'Sponsor risk' needs spot in a DB plan's portfolio

Corporate defined benefit plans need to pay more attention to the correlation between risks to the sponsoring company's financial health and a fund's own investment portfolio, according to consultants, managers and academics.

Regulatory changes toward mark-to-market accounting in both the U.S. and the U.K. have put more pressure on corporate pension funds to recover from dramatic drops in their solvency levels. Furthermore, the 2008 financial crisis exposed the mismatch between a sponsor's earnings stream, and therefore its ability to top up any shortfalls, and the fund's own performance. Many pension funds needed additional contributions at the same time their sponsors suffered severe financial stress, sources said.

“Sponsor risk is the biggest risk for pension plans. Take a traditional defined benefit pension scheme, there's really only this one risk — the risk that the sponsor goes bankrupt,” said Samuel Sender, applied research manager at EDHEC-Risk Institute. Mr. Sender is the author of “The Elephant in the Room: Accounting and Sponsor Risks in Corporate Pension Plans,” published earlier this year. “What we're seeing is that many (fund executives) are not managing that risk.”

Sponsor risk generally refers to the company's ability to contribute if funding levels fall or in the worst scenario — bankruptcy. Incorporating sponsor risk into the profile of the fund's investment portfolio could change the volatility of the fund dramatically, said James F. Moore, managing director and co-head of the investment solutions group at Pacific Investment Management Co., Newport Beach, Calif.

Although some corporate plans already have implemented ways of limiting sponsor risk, for example through liability-driven investing, most pension funds do not have a formal plan to minimize sponsor risk in the long term, said Mr. Sender.

“Two possible scenarios exist: either the sponsor is alive and well, and can make up for any pension shortfall, or the sponsor is bankrupt or in distress and cannot make up for the shortfall,” Mr. Sender said. “The risk that the sponsor is not healthy and cannot make up for shortfalls needs to be explicitly reflected in the pension fund's investment strategy.”

Simon Lee, London-based head of investments for group pensions at Lloyds Banking Group, said at the recent National Association of Pension Funds investment conference that running a DB fund has become more challenging because of a lower interest rate environment, increased volatility of returns over the past several years, higher longevity risk, and accounting and regulatory changes. “Some schemes will have longer durations than their sponsors,” Mr. Lee said. Lloyds Banking Group pension plans have a total of about £22 billion, or $37 billion, in assets.

“The appropriate investment strategy should include pre-agreed triggers for derisking ... with minimal correlation with the sponsor's assets and risk factors,” Mr. Lee said. In addition, fund trustees and sponsors should agree on an enhanced governance framework to support the decision-making process, implementation and monitoring of a fund's investment strategy.

“We are helping trustees to better understand covenant risks in order to take (LDI) a stage further in which covenant risk, funding and investing are all considered in the investment process,” said Craig Gillespie, senior investment consultant at Towers Watson & Co. in Reigate, England.

“I think demand will be higher going forward” for incorporating sponsor risk into the asset allocation strategy, he added. Towers Watson's covenant asset-liability modeling program launched in 2009 with a handful of clients. Now about 30 to 40 clients, mostly in the U.K., have included covenant considerations when reviewing their investment strategy. He declined to name them.

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.”