Pension Accounting: Catalyst for Change?

I have long wondered when people would really start to pay attention to what some describe as the "pension perfect storm". Could new accounting rules be the catalyst for change? Just recently, the Financial Accounting Standards Board unveiled the first of several changes in how companies will have to portray pension fund finances. Arguably long overdue, a company will need to recognize "the overfunded or underfunded status of defined benefit postretirement plans as an asset or a liability in the statement of financial position". A second phase of this multi-year project will impact reported earnings.

What lies ahead?

If past is prologue, a change in the way financial statements are assembled will have a material influence on corporate behavior. Consider FAS 133, the mammoth rule book for derivative instrument accounting. Not long after it took effect, more than a few companies cut back on the use of derivatives, citing FAS 133 compliance as overly complex and time-consuming. Reducing speculative positions is one thing. Abstaining from the use of derivatives to mitigate interest rate, commodity, currency or equity risk is another thing altogether. Following the promulgation of FRS 17 in the UK several years ago, the National Association of Pension Funds "found that more than three quarters of companies offering final salary pension schemes were less likely to do so because of the new accounting standard".

In both cases, the law of unintended consequences prevailed. Instead of promoting transparency, new accounting rules encouraged outcomes that were contrary to the original intent. Does this mean that additional companies will shed their defined benefit plans rather than report "bad" numbers? (Note that freezing or terminating a plan has both an accounting and economic impact so the choice is not as straightforward as it may seem.)

Am I saying that accounting reform is bad? Not all all. I think the marketplace is desperate for more and better information. Will that ensue with FASB initiatives? It's too soon to say. Final rules are months away. (Subsequent postings will dive deep into the issue of pension information and the lack thereof. Suffice it to say, there is so much about pension assets and liabilities that remains a mystery.)

Will the new accounting requirements improve pension economics? Will shareholders have a better understanding of the true cost of providing post-retirement benefits and the related impact on dividends, earnings and flexibility? Will employees and retirees feel more or less comfortable that defined benefit plan promises will be kept? Will taxpayers worry that a federal bailout looms large as post-implementation numbers surface? Will reported figures square with actuarial or statutory assessments?

Notwithstanding a plethora of unanswered questions, I'm betting on FASB to mix things up. After all, the pension issue impacts the lives of nearly every adult in the U.S. (and abroad), either as investor, employee and/or taxpayer. When accounting rules change, so too do people's actions. posted by Susan Mangiero at 3/31/2006 12:01:00 AM | 1 comments | links to this post   

Derivatives: The $270 Trillion Gorilla

The just released pension fund asset management guidelines, courtesy of OECD (Organisation for Economic Co-operation and Development), state that "legal provisions should address the use of derivatives and other similar commitments, taking into account both their utility and the risks of their inappropriate use".

I will devote considerable time to the topic of derivatives and pensions in this blog. For now, I will make a few introductory comments to hopefully whet your appetite.

1. Derivatives can be used in a variety of ways to manage assets and/or liabilities and for both defined contribution and defined benefit plans (though there are significant differences with respect to strategy, risk assessment, accounting treatment and so on). I have written a lot about this topic, including a book and countless articles, and there is still much more to say. Identifying, measuring and managing risk is a cornerstone of being a good investment fiduciary.

2. The derivatives market is huge. According to the Bank for International Settlements, outstanding over-the-counter derivatives contracts (in terms of notional amounts) exceeded $270 trillion when estimated in June 2005. Think about it. In comparision, the U.S. national debt tally is approximately $8.36 trillion. Estimated 2005 gross world product is $59.38 trillion. The global derivatives market is the proverbial 200 pound gorilla of the financial world. It is worthwhile understanding why this market continues to grow. (Stay tuned!)

3. Derivatives are contracts that "derive" their value from the value of an underlying security, commodity, index or other type of instrument. For example, the value of a gold derivatives contract depends on the price of cash gold. (Derivatives valuation is a broad topic and will be addressed in other postings.)

4. The term "financial risk management" typically refers to the use of derivatives in some fashion (though this is not always the case).

