Let me apologize for the length of this post but plan funding is another important subject relating to pension governance. It is impossible to cover all aspects of plan funding in one post, so I invite you to peruse through some articles and papers I posted in the pension liabilities section by scrolling down the right hand side.
Every day I skim through the PensionTsunami.com website (PensionWatch) to survey the latest news on U.S. and global pension funds. A recent article from CNN, Pension plans suffer huge losses, caught my eye. Not surprisingly, the rout in global equities and the credit crisis are weighing hard on corporate pension plans. I quote the following:
Since the credit crunch hit last fall, pension plans funded by S&P 1500 companies have lost about $280 billion in assets, according to an actuary at Mercer, a human resources consulting firm.
On paper, the losses from last October tally $160 billion. However, according to Mercer actuary Adrian Hartshorn, the asset losses are closer to $280 billion when pension plan assets and liabilities are considered together. The assets, which totaled roughly $1.7 trillion at the end of October 2007, fell by 17%, leaving about $1.4 trillion in assets at the end of June.
Companies should be concerned, he said, because - assuming no change in the market - a typical U.S. company can expect their pension expenses to increase between 20% and 30% in 2009. That's due to the higher cost of servicing the pension plan's debt and the smaller return from the plan's assets.The message is clear: U.S. corporate pension plans are not in good shape and pension deficits will impact the bottom line of many corporations as employers are forced to contribute to shore up their pension plans. (Pundits always forget pension deficits when analyzing corporate earnings).
There is nothing new here. We have seen this all before. After 2000, pension funds faced large shortfalls and employers sponsoring them had to contribute large amounts to their pension plans. Employers got hit by the double whammy of declining interest rates (which increases the present value of a pension plan's liabilities) and falling asset prices (which decreases the present value of a pension plan's assets).
By the nature of funding rules governing defined benefit plans, pension plan funding is tied to changes in interest rates and stock prices. According to Christian Weller of the Center for American Progress, the main problem is that both of these tend to decline around the time of a recession, when corporate earnings are also declining. In his report, Sensible Funding Rules to Stabilize Pension Benefits (click here to view), Weller argues that alternative funding rules that provide for greater leeway in averaging fluctuations in pension funding over the course of a business cycle improve the outlook for pensions. This process is called “smoothing.”Another view comes from Ron Ryan of Ryan ALM Inc., who wrote a paper stating that the pension crisis was caused because corporate pension liabilities were significantly understated and therefore pension deficits were much greater and more serious than reported. Ryan believes that inappropriate accounting rules and actuarial practices have led to inappropriate asset allocation decisions and benchmarks which caused a risk/reward behavior mismatch of pension assets to pension liabilities. His company focuses on Portable Alpha Liability System (PALS) which aims to closely match assets with a pension plan's liabilities. (You can read more research from Ryan ALM by clicking here).
But what about public pension funds? Are these liability indexes appropriate for them? No, they are not because there is no risk that governments will terminate public sector pension plans and unlike corporations, governments are not subject to mergers or acquisitions. Nonetheless, public pension funds also face funding shortfalls and this has important policy implications for plan sponsors and beneficiaries who both want stable contribution rates. And if the shortfalls are significant, governments cut benefits, increase contributions and they might even increase taxes.
Nobody is more transparent about its funding shortfall than the Ontario Teachers' Pension Plan (OTPP). In its 2007 annual report, OTPP states its funding approach and the challenges they face very clearly:
The plan’s funding approach is aimed at providing pension security for all generations. The goal is to be able to pay promised benefits in full as they come due while keeping contribution rates affordable and stable. This requires ongoing effort and a spirit of cooperation and consensus among the two sponsors – the Ontario government and the OTF, who are responsible for all funding decisions – and management of the pension plan.
When assets exceed future benefits by more than 10%, the surplus can be used to lower contribution rates below the regular rate of 8%, improve benefits, or a combination of both. When assets fall below the plan’s fully-funded zone, the plan must be rebalanced by increasing contributions and/or reducing future benefits for working teachers. (Under Ontario law, benefits already earned by working teachers and retirees cannot be reduced.)
Teachers’ fundamental challenge is that the plan is continuing to mature. Within this challenge, the cost of future benefits is increasing as pensioners live longer than expected, and the current low interest rate environment limits prospects for investment returns, thereby driving up projected pension liabilities. Nearly all defined benefit pension plans worldwide face these concerns and are having to make the difficult decisions needed to balance assets and pension liabilities.
Like other mature plans, OTPP faces pressure to deliver benefits as the ratio of working to retired members keeps declining (there are currently 1.6 working teachers for each retiree and this ratio is projected to fall to as low as 1.2:1 in 10 years). In order to achieve the required returns, OTPP made significant changes in its asset mix over the past several years to diversify away from public equities into private equity, infrastructure, real estate, hedge funds, commodities and timberland.
So far OTPP has delivered impressive results. According to the performance highlights for 2007, the pension plan’s investment managers produced 4.5% annual return in 2007 compared to a 2.3% composite benchmark or $2.3 billion in value added above the fund’s composite benchmark. These consistent results are why OTPP is highly regarded in the pension fund community as being a leader among its peer group.
