A Treasurer's Role in the Business of Pensions

Not everybody realises that pensions are big business. In a consumerist world, today’s expenditure inevitably takes precedence over saving for seemingly distant retirement. Whether they bore you, interest you or are something you just see as a deduction from salary, let’s be clear- pensions are a big deal.

• From an individual’s viewpoint, they are the largest aggregate purchase that they will ever make during their lifetime (worth much more than a house or several expensive cars).
• From a sponsoring company’s viewpoint, the aggregate funds in its pension scheme are often worth more than the market capitalisation of the company.
• From a government’s viewpoint, most realised years ago that retirement provision is something to be transferred to the private sector and to the individual because over the long term pensions are too expensive to be supported by future tax revenues.

And isn’t it odd that pensions only make the news headlines when something goes wrong? That is because people only realise how valuable their pension is when some (or all) of it is threatened or disappears.

Many treasurers do not realise just how much they have to offer in terms of their skills, knowledge and experience to their company pension plan.

Here’s the dilemma:

• Treasurers manage a company’s capital.
• Pension plans are managed by fiduciaries (trustees in many jurisdictions). Responsibilities include running the plan in line with plan documents, compliance with the law and investing the funds responsibly.
• International accounting standards require recognition of the pension obligations in company accounts, despite plan assets not being held directly by the company but held instead in some separate entity (possibly a trust or separate contract).

To the purist, the pension plan is not company capital. That might be why the pension plan has tended to be set to one side and left to the pension department. Yet the financial strength of the pension plan has such a direct, often immediate and material, impact on company capital.

“Not part of capital, but capable of material impact on capital” might sound like semantics, but on the contrary it is a convincing argument for the treasurer to take a deeper interest. And there are strong indications that this has been happening in some countries over the past three years.

Risk Management on Behalf of the Plan Participants …

An employee signs up to a pension plan because the employer has stated that a benefit is available (on retirement, illness or death) and because the employer has a stated intention to do its best to pick up a large share of the cost of those benefits. Use of the terminology ‘stated intention’ is deliberate. The fine print of the plan documents rarely refers to any guarantee, understandably so. That said, everyone concerned with the pension plan should do their level best to honour the stated intentions.

Not being able to honour the stated intention because an unforeseen disaster has struck the plan, the plan sponsor, or both is- to say the least- distressing. For most plan participants, it means losing the only source of income in retirement. Those words cannot begin to describe the angst at a time of life when there is no realistic opportunity of financial recovery through finding replacement income from elsewhere.

That’s why there are last resort providers in many countries, such as the Pension Benefit Guaranty Corporation in the US and the Pension Protection Fund in UK. That’s also why there are a plethora of regulatory regimes to encourage (with legislation, if necessary) good practice, so that the call on those providers of last resort is limited to the genuinely needy. It is much easier for everyone if the plan continues without outside support.

Plan participants have every right to expect to receive exactly what they were told they would receive when they signed up for the plan. They also have every right to expect their pensions are safe.

… And on Behalf of the Sponsor

Sponsors have every right to be concerned about cost, such as this year’s cost, plus likely trends in future costs and volatility of cost. A sponsor might have agreed to finance a given level of benefit some years ago, only to see external interference impose costs not anticipated at the outset. When that happens, the sponsor’s balance sheet is likely to be bruised.

Sometimes those external influences might be a government deciding to change tax regulation, or legislate inflation linking of pensions, with resulting upward costs. A company might review the benefit levels, but mitigation of costs might only be feasible for the future. That depends on the jurisdiction and local laws.

Investment of assets backing the pension is, however, an area where the treasurer has much to offer. Even if the pension assets are held separately from the sponsor and overseen by external fiduciaries, it would be a brave sponsor which would leave the external fiduciaries (or trustees) to invest these assets unilaterally, particularly when the sponsor is obliged to make good any poor investment performance detrimental to the plan. To do so would be like a parent giving a young child an expensive new toy and promising that, notwithstanding how many times the toy is mistreated and broken, the parent would always pay to have the toy mended. Far better for the parent to keep a close watch on the child, helping with some risk management when necessary. That is where the treasurer can really start to make a contribution to the pension plan.

In my experience, the best run pension plans have a strong, mutually respectful partnership between sponsor and fiduciaries/trustees. Fiduciaries and sponsors will not agree on everything all of the time, but they should work together. The ideal point of contact at the sponsor for the fiduciaries is the treasurer. Some CFOs might view that as heresy, viewing themselves as the ideal point of contact, but occasionally the CFO might have a conflict of interest (possibly arising from being privy to information about company plans, perhaps a pending transaction), making the CFO less suitable.

Issues Affecting Pension Plans

• Longevity- People living longer is good news, but it does mean pensions have to be paid for longer, effectively increasing the cost. UK schemes and sponsors seem to have been at the forefront of analysis of the impact of longevity, but it is becoming a subject of international interest. The factors giving rise to longer life expectancy are prevalent globally, with resulting global impact for pension costs.
• Complex investment products- This is where a treasurer can offer the fiduciaries a great deal of help. Not enough pension fiduciaries or trustees have the necessary financial knowledge, experience or confidence to examine critically some of the complex investment vehicles on offer to modern pension funds. Derivatives (particularly swaps and options) are very familiar territory to most treasurers, but not to lay pension trustees. Lay trustees always welcome help from a professional on this subject, either from a professional trustee sitting alongside or from a treasurer experienced in the field.
• Credit risk- Again, of particular interest to treasurers, which comes in three forms:
  1. Counterparty risks in connection with derivatives and securities lending, where collateral arrangements are now attracting greater scrutiny.
  2. Sponsor credit risk: more sponsors and fiduciaries/trustees are now considering, in the light of the recent credit turmoil and commentary on credit ratings, formal documentation of contribution arrangements by legally binding agreements covering, among other issues, the consequences of credit downgrades.
  3. Creditworthiness of insurers where a buy-out of benefits from an insurer is being contemplated.
• De-risking the pension plan- This can be explored in many forms, the detail of which is beyond the scope of this article. In general however, de-risking may also lead to an increase in the value of the sponsor and is likely to have an impact on its capital cost.
• Accounting standards for the recognition of pension obligations and costs are under review. The detail of the points for debate does not merit discussion here, but any change in the standard is worthy of addition to the list of issues, of which a treasurer should have a sound understanding.

Conclusion

Some companies have carried out exercises to quantify the risk to their company’s balance sheet (expressed as VaR) arising from pension plan risks due to interest, inflation, equity investment, currency, longevity, and credit risk. Those companies have seen the stark reality of how those quantified risks far exceed the risks of a great deal of the traditional areas in which treasurers have operated.