the tale of a man who has a gaping hole in his roof but never fixes it. One evening, a dinner guest leans back in his chair
and gazes up at the stars. He asks, “Why don’t you fix this hole in your roof?” His host answers, “On
a beautiful night like this, it’s great to have an open roof!” The guest responds, “But what about when
“When it’s raining,” the host says,
“I can’t possibly fix it.”
That hole could represent exposure to the market climate
that often drives pension-funding levels. When markets are flush, pension funds with sizeable equity stakes bask atop their
heap of earnings. In bear markets, managers wring their hands over funding shortfalls and the coming wave of retirees.
For Zvi Bodie, renowned pension expert and professor
of finance and economics at Boston University, the tale represents something else: the slow reaction to issues that have been
festering in the world’s pension plans for some time. “Now that the market is down and many pension plans are
underfunded, the pension funds are groaning, “‘How can we hedge our liabilities?’”
Bodie asks, “What took them so long?”
Millions of workers around the globe are nearing retirement.
(See “Global Megatrends,”
Point of View, July
2006 issue.) With a looming payday in sight for pension distributions, plan sponsors are growing wary of tying their fortunes to volatile
equity markets. A safer and more reliable way to fund pension obligations, they say, is to match assets to liabilities. It’s
a changing mindset that seeks to reduce risk and ensure retirement benefits are funded.
isn’t just a U.S. problem. It isn’t just a U.K. problem. It’s a global problem.”
director of global fixed income for Northern Trust in London
“Matching assets to liabilities is the most secure
way to guarantee a minimum of retirement income,” Bodie says. “A corporate plan sponsor that’s committed
to making those payments ought to be securing them with a portfolio managed this way.” The term most often used to describe
this behavior is “liability-driven investing” (LDI), yet its definition is a broad one. On one hand, LDI may signify
little more than risk aversion. On the other, LDI describes complex strategies that combine fixed-income instruments, derivatives
and other vehicles to generate greater investment return.
funds have led the trend toward liability-driven investing. By 2050, a third of the European population will be over the age
of 60, according to a recent study by the Merck Company Foundation and the International Longevity Centre U.K., a think tank
on aging issues. If such numbers weren’t compelling enough, the trend toward LDI was pushed along by policymakers concerned
about picking up the tab for unfunded corporate pension promises.
Across Europe, “corporate sponsors have already
closed or frozen defined-benefit schemes far more rapidly than people thought possible,” says Oxford University professor
Gordon L. Clark, who has researched and written about the economics of pensions. “Many employers are starting to question
whether or not they should be in the business of providing retirement income through pension funds at all.” Such thinking
provides additional impetus for pension reform legislation.
New pension funding laws and regulations are taking hold across Europe. In the Netherlands, the
government projects that by 2040 the elderly population (age 65 years or older) will double to four million. Pension rules
called Financieel Toetsingskader (FTK) enacted earlier this year now require employer-sponsored plans to be overfunded. At
a minimum, Dutch pension funds must show that they are funded at an assets/liabilities coverage ratio of 105%. The penalties
for noncompliance are stiff. FTK also requires assets and liabilities to be valued on a marked-to-market basis. Even with
these rules in place, Dutch pension plans still face potential future funding shortages as the gap of retirees to workers
narrows and the capital markets fluctuate.
question: Is the pension a liability or an asset?”
chief executive officer of Northern Trust’s investment division in London
The idea of aligning investment goals with liabilities
has gained a foothold in the United Kingdom, as the “LDI Penetration” chart shows. Several years ago, the U.K.
issued new pension accounting guidelines, under Financial Reporting Standard 17, that require assets and liabilities to be
recognized in full on a corporate sponsor’s balance sheets. The Financial Times
estimates a fifth of U.K. companies would be found insolvent if they had to account for their pension schemes today. In May,
the U.K. government outlined its proposals for overhauling the pension system, setting forth findings in a white paper based
on the widely cited Turner Commission report.
The Turner Commission’s charge: “to keep
under review the regime for U.K. private pensions and long-term savings, and to make recommendations to the secretary of state
for work and pensions on whether there is a case for moving beyond the current voluntarist approach.” The three-year
investigation found widespread problems among plan sponsors and government policies alike.
As of July, the total underfunding of FTSE 100 U.K. defined
benefit pension schemes stood at £36 billion despite record contributions and rising stock markets, according to the 2006
edition of the annual “Accounting for Pensions Survey” by actuarial consultants Lane Clark & Peacock LLP.
