BOSTON, Nov. 28, 2017 (GLOBE NEWSWIRE) -- Even amid a surging bull equity market, the average funded status of US defined benefit pension plans – the difference between the average plan’s current assets and its projected benefits obligations, or liability – has risen by only 2% in the last eight years, from 79% to 81%. That’s a growing problem for balance sheets at many organizations, and the CFOs, Treasuries, and other financial executives who manage them – and it probably won’t get better when the public markets inevitably turn.
Many plan sponsors pursue singular responses to this funding gap dilemma – for instance, focusing on raising company contributions to the pension, or waiting for higher interest rates to lower the value of the plan’s liabilities. But over-emphasis on any one tactic is a major risk, according to “A Balancing Act: Strategies for Financial Executives in Managing Pension Risk,” a new report by the pension practice at global investment firm Cambridge Associates.
“Pension liability can be one of the biggest and most volatile lines on the balance sheet. Too many underfunded pensions are negatively impacting corporate finances in the near and long term by having an incomplete picture of the problem and leaning too much on any one given strategy to fix the issue,” says Brian McDonnell, managing director and head of the global pension practice at Cambridge Associates. “Closing the funding gap is complicated, and there are many risks and issues that may not be evident to the executives involved.”
The best approach to addressing the problem is to coordinate across four “levers” that can help improve funded status and mitigate negative impacts of under-funding on corporate financials, according to the report. These levers are:
- Asset Returns: Maximizing investment returns from growth assets, like public equities and alternative investments;
- Liability Hedges: Optimizing investments in liability-hedging assets, such as bonds, to hedge key liability risks, including interest rate risk;
- Contribution Policy: Having an established plan and set of guidelines around when and how to make incremental corporate contributions to the plan; and
- Benefit Management: Altering future benefit structures, policies, or strategies.
No lever alone is enough to close the pension funding gap, according to the report. For example, consider a hypothetical defined benefit plan that is 80% funded ($1 billion liability; $800 million in assets). To reach 100% funded status in five years, relying only on growth asset investment returns would require an unrealistic 15.7% return in each of the five years. Similarly, it would take an unlikely 5.5% increase in interest rates over five years for the liability to shrink and close the funding gap. This hypothetical plan would need to contribute $67 million per year to close the gap with contributions alone.
“To most financial executives, these four levers may sound familiar, but what’s involved within each one is complex. It’s essential to have a full understanding of how they work, as decisions can have lasting impacts on a corporation’s financial health and enterprise-wide priorities,” says Sona Menon, head of Cambridge Associates’ pension practice in North America, and one of the firm’s outsourced chief investment officers. “Moreover, taking action will likely become more difficult as the markets become more challenged. The stakes have never been higher to get this balancing act right.”
The report outlines considerations that CFOs and financial executives should keep in mind for each of the four levers.
Creative Use of Illiquid and Other Strategies Can Help Grow Plan Assets
Returns from growth-oriented asset classes are the primary engine with which defined benefit pension plans can grow assets relative to liabilities and close their funding gaps. But over the next 10 years, Cambridge Associates’ analysis projects low-single digit returns from traditional growth assets, such as global equities, which will not be enough for most plans to meet their spending requirements. Plan sponsors may benefit from looking to private equity and other illiquid asset classes, which have historically outpaced traditional assets’ returns and which are expected to outperform by even wider margins in the decade ahead. In fact, most corporate pensions in the US can likely afford to invest more in illiquid investments than they think, according to the report. And, by under-allocating to these investments they may be exposing their plans to unnecessary risk. Also, some growth portfolio assets can act as liability-hedging or “de-risking” assets; these investments allow plan sponsors to hedge against interest-rate risk without reducing allocation to growth, essentially “having one’s cake and eating it too.”
Mismanaging Liability Hedges Can Actually Raise Portfolio Risk
While liability-hedging assets – such as longer-duration bonds – can minimize the effect of interest-rate changes on the value of the plan's liabilities (and therefore how it appears on the company balance sheet today), many sponsors may not be fully hedging their liabilities, betting too much on interest rate increases in the near future – a tactic also known as the “rate wait.” If long maturity rates do not rise or rise very slowly, the value of liabilities may grow faster than plan assets, which could negatively impact balance sheets.
Proactive and Disciplined Contribution Policy Can Maximize Bang for Each Buck
Employer contributions into a defined benefit plan are probably the most direct link between a company's balance sheet and its pension, and there are regulations that govern the minimum annual contribution employers must make into their plan. Some financial executives may be tempted to follow the minimum funding levels required by the government, but those amounts may not keep the plan well-funded over the long term. Sophisticated financial executives also remember that they shouldn't do too little in steady times, because if their company faces financial issues down the line it will only make it harder if they've been under-contributing to their pension in more profitable years. On the other hand, capital infusions to a plan are irreversible and will always represent a trade-off versus other strategic corporate investments. A well-articulated contribution policy should balance payouts with other company priorities, within the context of market cycles.
Benefit Management Decisions Can Help Refine Future Obligation Costs
Whether a defined benefit plan is fully frozen or still accruing benefits in some fashion, the corporation does have many choices at its disposal in terms of how to manage future plan benefits and their effects on the balance sheet. These choices vary, and include changing the benefit structure, offering different benefit payment options, various “risk transfer” tactics – by which a third party takes on a portion of the pension liability – and other techniques. Each of these alternatives carries with it both direct and indirect costs and risks, however, that should be fully understood, quantified, and reviewed in an organization’s benefit management policy.
“There is no single answer to the funding gap problem, and focusing on any one lever is neither practical nor cost effective. The most productive outcome depends on a blend of all four in a way that reflects the unique objectives and circumstances of each organization,” says Jeff Blazek, managing director in the pension practice at Cambridge Associates, and an outsourced chief investment officer for the firm.
To read “A Balancing Act: Strategies for Financial Executives in Managing Pension Risk,” click here. The report offers simple solutions within four levers by providing a holistic picture for plan executives on tackling these complex issues, complete with detailed insights, graphics and data, and questions to consider for effectively addressing each lever. It is authored by pension practice team members Jeff Blazek, Greg Meila, Alex Pekker, and Justin Teman. To learn more about the dedicated pension practice at Cambridge Associates, click here.
About Cambridge Associates
Cambridge Associates is a global investment firm founded in 1973. The firm helps more than 1,000 endowments, foundations, pension plans, and private clients maximize their impact on the world by building custom investment portfolios aimed at generating outperformance across all asset classes. Working alongside its early clients, among them leading university endowments, the firm pioneered the strategy of high-equity orientation and broad diversification, which since the 1980s has been a primary driver of performance for institutional investors. Cambridge Associates delivers a range of services, including outsourced CIO; investment consulting; and access to investment research and tools across the continuum of global asset classes.
Cambridge Associates has more than 1,200 employees and maintains offices in Boston; Arlington, VA; Beijing; Dallas; London; Menlo Park, CA; New York; San Francisco; Singapore; Sydney; and Toronto. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information, please visit www.cambridgeassociates.com.
Media contact:
Eric Mosher
Sommerfield Communications, Inc.
eric@sommerfield.com/(212) 255-8386