Planning your way out of the financial crisis
Jeroen Bogers, Product Development Manager, AEGON Global Pensions
Few people could have foreseen the severity of the present ongoing financial crisis. Back in 2007,
the headlines were full of company pension plans moving into the black and of healthy reserves.
One and a half years’ later, these same company pension plans are in the news again – this time
with dire warnings of underfunding and the freezing of indexation. Some pension fund managers
will have seen the storm coming and fully derisked their pension funds, but many didn’t. The
reasons for not derisking are various, but the consequences are painful. Why didn’t more
companies and pension funds take the opportunity to derisk – and what can they do now?
Pensions in the headlines
Pensions have not usually made for exciting reading material. Recently, however, pension funds have been
hitting the news. For most CFOs, this is not a welcome development. Looking at today’s dramatic headlines, it is
hard to believe how different everything appeared in 2007 – with talk of shrinking deficits and healthy surpluses.
While some pension fund managers saw the gathering storm and derisked their pensions, many didn’t. It is easy
now to speak with the benefit of hindsight but a brief historical survey shows that many pension funds could
have been derisked more fully than they were. So why didn’t more pension funds and their sponsoring
companies take advantage of the opportunity while it was there?
Pensions are a board room issue.
Just after the stock-market crash of 2001, corporate CFOs did not have to disclose what was happening with
their pension funds. Both FASB and IASB accounting rules did not require putting the funded status of the
pension fund on the balance sheet. Pension funds were little more than a footnote in the annual report. Even if
analysts checked this footnote, the funded status of a pension fund was buried under assumptions that could
increase reported asset returns and decrease liabilities more or less at will.1
Those days are over. Not only do local regulators demand more stringent measures to decrease pension fund
risk, international accounting rules have also changed in such a manner that pension volatility is much more
visible both on the balance sheet and in a company’s profit and loss statement. In 2009, pensions are a major
concern for CFOs.2
On top of other issues, CFOs are now facing an additional problem: while their company’s stock value and
revenues are hit by a downturn in the economic cycle, the pension fund they sponsor has also been hit by the
1
‘The Gerstner Effect: Managerial Motivations and Earnings Manipulation’, Daniel Bergstresser, Mihir A. Desai,
Joshua Rauh, December 2003.
2
CFO Europe, ‘Top Ten Concerns of CFOs’, February 2009.
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February 2009
crisis and its funding ratio has dropped. Pension fund trustees are demanding higher contributions from their
sponsor, or even worse, immediate cash injections.
The ‘derisking dilemma’
Funding ratio
In addition to the fact that not all companies could
afford to derisk their pension funds, there is
another important reason why pension funds
Desirable
Desirable
have been unwilling to hedge their risks – the
derisking dilemma.3 This means that when
derisking was affordable, it was not perceived as
being desirable. In the current climate, however,
derisking is seen as being desirable but is also
Affordable
Affordable
perceived (rightly or wrongly) as being
unaffordable. If the funding ratio of a pension
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2007
2008
fund is high, derisking becomes more affordable
Figure 1. The derisking dilemma
(see Figure 1). However, it is very hard to persuade (source: AEGON Global Pensions)
both members and sponsors to derisk at such a
time, as equity markets are rising, interest rates are low and hedging seems both expensive and unnecessary.
However, when equity markets fall, the desire to hedge risk increases rapidly, but the ability to fund derisking
decreases as it becomes less affordable (see Figure 1).
This derisking dilemma highlights an important issue of judgement – how should sponsoring companies and
their pension funds approach risk? And how should they weigh up short-term gains against both short-term and
long-term risks? In other words, what level of risk should companies and pension funds be willing to take with
their pension schemes?
The rising cost of risk
The financial crisis has sharply raised the
awareness of risk – and the effect of this newly
acquired risk awareness can be seen in the
exploding risk spreads above the risk-free rate
(see Figure 2).4 As the market price of default
risk of once highly rated companies increased
sharply overnight, corporate borrowing became
more expensive. At the same time, due to a
flight to quality and the reduction of short-term
government interest rates, the yield of long-term
government bonds is now decreasing.
8,0%
7,5%
7,0%
6,5%
6,0%
5,5%
5,0%
4,5%
4,0%
3,5%
3,0%
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2001
2002
2003
Risk free rate
2004
2005
2006
2007
2008
AA corporate yield curve
Figure 2. Exploding risk spreads
(source: LehmanLive ®, MLX®)
3
In this paper, the term hedging strictly refers to the process of protecting the investor or pension fund against
possible loss through closing contracts with a third party.
4
Euro aggregate corporate AA spread 10-year; Euro government 15-year.
2
February 2009
As risk spreads between corporate bonds and
government bonds increase, it becomes harder
and more expensive for companies to borrow
money, and revenues are hit by higher interest
payments. The increase of risk spreads is an
important factor presently affecting company
equity values (see Figure 3)5.