That was after aggregate shortfalls reached a high of £54 billion in January and fell to £29 billion in April.
Europe might be leading the charge in pension reform,
but it’s not alone. Governments around the globe face similar challenges as people continue to live longer, notes Wayne
Bowers, director of global fixed income at Northern Trust Global Investments in London. In addition, pension funds have faced
a low-interest-rate environment and a flattening of global yield curves. “All these changes impact not only the valuations
in pension fund assets but also the valuations in liabilities,” Bowers says. “There is significant change going
on. Plan sponsors and trustees need assistance and education on country-specific regulations and the appropriate solutions
they can use.”
“Pension funding isn’t just a U.S. problem.
It isn’t just a U.K. problem. It’s a global problem,” says Bowers. In some countries, such as Japan, strict
immigration policies, coupled with low birth rates and longer life expectancies, will put a tremendous economic squeeze on
plan sponsors. “Something’s got to give,” he adds. “The U.S., the U.K. and Japan — which account
for some three-quarters of the estimated $19 trillion in global pension assets — will likely benefit by observing developments
in Europe.” What path will they choose?
sponsors in the U.S. are “ahead of the curve because they understand the implications of the changes in Europe,”
Bowers says. “The take-up for liability-driven investing will be faster in the U.S. than in other markets.”
New legislation adds urgency to the efforts. In the U.S.,
Congress passed reform laws in August that require pension plans to fully fund their liabilities, amortizing their shortfalls
over seven years. Plans deemed “at-risk” face increased liabilities. The Pension Protection Act of 2006, signed
into law by President Bush this summer, is a culmination of efforts to bolster pension funding levels and require more transparency.
In his testimony before the U.S. Congress last year,
Bradley Belt, then executive director of the Pension Benefit Guaranty Corporation (PBGC), noted that U.S. corporate pension
plans faced shortfalls of $450 billion in 2004. Fiscally weak companies were responsible for $100 billion of that deficit.
The PBGC, which is the government agency that insures some $2 trillion in private pensions, faced a $23.3 billion deficit
of its own at the time. That deficit stands at $22.8 billion as of the fiscal year ended 2005, and it remains a priority issue
for U.S. lawmakers.
Corporate bailouts aren’t the only concern for
policymakers. In July, the U.S. Senate Committee on Finance asked the Government Accountability Office to study the financial
viability of public pension funds. “Because of different rules, many of the public sector plans are even more poorly
funded than their private sector equivalents,” said Senators Chuck Grassley and Max Baucus.
According to a recent study by Milliman, a global actuarial
consulting firm based in Seattle, Wash., U.S. corporate pension plans saw their funding status improve somewhat last year.
But as the “Funded Ratios of 100 Largest U.S. Plans” chart on page 4 shows, levels remain below the 131% mark
seen in 1999.
Under proposed accounting rules, U.S. companies would have
to report funding levels on their balance sheets. That requirement would result in corporations taking a pretax charge of
$222.2 billion in 2005, according to the Milliman report. The proposed new standards would require corporate treasurers to
show plan funding status using current market value of assets and liabilities. According to Milliman, the projected funding
deficit for the 100 largest U.S. plans still tops $96 billion, despite market gains during the past several years. (See “Assets
and Liabilities of the 100 Largest U.S. Pension Plans.”)
there are compelling reasons to take the liability side [of the pension equation] into consideration as part of the investment
managing director of Northern Trust’s global investment solutions team
Again, Europe has led the way, having demanded more transparency
in corporate pension record-keeping for some time. Bowers notes pension liabilities weigh heavily on a company’s financial
standing. “It’s something that analysts following the company will want to see,” Bowers says. “If
you are a company with a credit rating or share price and you have a pension deficit, they’ll ask, ‘What are you
doing about this?’”
An underfunded pension could also cast doubts on the
sponsor’s share price and credit-worthiness and even lead to a violation of previously contracted loan agreements. For
banks and other financial concerns, pension solvency may be critical to their ability to function.
“The all-important question: Is the pension a liability
or an asset?” says Barry Sagraves, chief executive officer of London-based Northern Trust Global Investments Limited.
“In the last year and a half, a couple of merger and acquisition deals in the U.K. were scuttled because the target’s
pension liabilities were too big. These examples show how pension funding has become a major economic issue.”