5. Pension fiduciaries who ignore derivatives, especially if the Investment Policy Statement restricts their use, may want to rethink their stance. They should know that financial performance is impacted by the price behavior of derivative instruments if they have allocated monies to: (a) hedge funds or mutual funds that employ derivatives (b) asset-backed securities such as mortgage-backed bonds or collateral default obligations (c) convertible bonds (d) callable bonds (e) currency sharing agreements (f) private equity with warrant arrangements (g) contingencies of any type and the list goes on.

6. Derivatives, used improperly, can wreak havoc. Much more will be said about the identification and measurement of risk, how to determine appropriate use and a host of other critical MUST KNOW elements of the decision-making process.

7. The issue of a fiduciary duty to hedge is an ongoing and interesting legal question.

8. Financial engineering opens the door wide to a variety of new investment opportunities for pension funds. Fiduciaries must know (or learn) how to evaluate each opportunity. Outsourcing does not eliminate the fiduciary's duty to monitor.

9. Using derivatives is seldom a one-time event but instead requires a commitment to evaluate economic efficacy on an ongoing basis.

10. Creating a risk management process is just the beginning. I will address the Five C Approach(SM) as a way to assist fiduciaries. posted by Susan Mangiero at 3/26/2006 10:31:00 PM | 0 comments | links to this post   

Hedge Fund-Pension Nexus

The growth in the hedge fund industry has been nothing short of meteoric with assets now exceeding one trillion dollars. At the same time, the winds of change are blowing hard. Hedge funds and fund of funds are arguably facing tougher competition, increased regulatory pressures and, in some experts' opinion, a capacity constraint. (These points are discussed in greater detail in my article for Hedgeco.net entitled "Promise or Peril".)

Of particular importance is a trend in institutional investor interest in hedge funds and other alternatives. According to "Institutional Demand for Hedge Funds: New Opportunities and New Standards" (a joint 2004 study by Casey, Quirk & Associates and the Bank of New York), defined benefit plans represent the fastest growing source of capital. This trend is already having a dramatic impact on hedge fund practices and will likely accelerate if pending Congressional pension reform liberalizes the amount of ERISA money a hedge fund can manage before having to declare itself a fiduciary.

As plan sponsors are being asked to better justify their investment decisions, they will look to hedge fund and fund of fund managers for more and improved information. Valuation of relatively illiquid securities is another concern. On March 23, 2006, the Financial Services Authority in the UK described asset valuation as a central part of its supervisory focus, adding that "hedge fund managers may be exposed to conflicts of interest as their remuneration is based on performance and assets under management". Elsewhere, the U.S. Securities and Exchange Commission has commented that "the broad discretion that these advisers have to value assets and the lack of any independent review over that activity gives rise to questions about whether some hedge funds' portfolio holdings are accurately valued". I will spend considerably more time on this topic in future postings.

On a related note, experts consider what will happen if 401(k) plan participants are given the choice of investing in hedge funds or fund of funds. Suitability, liquidity, transparency and potential returns are just a few of the issues that will be discussed at a free panel in New York City on April 4, sponsored by the North American Securities Administrators Association, Inc.

With billions of dollars at stake, the hedge fund-pension nexus is attracting a lot of attention and for good reason. Stay tuned! posted by Susan Mangiero at 3/24/2006 10:00:00 PM | 0 comments | links to this post   

Is There a Pension Crisis?

People are living longer, requiring even more in the bank to pay bills once they quit working. Studies consistently show that most people are saving very little and are not financially prepared to retire any time soon. Social Security trustees project costs to exceed tax revenues as early as 2017 and are urging reform. This is particularly compelling now that only three workers pay taxes into the system to support each existing beneficiary, compared to the original sixteen persons at inception.

Last summer, the U.S. Government Accountability Office released a study citing the largest ever deficit of $23.3 billion for the Pension Benefit Guaranty Corporation, a single-employer insurer that protects the retirement incomes of more than 40 million American workers in excess of 30,000 defined benefit pension plans. Executive director, Bradley Belt, stated that "financially troubled companies have shortchanged their pension promises by nearly $100 billion, putting workers, responsible companies and taxpayers at risk." In July, Standard & Poor's reported that defined benefit plans for 364 of the S&P 500 Index member companies remain under-funded by $165 billion. Public pension plans are struggling too. National Association of State Retirement Administrators statistics indicate a $300 billion aggregate pension shortfall for the largest state and city plans.

