This month’s Off The Record asks readers whether European pension funds and their members should be worried about the knock-on effects of the credit crunch on their assets.

It also asks whether this after-shock will reverse the steady progress of pension funds towards investing in riskier assets to get the returns they need.

Clearly, pension funds, like all institutional investors, are not immune from what is happening on the equity and bond markets. And with the new international accounting standards, whereby corporate sponsors have to mark-to-market the assets and liabilities of their pension funds, what is happening in the market is translated all too swiftly into losses or gains on the corporate balance sheet.

Yet taking into account the 40-year time horizons of pension funds, the events of even 40 days need to be put into perspective. Pension funds are not retail investors, queuing to withdraw their savings when markets fall or financial institutions look likely to fail. They can afford to wait until markets recover.

Yet the press and other media report the impact of falling equity prices on pension fund assets in terms of shrinking surpluses and deepening deficits. This creates, arguably, the same sort of anxiety that retail investors are currently experiencing.

Will pension fund members get their full pension promise if asset values fall? Will employers decide they can no longer afford the pensions promise and close their defined benefit (DB) plans?

These are legitimate worries, as the demise of occupational pensions in the UK demonstrates. Yet, as 2007 has shown, pension fund deficits can become surpluses as quickly as markets can recover.

Will markets recover? Equity market volatility is likely to continue for some time, according to research by Deutsche Bank. Pension funds must be prepared for perpetually choppy seas.

So is there any real cause for concern among pension funds and their members? Members of defined contribution schemes, who bear some if not all of the investment risk, may have most cause for concern, particularly if their pension is near payment.

Even members of DB schemes, where benefits are guaranteed, may be concerned that their plan sponsor could close the scheme to reduce the impact of the pension fund deficit on the company balance sheet.

The message from the pension fund trade associations has been bullish. The chief executive of the UK’s National Association of Pension Funds, Joanne Segars, has reminded pension fund
members that “pension funds are long-term investors and pension funds will set their funding
strategies in accordance with their long-term liabilities, not short-term market moves”.

She concludes that “there is no reason to think that the stock market falls will have a significant impact on pension provision”.

Yet stock market falls may have an impact on the way pension funds manage that provision in the future. Market volatility may make pension funds less likely to invest in riskier assets like mortgage-backed securities (MBS) and riskier strategies like hedge funds.

Aon Consulting has also suggested that pension funds are likely to reduce the risk of their portfolios by reducing their exposure to equities.

Are these worries an over-reaction to a market correction, or are pension funds and their members right to be concerned? We wanted your views.

The response from the pension fund managers, administrators and trustees who answered our questionnaire suggests that they think that the crisis will have little impact on European pension funds. It may make pension funds a little more cautious about investing in hedge funds and riskier fixed income assets such as MBS. However, it will not blow them off the course they have set themselves in terms of asset allocation.

Most are prepared to ignore the ups and downs of the market. Almost three-quarters of respondents (71%) agree that short-term market movements should not concern a pension fund manager.

There is little support for Aon Consulting’s view that the recent market turmoil will encourage pension funds to reduce the proportion of riskier assets in their portfolios. Only one in three agrees, while a majority (58%) disagree and a few (5%) are undecided. Fewer still (13%) think that the crisis will encourage pension funds to reduce their exposure to equities.

It could have some effect, however, on pension funds’ perception of risk. The manager of an Austrian pension fund suggests that “it will lead to better risk assessment”.

Yet hedge funds are no longer on the menu. Almost two-thirds of respondents (62%) agree that pension fund managers are now less likely to be less interested in investing in hedge funds. “The allure of hedge funds has gone,” one pension fund manager says.

The riskier shores of fixed income are also now off limits. The sub-prime lending origins of the crisis clearly have also made an impression, since a substantial majority of managers (87%) think that pension funds will be less likely to invest in MBS in the future.

International accounting standards (IAS), the whipping boy of corporate pension funds, also come in for their share of the blame. Three in four agree that IAS19, which requires corporate pension funds to mark their assets and liabilities to market, has made market volatility a major issue for pension funds.

There are caveats, however. An Austrian pension fund manager says the impact of IAS19 will depend on the regulatory environment which is still not uniform in Europe, while a Portuguese pension fund manager points out that IAS19 will only affect corporate pension schemes where assets do not match liabilities.

There is absolutely no doubt that the mark-to-market accounting requirement of IAS19 has encouraged corporates to take a short-term view of the impact of their pension fund liabilities on their profit and loss accounts. An overwhelming majority (92%) think this to be the case. One manager after another emphasises that this effect is most unfortunate.

Is there a silver lining to the dark clouds hovering over the markets? Perhaps pension funds should welcome volatility in the equity markets since it provides good buying opportunities for their asset managers. This suggestion gains some support, with almost two in three (62%) agreeing.

Yet a Swiss pension fund manager points out that although this is a positive factor, it is also marginal. “This is a meagre consolation for pension funds,” he observes. And the manager of an Austrian pension fund manager warns that “not every correction is a price correction. It could be the beginning of a downward trend as well.”

Speculation, however, is out. A majority (67%) agree that pension funds should not attempt to time the market, although a French pension fund manager qualifies this by pointing out that “it is impossible to completely ignore the market”.

There is less consensus about whether members of DB pension plans need to worry about price falls in the equity markets. A small majority (58%) think they should. One manager says: “They should take a closer look at the financial situations of their plan sponsor.”

Only a minority (38%) think that pension funds should inform their members about the effects of every substantial market movement on the assets of their pension schemes. One manager suggest that “they should inform their members only if they believe the situation has significantly changed”, while another says they should do so only “if it will affect employee contributions in the future”.

A pension scheme’s website is the best way of communicating this sort of information, one Dutch pension scheme manager says.

Finally, there is broad agreement (83%) that the press and media focus on the effect of short-term market movements on pension funds assets is unhelpful and even misleading. This is a pity. As one pension fund manager points out, press attention can be helpful. “Insofar as they stimulate a well founded discussion about risk management - which they seldom do.”