Monday, November 2, 2009

Time to Get Serious on Pension Governance?

Edmund Conway of the London Telegraph reports that UK alone in pension fund slump, says OECD:

Sharp increases in share prices have improved the outlook for pension funds in every major developed nation apart from the UK, according to research from the Organisation for Economic Co-operation and Development.

The news coincides with figures which reveal that the deficits in Britain's largest privately-sponsored defined benefit schemes have soared by £15bn to £77bn, wiping out almost all the gains achieved by market increases the previous month.

It underlines the challenges facing Britain's long-term savings industry, even as Britain attempts to rebalance away from its reliance on debt and to encourage saving.

OECD research has shown that the average level of pension deficits for defined benefit, or final salary, schemes, throughout the developed world improved from 24pc of their total obligations in December 2008 to 18pc this June. However, the UK alone saw its comparable deficit increase from 9pc last December to 13pc in June 2009.

The deterioration is largely an unhappy consequence of quantitative easing (QE). Pension funds' deficits depend on two factors: the value of their assets, much of which are equities, but also the potential amounts they will have to pay out when people retire in the future. These future liabilities have been pushed higher as QE has depressed yields on gilts and other bonds.

However, it is not merely QE that is depressing pension fund balance sheets. According to research published today by Aon Consulting, the deficits of 200 major final salary schemes in the UK rose from £62bn to £77bn in October, with an increase in inflation expectations to blame.

Sarah Abraham, consultant and actuary at Aon Consulting, said: "Many investors believe that the Government will be unable to deliver its annual inflation target of 2pc. This increases pension scheme deficits because most pension schemes promise to pay benefits that are linked to inflation. The position is very volatile because if this lack of confidence in achieving inflation targets worsens, then pension schemes can expect deficits to increase further.

"On the other hand, if the market had confidence that inflation will remain under 2pc, pension scheme deficits would decrease by £60bn."

I already wrote about how quantitative easing is bringing pensions to the brink. UK pension funds are experiencing serious deficits, but they are not alone. While the rally in global equity markets has eased pension shortfalls, it has not assuaged concerns that pensions will be unable to meet future liabilities.

Pat Boyle of the Irish Independent reports that Irish pension funds recoup 5pc of 2008 losses, says OECD:

Following a dire performance in 2008, Irish pension-fund assets recovered around 5pc of the losses in the first half of the year, the Organisation for Economic Cooperation and Development (OECD) said in a report published yesterday.

In June this year the OECD reported that Irish pension funds notched up the biggest losses in the developed world during 2008, as retirement funds here collapsed spectacularly because they are over-exposed to shares and property.

In its updated report, the OECD also pointed out that the National Pension Reserve Fund (NPRF) experienced the worst performance of any sovereign or national fund within the OECD group, shedding 30.4pc of its value last year.

The next worst performance came from New Zealand, which had a loss of 26.2pc followed by Norway and France, whose national pension funds shed around 25pc of their value.

The OECD said the impact of the crisis on investment returns varied greatly between countries but has been worst among public pension reserve funds where equities or shares represented a large part of total assets invested.

The Irish National Pension Reserve Fund was the most exposed to equities in December 2008, at 59.8pc of total assets, followed by New Zealand (53.8pc), Norway (50.8pc) and France (49.3pc), the OECD said.

At the other extreme, public pension reserve funds in Spain and the United States experienced positive returns as they were fully invested in bonds in 2008.

The OECD said funds have also come under pressure as governments have turned towards them to help them alleviate the impact of the financial crisis, noting that the Irish Government approved the use of 25pc of the reserve fund assets to recapitalise our domestic banks.

Earlier this year the NPRF said that its €7bn commitment to the banks had been met by €4bn of its own funds and by front loading €3bn worth of annual contributions from the State to the pension reserve fund.

Established in April 2001, the NPRF is designed to meet as much of the costs of social welfare and public service pensions as possible, from 2025 onward.


The National Treasury Management Agency was appointed as manager of the Fund for ten years until 2011.

At the end of 2008 the fund's market value was €16.1bn and after growth of 1.3pc over the first six months of 2009, and receiving €3bn in front-loaded annual contributions, its value at the end of June this year amounted to €19.1bn.

