Laying the Groundwork: Managing Pension Plan Risk

Laying the Groundwork: Managing Pension Plan Risk
Risk management goes beyond realizing suitable returns with a given level of volatility.
by Peter Muldowney

A retirement plan is an integral part of the business - essentially a continuing investment in its workforce with a direct impact on the bottom line. Consequently, pension plan risk management goes beyond the historical concern of realizing suitable returns with an acceptable level of volatility.

From a defined benefit pension plan member's perspective, the risk management concern is easily summed up: If the plan were wound up today, is there sufficient money to pay my entire benefit? It is the sponsor's fiduciary responsibility to be able to answer this question in the affirmative.

For a corporate plan sponsor, risk should be managed from two perspectives. The first is the sponsor's fiduciary responsibility to plan members. Management's secondary obligation is to maximize value for the shareholders, who ultimately pay the bills. The same situation applies to public sector plan sponsors, except that management's secondary obligation is to the taxpayers (rather than shareholders).

From both perspectives, there are four key factors that will determine the flexibility available to the sponsor, all of which are interrelated:

* The plan's investment return and volatility

* The level of solvency

* The level of required funding (i.e. cash contributions) and its variability from year to year

* The impact of pension expense reporting on the sponsor's income statement.Traditionally, risk management focused on the first of these factors. An acceptable return was often defined as being above the median of a universe of pension plan returns, and acceptable volatility as placing in the upper left quadrant of a chart that plotted risk (standard deviation) and return, typically over a four year period.

Greater attention is now given to the level of solvency, and how it impacts the asset mix and the likely contributions required by the sponsor. The key solvency factor is the funded ratio - the plan's assets as a percentage of its windup liabilities. Risk management issues discussed with the plan actuary now centre on the size of that percentage and any funding questions, such as:

* Would the sponsor's fiduciary obligations be met by simply making the minimum statutory contributions?

* If not, what is the optimal funding target and how quickly should it be reached?

* If the plan is in deficit, how much more funding is required and over what time period?While this approach creates a link between the asset mix and liability profile unique to each plan sponsor, decisions regarding the pension plan are still generally considered separately from the potential consequences for the sponsor's financial statements.

Sponsor's Perspective
In managing the business, senior management take into account economic or market factors that may affect the various parts of their business in the next 12 months and longer. Many organizations assess objectively how the pension plan fits within - and contributes to - the plan sponsor's overall business plan. Here, the key focus is on the significance of any changes to funding and/or pension expense. This can be achieved through a four-step process:

* Identify financial objectives and workforce assumptions.

* Analyze the current plan in terms of the risk exposures.

* Assess which financial levers may be used (e.g., asset mix, actuarial methods and assumptions, contribution policy).

* Optimize the plan's financial operations relative to the objectives.For a corporation, this means looking at the pension plan's impact on the company's cash flow, financial statements, and ultimately its earnings per share. For a public sector plan sponsor, this usually means focusing on its impact relative to an inflexible revenue stream. For plan sponsors in either sector this focus can be divided into three inter-related sections: investment policy, funding policy and expensing policy.

Investment policy addresses the plan's asset allocation and sets parameters for an acceptable trade-off between long-term financial rewards and short-term uncertainty. In assessing this trade-off, it is essential to remember the fundamental pension plan equation, which must always hold true over the lifetime of a pension plan:

* Benefits paid are solely a function of the design of the pension plan, and expenses are insignificant relative to the other elements. Thus, the only way to reduce long-term contributions is to achieve better investment returns. This is the relationship that drives plan sponsors to accept short-term uncertainty.

* A plan sponsor whose plan is 100% funded and who requires certainty of contributions (i.e. a fully matched environment) will invest in a mixture of nominal and real return bonds, with duration and inflation sensitivity matched directly to the plan's solvency liabilities. But, this certainty clearly comes with an opportunity cost if the typical long-term expectation that equities will produce superior investment returns to bonds holds true.In considering the degree of asset/liability mismatch, the plan sponsor must consider a wide variety of different factors. For example:

* A plan that is poorly funded has a greater capacity to accept investment risk than does a plan that is close to 100% funded. When a plan is poorly funded, contribution requirements will be large as a percentage of payroll. Even when investment returns are very poor for a year, the incremental contribution is fairly small, because the assets have a much smaller impact on the funded position than do changes in the liabilities due their small relative size;

* The pattern of contribution volatility should be put in the context of the plan sponsor's ability to accept the unexpected additional contributions. Does the plan sponsor's operating cash flow follow a similar cycle to the cash requirements of the pension plan (i.e. do pension plan contributions increase occur during periods when the plan sponsor is experiencing a cash flow crunch within its business)? The taxable position of the plan sponsor and future expected changes in corporate tax rates should also be considered.

* While asset mix can affect the level of funding required, the plan sponsor's funding policy can significantly affect the amount of investment and financial uncertainty that can be absorbed. A plan sponsor who has the ability to vary contributions substantially from year to year can withstand years when investment results are poor and can even plan its contributions to offset any adverse impact the pension plan may have on the sponsor's income statement. Similarly, a plan sponsor who can contribute additional amounts during "good" years can create a buffer to protect itself against the "bad" years.Expense policy governs how the sponsor reports pension expense within standards set by the CICA in Canada and the FASB in the United States. This does not necessarily mean recognizing the lowest possible level of expense. Rather, it may imply using any leeway the standards provide to manage this reporting in line with overall corporate objectives. For example, by plotting the projected trend of pension expense against projected corporate earnings over the next five years, a year by year analysis of the probable impact on earnings per share can foster discussion of how actuarial tools and/or contributions can be used to manage that impact.

Consider whether pension expense changes can be offset by economic or capital market factors that affect the sponsor's financial statements. For example, falling interest rates tend to increase pension expense, but the bottom line impact is mitigated if the company has a lot of floating rate debt on which the interest expense would be reduced.

As with contributions, it is important to consider all of the "levers" available to the plan sponsor to manage pension expense, including asset mix, actuarial factors and contribution patterns.

What Does This Mean for the Plan Sponsor?
The long-term cost of benefits is a function of the level of the benefits promised, contributions and the performance of the assets. Long-term costs can be reduced through better performance. While there are a number of approaches that can be used to manage the incidence of pension expense and contributions, they do not affect the resulting long-term recognition of costs.

Risk management concerns should include consideration of:

* Solvency risk: the ratio of plan assets to windup liabilities, a prime concern for plan members

* Cash flow risk: the year-to-year variance in required funding by the sponsor

* Income statement risk: the impact of pension expense on EPS, a prime concern for shareholdersWhile decisions must meet the plan sponsor's fiduciary obligations as well as myriad legislation and professional standards, pension plan performance and underlying policies should be continually reviewed in light of sponsor objectives and changing environmental considerations, such as market performance and legal developments.

This article was prepared by Peter Muldowney, David Service and Steve Bonnar of Towers Perrin.

Contex Group