Pension plans have reached middle age. During the 1990’s bull market, pension plans were viewed as the golden goose for many companies, boosting bottom lines all across corporate America by millions every year . Fast forward two decades and the picture changes dramatically. Post Enron, the Dot Com Bubble, the Financial Crisis, and now Covid-19, the name of the game is volatility.
Volatility of pension financials has resulted in many companies closing or freezing their plans in the last 20 years. Without proper management, CFOs might view them as a financial albatross that consistently defies planning and budgeting exercises: 12 times in the last 20 years, the typical 60/40 (equity/fixed income) pension plan has experienced year-to-year funded status changes of more than 5%, and 8 out of the 12 times the change has been more than 10%! These funded status changes can wreak havoc on balance sheets, P&L and short and long-term cash requirements.
But history has taught some CFOs how to manage this volatility. As the tragedy of COVID-19 hit the financial markets hard, reducing the funded status of some plans over 10% in a month, they were able to focus on other important matters. Here’s what they know:
1. A pension plan should run on autopilot.
When pension assets and liabilities change in value dramatically over a short period of time, should any action be taken as a result? The answer is a definite “maybe.” To get past the maybe requires thoughtful analysis and review. This takes time and ideally is not done during a crisis when many other items need attention.
The CFOs who have no trouble sleeping have done this analysis and adopted a glide path strategy that has pre-determined when the fund will increase or decrease exposure to risk in reaction to market changes. Planning ahead allows the plan sponsor to take advantage of opportunities when they present themselves. There’s no delay in determining the course of action, and no decisions to make in times of crisis. All the decisions have already been carefully considered and made.
CFOs who have outsourced the Chief Investment Officer (OCIO) role sleep even better, because they don’t have to be concerned about executing of the plan. The OCIO is hired as the expert in charge of watching the plan financials every day and executing according to the CFO’s plan. The CFO can even hit the snooze button without worry!
2. Exposure to interest rate risk is pure folly.
“Interest rates will go up soon.” That single thought has cost pension sponsors dearly. The further rates have dropped, the more some insisted they will go up. The cold, hard fact is that interest rates have been on a downward trend for the better part of 40 years. You likely would be much better off in a casino than betting on interest rates rising back to levels not seen since the 80s.
The well-rested CFO doesn’t gamble with pension financials. Interest rate risk is hedged as much as possible. Period.
3. Liquidity provides opportunities.
A pension plan needs liquidity primarily to make cash benefit payments. This consists of cash and other short-term interest bearing investments. Having liquidity on hand gives plans flexibility to make tactical allocation decisions without the need to sell depressed assets to meet cash needs at a time when buying or holding makes more sense.
The CFOs who take their daily siesta have at least six months of cash needs in short-term liquid investments and cash.
4. Diversification really does reduce risk.
So far in 2020, growth stocks and high quality fixed income investments have substantially outperformed value stocks and higher yielding investment grade or high yield fixed income. Holding a concentrated position in style, size, quality, or other factors results in risk that can instead easily be diversified away and generally does not belong in a pension plan.
The bright-eyed CFO knows that factor risk is just not worth it and holds broadly diversified investments within asset classes. A concentrated position in the wrong place at the wrong time could give a CFO nightmares.
5. Asking your actuary for funded status updates isn’t always the best solution.
Traditionally sponsors only see their funded status once a year, even though it changes daily. CFOs need quick and reliable updates on the pension fund status in volatile markets to understand if budget updates or other action is warranted.
The CFO who actively follows the impact of market shifts in pension financials tends to sleep like a baby. This CFO is always tuned in, but doesn’t spend a lot of time. Checking the plan’s current funded status with the click of a mouse on a dashboard or, better yet, getting the information delivered to their inbox well before the morning cup of coffee. Just 10 seconds a day spent knowing the strategy is working amidst all the market turmoil, and the CFO can move on to more important concerns.
6. Derisking is more than a buzzword, it is a credo.
Risk is taken in every business. But the CFOs who understand that a company’s pension risk hardly ever goes rewarded do everything they can to “wall off” this risk. There are many ways to wall off risk, and no specific method is right for all plan sponsors.
The most effective way to reduce the risk to the company is to make the plan smaller. This is accomplished by transferring the burden and risk of providing the pension benefit to someone else. That someone else can be the participant in the case of a lump sum offering, or an insurance company in the case of an annuity purchase transaction.
Other ways include an annuity buy-in, where the plan holds the annuity contract but the insurance company assumes the risk for the payments, or a Liability Driven Investment strategy where the assets and liabilities move in lock-step.
Using a combination of these actions will dramatically reduce the risk the pension plan has on the organization. This is better than warm milk before bedtime.
The CFO who has done all of these activities is spending their waking hours focusing on other pressing matters for the company, employees and shareholders. If only everything else were this easy.
Goodnight CFO.