What do you think about the current retirement situation? Choppy waters or calm seas?

Take our five question survey and see what others think too. posted by Susan Mangiero at 3/23/2006 11:00:00 AM | 0 comments | links to this post   

Executive Compensation and Everybody Else

Pension fiduciaries inside a company have a tough life. They are tasked with making multi-million dollar decisions at the same time that they are seldom rewarded for the time and energy required to do an excellent job. What's odd is that so few people pay attention to all things "fiduciary" in terms of how these individuals get selected, compensated and evaluated for performance. In contrast, extensive time and money is expended in an effort to determine the optimal pay package for an executive (including pension benefits), how to gauge leadership acumen and when to pull the chord on the golden parachute.

Several questions come to mind. Are fiduciaries getting paid enough? Do they have an appropriate educational and experiential background to decide how to properly select and review external money managers, assess operational controls, determine suitability of 401(k) investment choices, evaluate plan performance, interpret actuarial estimates of explicit and pseudo liabilities, identify hidden risks and otherwise carry out their fiduciary duties? How should they be rewarded for a job well done? Should the job of pension fiduciary be a full-time position? Should information about who serves as a pension fiduciary be made public to shareholders and other interested parties? Should C-level executives and board members be made more accountable for pension fiduciary recruiting and decision-making? Is it time for a "fiduciary expert" that parallels the notion of a financial expert, a la Sarbanes Oxley?

There are a few training programs that specifically address retirement fiduciary concerns. Stanford University Law School has Fiduciary College and Peter Hapgood, president of Public Pensions Online, is working on the municipal side with several public fund organizations. The U.S. Department of Labor established "Getting It Right" several years ago.

Notwithstanding these efforts, I think it would be fair to say that fiduciary management has a long way to go. If there was ever a time when the issue of defined benefit and defined contribution plan stewardship deserves examination, now is that time. With so much at stake, why wait?

For a discussion of the topic of fiduciary compensation, see "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?", co-authored with Wayne Miller (Executive Decision Magazine, January/February 2006). posted by Susan Mangiero at 3/22/2006 02:07:00 PM | 0 comments | links to this post   

Retirement: Dream or Nightmare?

Thinking about a fun retirement when you turn 65? Dream on. With so many questions about the financial health of the Social Security and private pension systems, working at eighty may be a reality for more than a few people. As I explain in "Pension Risk Management: The Importance of Oversight" (Risk Review, March/April 2005), ineffective leadership is far from trivial. According to the U.S. Department of Labor, there are approximately 730,000 private sector pension and 401(K) plans that cover 102 million individuals. Factor in the millions of people in state and city plans and it becomes painfully clear that a failure to meet retirement promises will put family and friends at risk.

One of the biggest problems is the extent to which people in charge may not know enough to ask the tough questions that allow them to properly carry out their duties on behalf of plan beneficiaries. These "fiduciary persons" frequently think they have completed their work once they hire outside companies to manage money or provide advice about self-directed plans. Nothing could be further from the truth. Even a non-lawyer knows that continued monitoring is paramount.

Experts are right to worry. Several years ago, the U.S. Department of Labor launched a training program called Getting It Rightafter discovering that many ERISA fiduciaries have other job responsibilities, leaving them little time or energy to focus on retirement plans. In some cases, they did not even identify themselves as fiduciaries.

Another problem is complexity. Someone who is uncomfortable with basic investment concepts is unlikely to know when and how to ask probing questions of a consultant or money manager. This is disturbing. Pension funds are increasingly investing in "alternatives" such as managed futures, hedge funds and venture capital. This may make perfect sense but only if decision-makers fully understand the risks. (To be fair, fiduciaries need to demonstrate due diligence for any type of investment. Moreover, funds are not created equal. Their riskiness depends on strategy, internal controls and market sensitivity, to mention a few factors. It's just that some investments are harder to value and less liquid and arguably require more care and feeding.) posted by Susan Mangiero at 3/21/2006 04:36:00 PM | 0 comments | links to this post