Mr. Sender said. “Now there are rules that limit the amount a pension fund can invest in its sponsoring company. But there's still a lot of room for improvement when it comes to fully taking into consideration sponsor risk.”