Four Key Strategies for Managing Pension Risk
While overseeing pension plans is increasingly complex and there’s no silver bullet solution, employing these four strategies can do much to reduce risk.
CFOs at companies that offer defined benefits might be forgiven for feeling frustrated that, in addition to oversight responsibility for company financial performance, shareholder relations, accounting, tax, and myriad other functions, they also have to manage a pension plan.
Compounding the challenge, the investment landscape has grown only more complex over the years, requiring greater day-to-day attention and oversight. Additionally, few internal or external constituents who influence plan direction have a clear 360-degree view, further confusing and distorting the picture for CFOs charged with plan oversight.
If managed ineffectively, pension plans can threaten cash flow, access to capital, liquidity, credit ratings, investor sentiment, and other corporate priorities. Their ultimate cost, while influenced by exogenous factors, depends greatly on strategic choices within each CFO’s control.
While there is no single silver bullet that can solve these challenges, CFOs have four levers at their disposal that we believe they should proactively employ to manage pension risk.
Strong asset returns are clearly the preferred way to improve funded status, reducing the amount of future required contributions. Unfortunately, today’s current market conditions project that future returns for traditional portfolios will be lower than historical average.
All is not lost, however. While sponsors may not be compensated for taking on additional risk, they can consider changing the type of risk they incur by adding exposure to alternative investments.
Many CFOs typically steer clear of unfamiliar investments, because of concerns over high fees or long lock-up periods. Ultimately, we believe these risks are compensated with diversified return enhancement, and strategies exist on a broad liquidity spectrum such that many plans can absorb some degree of additional illiquidity.
Funded status is obviously very sensitive to interest rates, which in many cases account for about half of a pension’s funded status volatility. But while CFOs can’t reliably control or predict the direction of rates, they can calibrate their plan’s sensitivity to changes in rates.
Many plan sponsors have reacted to the recent period of low rates by underweighting duration in their portfolios and hoping for rates to rise, while failing to acknowledge that if rates take a gradual path upward instead of rising quickly, a portfolio may still underperform.
Tactical bets that rely on being right on both the timing and magnitude of beneficial discount rate increases are bold and difficult. The good news is that even in a low rate environment, there are creative and capital efficient ways to lower the opportunity cost of putting on liability hedges without sacrificing returns.
Nothing improves the funded status of a pension with more certainty than making a contribution to the plan. Beyond minimum required contributions, however, this is an important capital decision for any organization to make.
Contributions are irreversible, and a company’s availability to contribute to its plan is not constant over time. In fact, the correlation of capital markets with a company’s financial health may be high.
Conversely, companies may find themselves with excess cash from operations to contribute when risk asset valuations are elevated, and facing financial adversity when they are required to contribute due to a funded status drawdown (when valuations are attractive).
Therefore, it’s important to think about pension contribution as a proactive decision, not a reactive one. CFOs should develop a contribution budget that aligns with other corporate priorities.
Finally, while low rates elevate the present value of pension liability, they also may give sponsors the ability to de-risk plans through thoughtful use of debt.
CFOs can proactively manage policies that govern benefit payouts. Accrued benefits are not adjustable, but benefit payments may be altered for future periods to be more aligned with the company’s current goals and compensation priorities.
Opportunities also exist to optimize benefit liabilities relative to plan costs, including the potential cashing out of small balances or terminating vested participants. In more extreme circumstances, CFOs could explore modifying or closing a plan or offloading pension risk in its entirety to an external provider.
When exploring such transactions, sponsors must determine their primary objective — for example, to cut administrative costs, offload a relic of a legacy benefits strategy, or reduce balance sheet risk. In addition, sponsors should be sensitive to potential indirect impacts of a possible risk transfer, such as employee sentiment regarding the transaction.
It is vital in the current environment for a CFO to acknowledge that it’s unrealistic to rely on any of the above factors in isolation to carry the burden of substantially narrowing a funded status gap. Balancing these four levers in unison, while understanding their interaction with one another, is not easy.
To add to the complexity, there is a major human aspect of pension management, as the plan impacts employees’ lives in retirement and the cash flow they need to meet their needs. Before any managers are selected, the CFO and other senior executives must define their top goals, taking into account all of the enterprise’s constituencies.
Only then can the sponsors appropriately review and quantify the trade-offs to be made within each lever and among levers to develop a balanced, multi-lever approach that enables a greater probability of success in managing pension risk.
This article originally appeared on CFO.com in May 2019