Corporate defined benefit pension funds are not all equal
Assessing the value of a pension plan in deficit with a weak sponsor company is no easy matter. EDHEC-Risk Institute's Lionel Martellini and Vincent Milhau explore your options.
Correctly assessing the value of a pension plan in deficit with a weak sponsor company is a real challenge given that no comprehensive model is currently available for analysing the risk that corporations and their pension funds mutually create. In fact, international accounting standards SFAS 87.44 and IAS19.78 recommend that pension obligations be valued on the basis of a discount rate equal to the market yield on AA corporate bonds, the same rate for all firms.
While the use of a market rate is arguably preferable to using a constant rate –whether it includes a credit spread component or not – the use of the same market rate to discount all pension liabilities regardless of the sponsor credit rating, pension funding situations and asset allocation policy can hardly be justified. Indeed, it is impossible to imagine that the sponsor's health has no influence on the future value of pensions, or even on their existence.
On the other hand, it is clear the financial situation of the pension fund and the risks that it takes, which are ultimately guaranteed by the sponsor, cannot have an influence on the financial health of the sponsor. Moreover, financial analysts have found at times that the value of the pension fund in some mature industries, such as the automobile industry in the US, has more influence on the stock exchange value of a corporation than its turnover.
In research supported by BNP Paribas Investment Partners in the context of the Asset-Liability Management and Institutional Investment Management research chair at EDHEC-Risk Institute, we have attempted to analyse the valuation of pension liabilities regarded as defaultable claims issued by the sponsor company to workers and pensioners in the context of an integrated asset-liability management model. This allows us to analyse the impact on the value of these claims of funding and leverage decisions at the sponsor company level, as well as asset allocation decisions at the pension fund level.
The results of this modelling are clear and show that the tendency of many DB corporate pension funds to invest on a large scale in risky assets – both in the US and, for example, in the UK – is not beneficial for pensioners and is the result of a veritable conflict of interest between the corporation's shareholders and its future pensioners. We find that the fair value of promised payments to pensioners is generally a decreasing function of the allocation to risky assets by the pension fund. This is a clear case of asset substitution, since a higher allocation to risky assets leads to an increase in the total riskiness of the total assets held by the firm (financial assets held off the balance sheet through the pension funds and real assets held directly on the balance sheet).
Overall, there is clear evidence of conflicts of interests between the various stakeholders and, in particular, between shareholders and pensioners. Assuming they do not have access to any surplus of the pension fund, this increase in risk-taking is detrimental from the pensioners' perspective because it involves increasing the likelihood of partial recovery of pension claims, while risk-taking allows shareholders to reduce the burden on contributions needed to meet expected pension payments due to exposure to the upside potential of the performance-seeking assets.
These conflicts of interests could be mitigated by granting pensioners some partial access to the surplus (see conditional indexation rules in the Netherlands), thereby allowing plan beneficiaries to benefit from the improvement in expected performance related to more aggressive investment strategies. More generally, our results have implications in terms of the optimal design of pension plans, since they advocate the emergence of more subtle surplus-sharing rules, which could include, for example, the use of hybrid retirement plans, and/or the use of contribution holidays for DB plans, which would allow equity holders to reduce the burden of contributions while protecting the interests of pensioners.
We also find that an effective way to align the incentives of shareholders and pensioners without any complex adjustment to the pension plan structure consists of enlarging the set of admissible investment strategies so as to include dynamic risk-controlled strategies such as constant-proportion portfolio insurance (CPPI) strategies, or their extension in a pension management context sometimes referred to as contingent immunisation strategies or dynamic liability-driven investment (LDI) strategies. In fact, implementing risk-controlled strategies aiming at insuring a minimum funding ratio level above 100% allows shareholders to get some (limited) access to the upside performance of risky assets, while ensuring that pensioners are not hurt by the induced increase in risk.
Lionel Martellini is scientific director, and Vincent Milhau deputy scientific director, at EDHEC-Risk Institute