 By Glenn O’Brien, Managing Director, Head of U.S. Distribution for Pension Risk Transfer, Prudential Financial (PFI)
In a recently published survey conducted as part of the Pension Plan De-Risking North America report, a growing number of pension plan professionals indicated they would consider de-risking. This trend helps confirm many of PFI’s observations regarding the future of the market as well as the behavior of large asset owners. The corporate sponsor landscape as we see it is divided into two categories – those sponsors focused on improving the situation as it stands today, and those sponsors focused on innovating lasting change. We’ll attempt to address the trends for each group, beginning with the sponsors focused on improvements.
For the better part of a decade companies have been incurring losses as they made large cash contributions to defined benefit plans. Greater transparency drove greater investor awareness and many of the existing strategies appeared insufficient. As with any subsidiary that has underperformed, the business leader’s reaction is to initiate a series of improvements.
In an effort to reduce funded status volatility we saw greater awareness of hedging strategies and the trend toward liability-driven investing. While the definition of LDI varies, growth in the size of fixed-income assets and duration extension are attempts to reduce interest rate risk.
Taking a different tact, to improve funded status we saw record flows into alternative asset classes with the hopes of a few extra points of yield. The growth of private equity allocations and use of hedge funds has sought to improve rates of return.
As the U.S. pension market stands ready to adopt a new set of mortality tables and improvement scales, the economic impact of $2.5 trillion in liabilities has not been lost on board members and CFOs. The ability to swap away deviations in long-term expected outcomes due to mortality improvement has been welcomed in Europe and the transaction flow appears robust.
The characteristics of each improvement attempts to answer the simple question, “How do we make today’s situation better by some measurable amount?” For any large asset owner listening, there are a number of solutions available to improve upon the multi-decade strategy that might have been in place prior to the last recession. We recognize that each business system and sponsor has their own unique issues.
The second categories of sponsors are focused on a different set of questions. Rather then improving the current situation they ask why the situation exists. When we ask the “why” question we challenge what are often long standing traditions which in turn might deliver a very different set of outcomes.
For senior finance people looking to apply the fundamentals of innovation the de-risking trend suggested in the survey seems natural. If a large set of pension liabilities meet the following criteria, innovators begin to look for fundamental change. Those criteria include:
• Unrewarding to investors
• Not engaging for employees
• Increase the risk of the enterprise, and
• Continue to increase in cost.
This response is consistent with how any business would evaluate its portfolio of businesses and question if the mix is still compelling.
As I mention above, large pension liabilities are akin to running an insurance subsidiary. Our experience tells us that the divestiture of any corporate entity comes with diligent planning and some measure of privacy. We believe many sponsors will refrain from comment until the strategy is set, the economics are known and execution is a certainty.
For state and government plans the response rate seems consistent with our history. Simply said, the magnitude of the issues at hand is hard to rationalize within today’s budget constraints.
We have seen some large pension reform efforts attempt to address the overwhelming demand on a set of finite economic resources. Those sponsors have sought improvements that, over time, might lead to lower overall cost. Given that many of these plans are open and continue to accrue liabilities, the concept of risk reduction is often seen at odds with their current mission.
The sudden end to a three decade-long bull market and subsequent recession served as a reminder that large long-term liabilities exist inside the capital structure and budget limits of their owners. Furthermore, senior finance professionals are closely watching interest rates, which drive funded status, because deficits are costly to maintain.
The pace in which any particular improvement or innovation is adopted is unknown but we do see the trend moving to more risk transfer and risk reduction for corporate pension plans.
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