This gave it an annual growth rate of 0.6pc since inception.

IPE reports that according to some experts, poor governance hit Irish pensions funding:

Pensions experts have claimed that a lack of focus on governance strategy had as much to do with the recent lower funding levels of Irish pension schemes as investment strategy.

Speaking at the IMN UK & Irish Pension and Investing Summit in Dublin, Michael Curtin, senior investment consultant at Mercer Investment Consulting, suggested that trustees could have improved scheme performance had they looked at governance processes to find ways of identifying and mitigating risks.

Curtin said: "The reason [Irish] schemes have funding levels of 60% is as much about governance as investment strategy. If we step back from strategy and look at governance we might see schemes with more diversification. We are talking to our clients about scheme-specific benchmarks. It's about minimising the concentration of risk in an area such as Irish equities."

Fiona Daly, managing director of Rubicon Consulting, also noted that many Irish pension funds are still invested in managed fund-type instruments, which performed particularly badly in 2008. She questioned whether there is an element of 'group thinking' by trustees as well as asked how this can be changed.

Stephanie Condra, investment consultant at Invesco, suggested one possible solution might be for investment managers to consider offering a different range of managed funds such as high risk and low risk funds, or provide schemes with more sector and style-specific investment funds.

In contrast, Ronan Smith, director of Ronan Smith Independent Consulting Limited, argued Irish pension funds consist primarily of quite small trusts and argued they need simple investment management funds, "which is why managed funds exist".

He warned any solution to try and replace these "will have to be a one-stop-shop, a simple way for trustees to buy into it". Smith also agreed that the decision-making process should be "free of peer consciousness as it is the most destructive thing".

He argued that when a fund looks at what other schemes are doing then "that's when you find they are not making proper investment decisions". Smith also admitted he did not know how the Irish pensions industry might avoid 'peer consciousness', though he said one possible solution might be for trustees to set up an investment sub-committee and delegate decisions to speed up the process.

Curtin added one other option is for pension funds to outsource the investment management process into the "rapidly growing" fiduciary management space, although he admitted there can be conflicts of interest for consultants on the issue of advising a scheme and taking on the fiduciary management.

But he said: "You need to think about whether the conflicts still make it a better option for the scheme than not doing it. Most funds are hoping the markets will bail them out eventually, and they are also negotiating changes to employer and employee funding and to the benefit structures. But the holes are so big it's not going to be that easy," he added.

Again, take everything that a pension consultant says with a grain of salt. Importantly, always ask, what is their angle? Are there potential conflicts of interests with the funds they are recommending? Do they get fees from the funds? Do they recommend funds that they've invested with in a separate account?

I like pension consultants that are fully independent. Even better if you find some that get paid on the performance of the funds they recommend (good luck finding that). I truly believe that once pension consultants recommend something, they should get paid based on the performance of their recommendations.

As for governance here in North America, Ellen Schultz and Tom McCinty of the WSJ report that Pensions for Executives on Rise:

Pensions for top executives rose an average of 19% in 2008, with more than 200 executives seeing pensions increase more than 50%, according to a Wall Street Journal analysis.

The executive-pension growth stemmed partly from generous pension formulas, which are based on executive pay, according to the filings. Also adding to the pension jumps are arcane techniques that have received little scrutiny, including increases triggered when an executive reaches a certain age or when companies change interest rates used to calculate the pensions.

Executive pensions rose even as the share prices at the companies declined an average of 37% in 2008 and many firms froze employee pensions and suspended retirement-plan contributions.

The growth of such supplemental executive retirement plans, or SERPs -- which can be worth tens of millions of dollars to executives -- largely has been overlooked amid a backlash against executive pay, particularly at banks and other companies receiving taxpayer bailouts.

Rules that became effective in 2007 have made more information available by requiring companies to report the estimated total value of each top executive's pension and the pension's growth over the prior year.

Using two years of improved disclosures compiled by research firm Capital IQ, the Journal examined 340 companies with pension plans in the Standard & Poor's 500-stock index and calculated the annual change of the value of the named officers" pensions. The analysis excluded executives who didn't participate in the plans in both 2007 and 2008.

