Capital Risk in Corporate Pensions
Corporate pension managers have not enjoyed the last fifteen years. The confluence of lower interests and equity performance resulted in funding deficits in their defined benefit pension plans. In some instances, the resulting cash flow impact tested the viability of the company. The response of corporations was to reduce the risk of the pension plan. These risk responses lock-in the cost of prior ineffective pension management, which magnifies the impact of demographic changes and lower interest rates. These two risk factors, however, are turning from a headwind into a tailwind and pension regulations hold a valuable strategy option.
Friends With Benefits. Employee turnover is a significant cost for corporations. Defined benefit pension plans improve employee retention and thus reduce the cost of employee turnover. For the employee, the pension defers compensation. In exchange for the beneficial salary deferral, the corporation accepts the investment risk for managing the assets of the pension with the possibility that investment out-performance may reduce the cost. Achieving Pareto Optimality brought everyone benefits.
For the last half of the 20th century, this relationship was a great bargain. A rising equity market provided a lift to assets and corporations enjoyed the benefits to their income statements. For decades, the Baby Boom generation's dominate size insured more money entering the plan than was paid out. Through it all, corporations paid little heed to managing the asset liability risk. Then it all ended.
The tailwind turned into a headwind as the technology bubble in equities burst in 2001. Asset returns were below expectation as stock markets went sideways and liabilities increased as interest rates fell over the following decade. The demographic pyramid turned into a square and compounded the problem as more payments were required than the contributions entering. Corporate cash flow problems arose as a surplus transformed into a deficit.
Failure To Focus. A pension plan is an unrelated non-core activity for most companies, so companies maintain focus by hiring external advisors for retirement investing. Despite the legion of investment advisors, company pensions have not duplicated the stability of insurance companies who manage pension assets and liabilities without causing themselves financial stress. In fairness, insurance companies did not manage variable annuity risk well either.
Investment managers who collect fees for their advice based on the value of assets under management, rather than the performance of their advice, have poorly designed incentives. Manager selection dominates the advice given, though it has little impact on outcomes even if it is consistently possible. The precariousness of the pension consulting business initiated a transition to liability-driven investing, a focus that can at least impact the outcome. Whether the advisor response is the result of new fiduciary obligations or self-interest as ETFs challenge their business model is largely irrelevant: corporate pensions remain underfunded.
Crisis Response. Companies responded to reduced cash flows from the mandated payments to the pension plan by transitioning to defined contribution plans, a decision itself that may misalign incentives. The defined contribution plan creates cost certainty for the corporation as payments to the employees are fixed and investment risk transfers to the employee. The employees, however, may have different thoughts on the risk transfer.
Alternate strategies to shift or reduce risk include liability strategies, employee buyout, insurance risk transfer, or closing a plan to new entrants. These actions lock-in the impact after the risk has occurred. Assessing the current risks from the multi-decade trends in demographics and interest rates may deliver a different response.
Demographic Dividend. Companies that have retained their pension but closed them to new employees have not addressed the management issue that, given past performance, may see a reduced performance in the future. Critically, they have closed their plans at a most inconvenient time: the millennial generation is entering the work force, and their participation in the pension would provide a cash flow counterweight to those retiring.
Companies who use pension buyouts or plan freezes are explicitly committing to using operating cash flows to address their underfunded status. These strategies may heighten the risk to the core business as an investment is foregone or higher financial risk by issuing debt to service the pension. At a time when the demographic trend is turning, a less cash flow intensive strategy may involve expanding the pension plan to young, new hires.
Buy High, Sell Low. As the gradual certainty of demographics progressed, companies also endured an increased liability valuation as interest rates migrated lower and mortality tables adjusted. Even if the demographic drain of cash flows from the retiring Baby Boomers continues, companies with closed or bought out pensions must assess their current strategy risk.
The risk from lower corporate yields is materially reduced when yields are near historic lows. Certainly, interest rates can go further: an outcome Japanese investors know well. A company that executes a risk transfer deal imposes a material cost on the company by accepting the current high liability valuation. This strategy is expensive when improved asset-liability management may manage the risk at lower cost. Regardless, a strategy that trades the avoidance of a small risk at the expense of large benefit seems penny wise, pound foolish.
Offering a defined benefit plan when long-term corporate yields are near historic lows appears a good value as the cost is inherent in the yield. Interestingly, the cost of this strategy is less than a defined contribution plan. While a risk transfer deal reduces the variability of the pension contributions, the action may be placing a higher cost on the business as the company absorbs the prior increased costs that delivered the pension deficit.
The Regulatory Option. There were various regulatory changes that occurred over the last decade to ensure stronger funding of company pension plans and help manage the impact of lower interest rates. Critically, companies have a real regulatory accounting option remaining that conveniently aligns with US financial accounting.
The regulations permit the company to elect a discount curve of interest rates based on either a twenty-four-month moving average or the current interest rates. In a declining interest rate environment, the moving average method delivers higher yields, a lower liability valuations, and a higher funded status. In a rising interest rate environment this works in reverse; however, a company can elect the interest rate at their discretion and take advantage of higher rates as they materialize.
Depending upon the duration of the pension plan, an increase of one percent in yields may remove the funding gap. If interest rates rise, companies well prepared to manage an asset-liability portfolio may reduce future pension contributions as the reach fully-funded status.
Strategy Risk. Employee buyouts, risk transfers, frozen plans, and liability-driven investing lock-in high costs for the company. These actions lock-in the prior impact of adverse demographics and low yields irreversibly and incur the highest cost, which may be an inefficient allocation of capital.
Prudence may dictate focusing on the strategy options that include the ability to improve funded status from marking-to-market with spot rates, leveraging demographics, or a higher level of interest rates. The steep yield curve also provides an inexpensive way to reduce risk while enabling the company to benefit from higher interest rates. In the current environment, these strategies present less risk and may reduce the pension cost. Of course, the challenge is not what strategy to implement, but how to apply the strategy.