The idea of aligning investment goals with liabilities is
not a new one. Corporate treasurers and chief financial officers have been using liability-driven strategies for years as
a way to manage their balance sheets. But “traditionally, pension funds have been managed more on a total-return basis,”
explains Duane Rocheleau, head of the global investment solutions team at Northern Trust. “They’ve focused primarily
or exclusively on the asset side and, to some extent, ignored the liability side. But increasingly, there are compelling reasons
to take the liability side into consideration as part of the investment strategy. Having a solid understanding of the risk
associated with the pension plan assets, in the context of the liabilities, is critical to ensure the long-term viability
of the plan.”
Bowers says pension plans should stop relying on index
returns as performance benchmarks. “The market indexes as benchmarks are becoming irrelevant for plan sponsors adopting
an LDI approach,” he says. “The true benchmark should be the pension plan’s liability stream.”
The laundry list of liability-driven investment options
may include any of the following, used alone or in combination: short-duration cash management, long-duration bond portfolios,
interest-rate swap overlays and additional asset classes to provide beta exposure and generate alpha.
“But not any particular mix is going to be suitable
for every client,” Bowers says. “By using a combination of those, you really should be able to come up with something
that has the ability to: a) hedge the liability of the pension fund, b) generate sufficient returns to pay for the hedge and,
c) if required, generate additional return above that to add alpha to the overall portfolio of the pension plan.”
That said, finding
the right combination and allocation of financial instruments is like finding a perfectly sized suit. Bowers notes that a
young company with employees who aren’t likely to retire for another 30 to 50 years can probably handle more risk than
a mature firm whose employees have perhaps five to 10 years left before retirement.
Sagraves also cites the differences in investment goals
between developed nations and emerging countries. “China and Thailand are just beginning to set up retirement safety
nets,” Sagraves notes. “Meanwhile, Japan and Taiwan are beginning to open up their markets to foreign investments.
Each market is different, and investment managers have to be sensitive to that.”
“The differences in pension plans are many and
varied. Therefore, you can assume that the solutions offered to pension plans are also many and varied, because you simply
don’t have a like-to-like investment requirement,” Bowers says. “Everything’s going to be slightly
Customized solutions that take into account market dynamics,
demographics and the unique characteristics of a pension plan’s assets and liabilities are what need to be developed
In most situations, the solution to the pension investment
question starts with a plan analysis. “A key component of the process is focusing on the plan’s assets in the
context of its liability risks,” Rocheleau says. “Quantifying the risk is crucial.”
Asset managers need to work with clients to help identify
their pension plan’s long- and short-term goals, risk appetite, funding ratio and projected liability stream, among
other considerations. “Once those inputs are analyzed, they need to compile an appropriate investment strategy and help
implement that strategy,” he explains.
“If, for example, the client wants complete neutralization
of their liability risk, which is more interest-rate related, an asset manager could construct a bond portfolio,” Rocheleau
says. “Or they might implement an interest-rate-derivative overlay to hedge the risks associated with their liability.
The chosen strategy comes back to the risk profile.”
Once a plan has adopted a
liability-driven investing mindset, the process is an ongoing cycle of risk-scenario analysis and adjusting the strategy.
Plan sponsors need to be kept abreast of asset performance, market fluctuations and other events that might impact their liabilities
or risk profiles.
© 2006 Northern Trust Corporation www.northerntrust.com
Past performance is not necessarily a guide to the future. Index performance returns do not reflect
any management fees, transaction costs or expenses. One cannot invest directly in an index. Index performance is based upon
information provided by the index providers. There are risks involved with investing, including possible loss of principal.
There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and asset allocation
models do not promise any level of performance or guarantee against loss of principal.
Northern Trust Global Investments (NTGI) comprises Northern Trust Investments, N.A., Northern
Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., the investment advisor division of The Northern
Trust Company and Northern Trust Global Advisors, Inc., and its subsidiaries.
This material is directed to market counterparties and intermediate investors only, it should
not be relied upon by private investors. This information is provided for informational purposes only and does not constitute
a recommendation for investment strategy or any product described herein. Opinions expressed herein are subject to change
at any time without notice. Information has been obtained from sources believed to be reliable but its accuracy and interpretation
are not guaranteed.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you
that any tax information in this magazine is not intended or written to be used, and cannot be used, for the purpose of (i)
avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction
or matter addressed herein.
Northern Trust banks are members FDIC. © 2006