4,5%
4500
4,0%
4000
3,5%
3500
3,0%
3000
2,5%
2500
2,0%
2000
1,5%
1500
1,0%
1000
0,5%
500
0,0%
0
The effects of the current market turmoil are
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
clear: investors are demanding a higher risk
AA corporate yield spread
MSCI World
premium for their investments and for debt from
corporations, while the interest rate of Figure 3. Falling equity markets (source: Datastream)
government bonds is decreasing. The sudden
changes in three core elements – equity returns, corporate bond yields and government bond yields – has had a
dramatic effect on pension funds and their sponsoring companies on a global scale.
The pension funding ratio – a corporate viewpoint
Funding ratio
Under FAS and IFRS, sponsoring corporations
discount their liabilities against a high quality rate
or the AA bond curve. Since the AA bond curve
has recently increased tremendously, pension
fund liabilities have consequently decreased.
This means that funding ratios have been
resilient or even increased, despite the downturn
in the stock markets. Figure 4 shows the effect
on the funding ratio of a model pension fund, fully
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2005
discounted against the discount rate of AA
Funding
ratio
100%
bonds. This funding scenario provides an
example of how corporate entities view the
Figure 4. Funding ratio under FAS/IFRS
funding ratio of pension funds.
(source: AEGON Global pensions)
2006
2007
2008
The pension funding ratio – a different view from the countries
Unlike the accounting rules for corporations, pension scheme funding regulations are still a national matter. This
makes it difficult to create a uniform account of the effects of the financial crisis on the combined pension funds
of a multinational corporation.
5
MSCI world € total return index.
3
February 2009
Funding ratio
In Figure 5, the model funding ratios of three
similar local pension funds (US, UK, NL) have
been plotted. The funding ratios of these pension
funds are valued using the reporting requirements
of the national pension regulators. Depending on
\
the regulator, pension funds either report that they
are underfunded (NL), almost funded (UK), or
have increased their funding ratio (US).6 From a
national perspective, many Dutch and UK pension
1998 1999 2000 2001
2002 2003 2004 2005 2006
2007 2008
funds are now judged to be underfunded, and are
US Pe ns io n Fun d
U K Pe n sio n Fu nd
NL P e ns io n Fun d
being required to increase pension premiums
and/or the sponsoring companies are being asked Figure 5. Funding ratio according to US, UK and Dutch
local pension regulator (source: AEGON Global Pensions)
to make cash injections into the funds. The
unprecedented events on the credit markets and the subsequent consequences on pricing have effectively
distorted the valuations of pension liabilities, especially for multinational companies.
Things will get worse before they get better
8.0%
7.5%
Funding ratio
The mismatch between corporate balance sheets
7.0%
6.5%
and local pension fund reporting is not the end of
6.0%
the story. It is useful to understand what will
5.5%
happen when markets start to return to ‘normal’
5.0%
4.5%
again, as shown in Figure 6. As markets become
4.0%
less volatile and AA bond rates start to decrease,
3.5%
3.0%
pension fund liabilities will increase dramatically,
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2006
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2008
2009
2010
as shown in Figure 7. As the AA bond rate
Risk free rate scenario
AA corporate yield curve scenario
decreases, it has a leveraged effect on pension
fund liabilities due to the mismatch in duration. Figure 6. IFRS/FAS funding ratio scenario
(source: AEGON Global Pensions)
Given the differences between pension funding
calculations and the increased influence of
international accounting standards, sponsoring a
pension fund has made balance sheet forecasting
and control more difficult than ever.
How much risk is acceptable?
The financial crisis and the subsequent
deterioration of pension funding levels have
increased the importance of a core question:
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2008
2009
2010
‘Which risks should a pension fund take?’. Now
Funding ratio
100%
that sponsoring companies are directly and
immediately affected by a shortfall in the funding Figure 7. Interest rate scenarios
ratio of their pension funds, the question of risk is (source: AEGON Global Pensions)
of increasing importance to CFOs. The previous balance between premium levels and risk levels has shifted.
6
The model used is intended to show the effect of different accounting regulations and does not necessarily reflect
the actual funding ratios of real pension funds in the UK, USA or the Netherlands.
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February 2009
For the sponsoring company, unhedged pension funds represent a balance sheet liability and a potential risk. In
order to regain control over the corporate balance sheet, it is important to limit the maximum possible shortfall
and to remove unrewarded risks from the pension fund, while retaining its ability to provide pension benefits.
A step-by-step guide to derisking
Although most pension funds cannot afford to derisk completely now, it is nevertheless the perfect moment to
draw up plans and to reach agreement on how and when to derisk. In other words, now that pension funds and
their sponsoring companies have the desire to derisk, they should make plans for when it becomes affordable. In
order not to become trapped by the affordable/desirable dilemma, it is essential to separate decision-making
from the execution of the decisions. Instead of having to go through the decision-making process every time an
opportunity presents itself, the most important decisions should be made now. Derisking can then be executed
according to predetermined factors that allow for long-term planning and continuous commitment.