My only pet peeve is that OTPP bundles investment activities together and does not provide enough transparency on the investment benchmarks governing each and every activity (internal and external) and whether or not they accurately reflect the risks and alpha of the underlying portfolios. Moreover, what was the fund's total risk budget to attain those results? If they are taking more risk in each investment activity to achieve these results, then this should be reflected in their composite benchmark.
As I stated in my previous post on pension governance, you do not want to compensate pension fund managers for beta of an investment activity or for taking on more risk. While $2.3 billion in value added above the fund’s composite benchmark sounds very impressive, the actual value added over the composite benchmark might have been significantly lower if the individual benchmarks that made up that composite benchmark reflected the risks and beta of each investment activity more closely. (In particular, the ones that govern private markets and hedge fund investments; see my previous post on governance for further detail).
There are other funds that do not face the same funding challenges as OTPP because they manage money for younger plans (PSP Investments) or because they are partially funded plans (CPP Investment Board). If you want to learn more about the Canada Pension Plan Investment Board, you should read David Denison's recent speech given to the International Working Group of Sovereign Wealth Funds at International Monetary Fund.
According to Mr. Denison:
The range of investment strategies used in managing the CPP Fund has evolved over time. When the CPPIB began its investment program in 1999, cash flows were initially invested passively in public equities. In recent years, management has elected to pursue value-added returns by diversifying into new geographies and expanding the range of investment programs to include private equity, private debt, real estate and infrastructure, along with a broad array of other active investment programs in the public markets.
It is still early days, but so far the results of this strategy have been both positive and significant. In fiscal 2007, the last year for which results have been disclosed, we delivered $13.1 billion in investment income of which $2.4 billion was our value-added returns over and above our relevant market based benchmark. The Fund’s total annualized rate of return for the past four fiscal years is 13.6% or 11.7% after inflation. Canada’s Chief Actuary has forecast the Fund’s assets will grow beyond $320 billion by 2020, and he has concluded that the Plan is sustainable for the 75-year period covered by his report.
While CPPIB is setting the standards for transparency, reporting, governance and accountability, the same pet peeve applies here too. Like PSP Investments, CPPIB has a legislated mandate that directs it to achieve “a maximum rate of return without undue risk of loss", having regard to the factors that may affect the funding of the plan. But what does "undue risk of loss" exactly mean? What are the benchmarks for each investment activity and do they accurately reflect the beta and the risks of the underlying investment activities?
And while I respect the arm's length relationship with the government of Canada, I think CPPIB should be subjected to rigorous performance and operational audits by independent fiduciaries (above and beyond the financial audits and special examinations which primarily focus on financials). I would also like to see the minutes and resolutions of the Board meetings made public like they are at the Alaska Permanent Fund Corporation.
Finally, I highly recommend you read a recent speech on the Canada Pension Plan by Jean Claude Ménard, Chief Actuary of Canada delivered to the Canadian Institute of Actuaries in Quebec City. (In my opinion, the Office of the Chief Actuary of Canada is one of the best organizations in the federal government and a model for government actuaries across the world).
Looking at the presentation, it is important to understand that unlike other plans, the Canada Pension Plan (CPP) is a partially funded plan (click on image above) that was never intended to be enough on its own to sustain an individual or family through retirement. It was designed to replace up to 25 percent of the average wage. Together with the Old Age Security program, and private pensions and tax-deferred savings, the CPP helps provide retirement security for working Canadians.
I quote Mr. Ménard:
One major distinction between the partially funded CPP and fully-funded pension plans is its sources of income. The CPP follows the 70:30 rule in that in the long-term, 70% of CPP income is attributable to contributions while 30% is attributable to investment earnings. When the CPP A/E ratio reaches about 5.5, 30% of revenue will come from investment earnings. Fully funded pension plans are funded in the opposite way: 30% of income is attributable to contributions, with 70% coming from investment earnings.
Currently, 100% of CPP benefits are paid by contributions since contributions exceed benefits and are expected to continue to until 2019. However, beginning in 2020, a portion of investment income will be required to pay benefits. When the Asset/ Expenditure ratio reaches about 5.5, 90% of the money required to pay benefits will come from contributions, with the remaining 10% coming from investment earnings. Under the 9.9% contribution scenario, each $100 of benefits paid in 2030 will be funded by $90 of contributions and $10 of investment earnings. This $10 needed to pay benefits represents 27% of expected investment earnings.
Why is this important for funding needs? Because unlike other fully funded plans, CPP Investment Board can take on more risk to attain the required actuarial real rate of return. Again this risk should be fully disclosed and reflected in the benchmarks that make up the fund's composite benchmark.
All public pension funds should have detailed funding policies that are evaluated annually based on current objectives, legislation, and financial markets. Stakeholders need to better understand the funding challenges of their plan. I would recommend that these funding policies are made public and that they clearly explain who is responsible for setting the risk parameters of the asset mix. Following the lead from Ontario Teachers' Pension Plan and Canada Pension Plan, transparency and accountability are the keys to bolstering your plan's funding status.