Managing Pension Risk
Frank Oldham: CFOs and CEOs should care about this issue as defined benefit pension obligations represent substantial commitments for many organizations. Low yields on bonds have meant that pension scheme liabilities are as big as they’ve ever been, leading to large pension scheme deficits.
Financial risk is, in my view, the most critical one to mitigate because pension scheme liabilities are very long term in nature and this means that they’re very sensitive to changes in market conditions. By way of example, last year, in the U.S., when yields on bonds fell to around 4.7 percent, we saw pension scheme deficits increase to their highest levels, highest level ever seen, at over $500 billion. So pension scheme deficits are large, they’re volatile and what we’ve also seen is that over recent years, increasing transparency of accounting treatment of pension obligations has meant that these deficits sit on company balance sheets, so they’re there for all to see. And for me, this is one of the reasons why companies need to get their arms around this issue and around the financial issue now.
Many plan sponsors have already taken steps to limit their exposure to DB risk by closing to new entrants or closing to future accrual. But there’s more that can be done, and, in fact, there’s more that we are seeing being done by many organizations. Action can be taken to better match the assets to the liabilities, so that some of that volatility and exposure to market movements, exposure to changes in the economic environment can be reduced. The liabilities themselves can also be managed by taking steps to make some changes in the nature of those liabilities, offering member options where they can select a less risky option to the business. We’ve seen that recently particularly in the U.K. and U.S., where members have been provided by the sponsoring employer with options to cash out their benefits in favor of a lump sum or a transfer value out of the plan. These are all things that can help to start to mitigate a business’ exposure to pension scheme risk over time. In some countries, we’re also seeing an increased instance or increased appetite for buying out some of the liabilities with an insurance company, effectively transferring the obligation to a third party or an external provider.
If you don't have a long-term plan in place, the danger is that the organization fails to act when the opportunity arises. We’ve seen that. We saw that in 2008. We’ve seen it more recently in 2010 and 2011, when funding levels in many parts of the world improved substantially, but organizations failed to take the opportunity as a whole to de-risk, to take risk off the table, to change their investment strategies and to lock in the gains that were made. We’ve even seen that again in 2012. In the U.S., funding levels improved generally over the first quarter of the year only to fall again in the second quarter. So the pension world is full of regret risk in terms of opportunities that potentially have been missed. I think now more organizations see the benefit of having a longer term plan in place, a plan with triggers against which the organization can take prompt action to de-risk, to implement changes in investment strategy, as and when you hit those triggers. To me, that's the only way the organization is going to enable itself to act in a timely fashion and to take advantage of volatile market movements.
Directed & Produced by
Jonathan Fowler & Elizabeth Rodd
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