Funding ratio
Decide
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2008
2009
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2011
2012
2013
2014
2015
Figure 8. Separating decision from execution (Source: AEGON Global Pensions)
The following guidelines were drawn up to support forward-looking decision-making.
Guideline 1: Perfect timing is impossible – plan for good timing instead
Price is not the most important factor but rather the commitment to derisk at the right moment. A step-by-step
roadmap should be drawn up on how to achieve the desired risk level. Pension funds are, in essence, long-term
vehicles, and history tells us that there will be times that a pension fund will have enough funding to derisk to the
desired level.
Companies and their pension funds should not try to find the ‘perfect moment’ to derisk but aim instead to derisk
at the point at which derisking is both reasonable and affordable.
Guideline 2: Decide on the aspired risk level and appropriate derisking instruments
Not all risk is bad risk. In the longer term, equity has more upward potential than risk-free bonds, and
diversification can lower risk while retaining return. If a sponsoring company is willing and able to bear the risk of
a sudden decrease in the plan funding ratio, then the long term return premium on risky assets can structurally
decrease pension contributions. However if a company is not willing or able to bear this shortfall risk, it is better
off increasing yearly contributions and lowering pension fund risk, improving pension cost forecasting and
balance sheet control in the process.
5
February 2009
Guideline 3: Step-by-step – derisking by segment
At present, not all pension funds and their sponsoring companies can afford to (or aspire to) fully derisk their
pension schemes in a single transaction. However, it is both possible and more efficient to derisk in stages,
segmenting liabilities according to affordability over time, while retaining solidarity between pension scheme
members. In this way, derisking occurs in manageable – and affordable – phases, according to a derisking
roadmap.
Risks in a pension fund can be split up into several major elements:
•
Market rate risk
•
Interest rate risk
•
Inflation risk
•
Longevity risk.
Hedge
inflation risk
Lower
Hedge
Hedge
Hedge market
contribution
Hedge Interest rate deffereds risk
risk
pensioners
Risk
risk
Funding ratio
Increase
Contribution
Decide
Execute and communicate
Figure 9. Example of segmented de-risking7
The price of hedging these risks changes over time and differs per member group. By splitting the scheme’s
liabilities into individual groups, and, for each group, reviewing which elements to derisk, risk can be identified
and prioritised for removal, where it is most needed. As each layer of benefit is secured, investment gains can
be ‘locked in’ and future funding volatility can be reduced.
Guideline 4: Set ambition levels to strengthen commitment
In order to strengthen commitment for the derisking roadmap, derisking levels should be agreed on beforehand.
By using preset ambition levels, the decision-making process is clear to all parties beforehand and ensures that
derisking can occur quickly once a window of opportunity arises. For example, ambition levels may be set by
deciding to target a specific interest rate at which to derisk. Once a target rate is reached and certain other
requirements are met (minimal funding ratio), the interest rate can be hedged to the desired level. Similarly, the
level of inflation risk or the level of market risk can be targeted by establishing an ambition level for the funding
ratio, the cost of an inflation hedge or the price of put options on equity markets.
Guideline 5: Select providers early, so that you can execute immediately
It is important to involve consultants, legal advisors and potential providers as early as possible in the process.
Providers can give you an overview of all opportunities, and help you determine the best pricing of the hedge at
7
Figure 9 shows a non-exhaustive example of a possible derisking scenario. Different risks can be hedged at different
stages from those shown in this example, depending upon circumstances and the characteristics of the pension fund.
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February 2009
any given time. Some risk hedges, like longevity, are difficult to price and a good consultant and provider should
be able to provide price indications on a frequent basis.
Guideline 6: Keep communicating
As with all important change processes, it is essential to communicate with all stakeholders in order to ensure
commitment and understanding. Once the roadmap is determined and there is agreement between all
stakeholders, this should be communicated to all pension scheme members. This communication is an ongoing
effort. Continuous communication ensures commitment to a common goal.
AEGON Global Pensions and derisking
Through our network of international partners and local AEGON companies, AEGON Global Pensions offers a
broad range of derisking solutions. AEGON Global Pensions helps multinational companies and their pension
funds to protect themselves against unwanted risks.
Using our in-depth knowledge of local requirements and our international expertise, AEGON Global Pensions
offers the most effective solutions for companies with operations and pension funds in more than one country.
All AEGON Global Pensions derisking solutions are tailored to the specific needs of our clients, addressing both
the impact of risks on their pension funds and also the impact of pension fund derisking on their corporate
balance sheets.
Interested? Please contact AEGON
www.aegonglobalpensions.com.
Global
7
Pensions
at
[email protected]
February 2009
or