Surging pay fueled much of the growth of executive pensions, which generally are calculated by multiplying pay by years on the job, a formula that can produce steep increases in pension values when either the pay or years of service increases.

Richard T. Clark, Merck & Co.'s chief executive, saw the portion of his compensation used to calculate his pension rise more than $6 million in 2008, which in turn helped boost the value of his pension to $21.7 million from $11.9 million.

ConocoPhillips included "certain incentive payments" in the compensation it used to calculate CEO Jim Mulva's pension, according to its filing. The additional compensation helped boost his pension $9.5 million, to $68.2 million.

Big bonuses, especially in the final years of executives' tenure, boosted some top executive pensions substantially, filings show. One of Exxon Mobil Corp.'s two supplemental pension plans for executives uses the three highest bonuses in the five years prior to retirement to calculate the executive's pension. Thanks to this, a $4 million bonus to CEO Rex Tillerson in 2008 helped push the total value of his pension to $31 million from $23 million.

An Exxon spokeswoman pointed out that the proxy states that "by limiting bonuses to those granted in the five years prior to retirement, there is a strong motivation for executives to continue to perform at a high level."

Merck and ConocoPhillips confirmed the information and had no further comment.

Awarding executives additional years of service, a practice that some pay watchdogs have criticized, remains common, filings show.

PG&E Corp. awarded CEO Peter Darbee an additional five years of service in 2008, which helped boost his pension to $5.2 million from $3.8 million, a 38% rise. A PG&E spokesman said Mr. Darbee's benefit was increased to "address disparity between his pension benefits and other officers" at PG&E.

In February 2008, Constellation Energy Group Inc. awarded Chairman and CEO Mayo Shattuck with an additional 2µ years of service, which helped increase his pension by $10.3 million, a 45% increase, according to company filings. A Constellation Energy spokesman said the compensation committee decided to count Mr. Shattuck's years as a director at the company, and said the increase in his pension is "due in large part to a performance bonus our CEO received after the company posted record results in 2007."

Reaching a milestone birthday also can enhance an executive's pension. Altria Group Inc. CEO Michael E. Szymanczyk's pension rose when he turned 60 last year, triggering a subsidy built into the pension formula, boosting its total value to $23.5 million.

Mr. Szymanczyk benefited from an early retirement subsidy, a feature widely used in employee pensions in the 1980s and 1990s. The subsidy, which typically kicks in when a worker reaches age 55 or 60, enables him to retire with the same pension benefit he would have received if he remained on the job until age 65. The subsidies were intended to encourage older workers to retire.

An Altria spokesman confirmed the information, and said Mr. Szymanczyk's total compensation was roughly flat in 2008.

Under the rules implemented in 2007, companies also must disclose the assumptions they use to value the benefits. Many companies reduced an interest rate they use to calculate the pension, which boosted the accumulated present value, according to filings. Reported in the proxy, this is the company's estimate of what all the monthly payments to the executive in retirement would be worth in today's dollars. The lower the interest rate, the higher the pension payout.

Goodyear Tire & Rubber Co. lowered the rate it uses to calculate lump sums paid out from its SERP to 4% from 5.25%, which accounted for $1.6 million of the $6.2 million increase in CEO Robert Keegan's pension. Its total value: $17.5 million. Goodyear froze salaried employees' pensions at the end of 2008, saying it "could impair our ability to achieve or sustain future profitability." Goodyear said it also froze one of its pension plans available to executives and highly paid employees. And it said the top executives could receive payouts larger or smaller than the amounts shown in the proxy if the assumptions used to calculate pensions change.

That is true. But the Journal's analysis showed that nearly all executives who departed their companies in 2007 and 2008 received pension payouts at least equal to the amount that was disclosed in the prior year's proxy.

So are problems with pensions only limited to the UK and Ireland? Of course not. There are governance issues plaguing private and public pension plans all around the world. Unless we get serious and address these issues, pension systems will remain vulnerable to flagrant abuses. Do we need a total collapse of pensions to rectify these issues?

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