Corporate Pensions Embrace Riskier Assets?
Thinly traded and hard-to-value investments such as real estate and private equity stakes are taking up a larger piece of the corporate pension pie. The shift lets companies chase higher returns for their plans, but merits a closer look because such assets can be risky, says Fitch Ratings.I wouldn't worry too much about corporate pension plans and their "Level 3 assets." Sounds a lot scarier than it actually is. While the top five plans in terms of proportion of Level 3 assets to total have sizable investments, they're mostly hedge funds which are a lot more liquid than real estate, private equity or infrastructure. And their corporate balance sheets are in great shape, which means these assets pose little credit risk.
Among 224 large corporate pensions studied by Fitch, plans were on average 8.5% invested in illiquid “Level 3” assets, a significant boost from 7.8% at the end of the year-earlier period. Some 66 of those plans held illiquid assets worth more than 10% of their plans, which Fitch says is concerning.
“Plans with more than 10% of assets in Level 3 assets may call for further investigation, because these include relatively illiquid holdings,” Fitch said in a research note. Pension plans at companies with lower credit ratings and higher near-term benefits obligations are the most at-risk, Fitch said.
Concentrations of illiquid assets could complicate business decisions. For example, if a company needed to sell or close a business line, triggering large one-time cash payments to pension plan beneficiaries that work in that unit, illiquid assets could make it hard to come up with the cash.
But retirees shouldn’t necessarily worry that a buildup of hard-to-value assets mean their plans won’t be able to meet obligations. Companies with pension funding difficulties could find themselves further underfunded if those assets become impaired, according to Don Fuerst, senior pension fellow at the American Academy of Actuaries. Mr. Fuerst couldn’t recall a case where this happened, however.
The Financial Accounting Standards Board requires companies to break down assets into three levels, according to how easy they are to price and sell. Such rules went into effect after the financial crisis froze markets for many inscrutable investments, such as mortgage-backed securities.
Fitch said the top five corporate pensions, in terms of the proportion of Level 3 assets to the total, are: Exelis Inc., at 45%; Hanesbrands Inc., 44%; Verizon Communications, 43%; Lorillard Inc., 38%; and Kroger Co., 37%.
“From a management standpoint, it doesn’t scare us,” Hanesbrands treasurer Donald Cook told CFO Journal. Most of its Level 3 assets are in “hedge fund of funds,” or investments products that allow companies to invest in a basket of hedge funds simultaneously, he said, and just 5% or so of the pension’s assets are in real estate.
Mr. Cook said half of the Hanesbrands’ plans’ roughly $644 million in assets can be liquidated immediately, with the cash received a few days later when the trade settles, Mr. Cook said. He added that another 25% of the assets can be turned into cash in one quarter or sooner.
Pension managers typically do a good job of keeping the funds liquid enough to meet their liabilities as they come due, industry watchers say.
Although hedge funds are considered Level 3, valuing them correctly isn’t terribly difficult as they typically bet on and against stocks, said Scott Henderson, vice president of pension and investment strategy for grocer Kroger.
Mr. Henderson said investment-grade rated Kroger isn’t concerned about its plan, which had about $2.7 billion in assets at the end of its fiscal year in February. But he said Fitch is correct that companies with sizable Level 3 assets and a combination of low credit ratings and weak cash flow, or whose pensions are underfunded, have reason to worry. If Kroger found itself in such a situation, he said, “We would move away [from such investments].”
Spokesmen for Exelis, Verizon and Lorillard declined to comment. Companies are required to update their pension funding levels and broadly categorize their asset classes annually.
Hanesbrands’ Mr. Cook said the undergarment and casual-apparel maker, which was spun off with a large debt burden from what was then Sara Lee Corp. in 2006, decided to try “to get a nice risk-weighted return” for its pensions. By choosing hedge funds that can both buy long-term positions and sell short stocks, the company’s returns have outperformed long-only funds, he said.
Also, these plans are run by very smart people who know how to manage liquidity risk. I guarantee you they have thoroughly vetted their redemption clauses with their funds of funds and hedge funds and know exactly how long it takes to raise cash if a situation arises where they need liquidity to meet obligations. Moreover, a small allocation to real estate and private equity is well worth the illiquidity risk if the performance is there.
I'm much more concerned about grossly underfunded public pension funds that are indiscriminately plowing into very illiquid alternative investments, hoping this strategy will save them. If another crisis hits them, they will suffer serious liquidity issues, further imperiling their weak funded status.
Below, James Tisch, who invests in hedge funds to boost returns at Loews Corp. (L), said he avoids managers with the largest pools of money and sleeps better at night knowing he doesn’t face the same prospect of client withdrawals. Smart man, guarantee you his managers are not coming up short.