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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.