The Corporate View Of DB Plans
By: Ian Markham
The primary influencers in the critical decisions affecting corporate Defined Benefit plans have shifted from HR to finance in recent years. Pension plan design used to be within the exclusive jurisdiction of HR, in their role of managing total compensation strategy. And since pension costs were part of HRʼs budget, funding policy was often left to HR as well.
But, the maturing of DB plans has caused them to become such a material proportion of the corporate balance sheet and income statement that they have become a major cost centre.
More importantly, CFOs and boards of directors have become exponentially more focused on risk management in all of their business operations, and they often regard the DB plan as one of the top risk centres to be managed, given the significant equity content typically found in DB pension funds. Of all the DB pension challenges that CFOs face, cost volatility is usually at the top of the list.
Mitigating DB Risks
It is no surprise, therefore, that it is inevitably the CFO who takes on the task of mitigating the DB risks.
Investment policy is the key tool available for mitigating the risks inherent in ʻlegacyʼ DB plan benefits (that is, the pension promise accrued in respect of years of past service to date). In addition, some investment grade plan sponsors with a low risk of full plan windup, and whose plans have solvency deficits, are seeking regulatory solvency funding relief, pushing governments and regulators to allow existing and future solvency deficits to be amortized over a longer period.
However, there is another solution that is being increasingly used by decision makers in mitigating these risks – namely, changing the plan design by pushing more of the financial risks onto the shoulders of the active plan members. It is often limited to future hires (who, being young, are generally content with this outcome), but is sometimes also applied to future pension accruals by todayʼs active plan members (who are typically concerned about this solution, once they are mid-career). It is often the CFO who is driving this change to the total compensation package. HR may have no choice than to jump on board, even though it may be two decades or more before this solution will reduce the pension risks to a tolerable level.
By far the most influential source of DB risk is the mismatch between pension assets and liabilities. A decision maker seeking to reduce cost volatility significantly will realize that long bonds are a far better match for the liabilities than equities. However, there is a cost to a major shift from equities to long bonds in that the actuaryʼs discount rate for the going concern valuation of liabilities invariably includes an expectation of a future equity risk premium.
In addition, the pension expense for accounting purposes usually allows for an equity risk premium in determining one of its significant components (expected interest on assets). A significant move into bonds would drive up annual pension costs for both funding (cash) and expense (income statement).
As a result, most CFOs will likely shy away from pushing for a significant move into long bonds. However, if ever we move back into a world of pension surpluses, this strategy will become much more attractive and the impact on the markets may be hugely negative.
The DB pension plan is an important component of the total compensation package in many organizations. However, its position as a major cost and risk centre has caused it to evolve into a financial subsidiary that is solidly within the domain of the CFO. It is wise for HR directors to recognize this recent and permanent shift and bolster their relationship with their finance counterparts to ensure that critical employee and employer viewpoints are reflected appropriately in the overall corporate strategy.
Ian Markham is director, pension innovation, for Watson Wyatt Worldwide.
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