November 2011

EDHEC RESEARCH: Sponsor risk, accounting risk, pension risk

RetirementThe body of rules and laws under which pension plans are organised has a huge impact on the management of sponsor and accounting risks. Samuel Sender of Edhec-Risk Institute, analyses where the pressure comes from and how to manage it.
Accounting regulations, prudential regulations and certain social laws that govern pensions all have an influence on the investment strategy of sponsors and pension funds. These form part of the institutional constraints that pension funds and sponsors face, and in recent research conducted as part of the regulation and institutional investment research chair at Edhec-Risk Institute in partnership with Axa Investment Managers, we surveyed how funds and sponsors manage the main risks they face including those related to these restraints. Another institutional constraint is the organisation of the relationship between the pension fund and its sponsor, while the aforementioned social laws refer to laws that define the roles of parties to a pension contract, and whether providing pensions is mandatory. We found that this institutional set-up has a great influence on the risk management practices of sponsors and pension funds and that it contributes to inefficiencies in the management of risks. On the whole, accounting risk is important for sponsors and sponsor risk for traditional defined benefit pension funds. These two risks are often not hedged or managed because doing so is not facilitated by the institutional set-up. First, accounting risk would be better hedged by the pension fund itself but, in normal circumstances, the independence of trustees and the requirement to manage the fund’s assets in the best interest of members usually mean not much attention is paid to the sponsor’s constraints in the design of the pension fund’s investment strategy. Yet in a traditional defined benefit plan with full support from a strong sponsor and unconditional indexation, it is the sponsor – not the plan members – who bears the investment risk taken by the pension trustees with pension plan assets. In hybrid pension plans with a weak sponsor or limited sponsor commitments, the situation is the opposite: the participants bear most of the risk in the plan. Sponsors would thus hedge economic and accounting risks themselves, but when they are cash poor and unsophisticated, such hedging is difficult. When they are sophisticated, derivative-based hedges would usually not be recognised as hedges in their IFRS statements. Yet some arbitrary calculations such as spreading involve a specific credit yield risk that should be hedged, at least when spreads are high and when a fall in spreads would make the existing pension liability appear more expensive as well as raise the current service cost significantly. Information systems also lack the necessary transparency: accounting, prudential and buy-out values usually differ and neither the reporting standards nor the risk management systems provide sufficient information about these differing calculations. Sponsor risk
For sustainable pensions, the extreme separation of tasks as spelt out in trustees’ duties may not be optimal. The joint interests and risk tolerance of sponsors and employees should be taken into account clearly when designing the pension plan. In extreme situations, where the size of the pension fund far exceeds that of the sponsor (which usually happens when a sponsor has experienced economic problems), agreements have been found so that the management of the pension fund also aligns with the interest of the sponsor. As it happens, when the sponsor becomes very small, the pension fund cannot count on the support of the sponsor and the sponsor is easily threatened by investment policies that exceed its tolerance for risk. As employees have a strong interest in having the sponsor stay in business and go on participating in recovery plans, trustees are in effect ready to work together with sponsors rather than independently. Second, for a traditional defined benefit scheme, the sole risk for plan members is the bankruptcy of a sponsor. That is, that a bankrupt sponsor will leave an underfunded pension plan (this risk comes only second, after investment risk, in hybrid pension plans). Social laws have progressively paid attention to this risk by making pension insurance schemes, which guarantee/secure a fraction of the pension rights, mandatory for members in many European countries, with the notable exception of the Netherlands. In most countries, however, the protection offered jointly by prudential regulations and pension insurance schemes is incomplete. It would be in the interest of plan members to see sponsor risk hedged: the UK suffers from structural underfunding and has incomplete pension insurance. The Netherlands, which relies exclusively on adequate funding requirements and risk-management incentives, has not been able to avoid underfunding and sponsor risk. Therefore, because of the incomplete protection against sponsor risk (only in Germany and Sweden does the pension insurance scheme offer participants a close substitute to their pension rights if the sponsor goes bankrupt), some pension funds seek to manage this risk, which can be viewed as a put option. But the levy charged by pension insurance is not fully risk-based and, in particular is not reduced for pension funds that are protected against sponsor risk. In the UK, pension indemnity insurance, or an insurance contract that offers protection against the default of the sponsor, can be recognised by the pension protection fund as offsetting sponsor risk. This failure to fully take risk into account in the levy charged for protection by pension insurance schemes acts as a counter-incentive for the management of sponsor risk: a pension fund that hedged sponsor risk in its books would pay part of the risk-based levy twice, the first time to the market and the second to the pension insurance scheme. Many pension funds are reluctant to consider hedging sponsor risk because they fear that such hedges would be taken amiss by their corporate sponsors. But cash generated by these hedges could take the place of contributions made by the sponsor, so these hedges could benefit the sponsor, too. Holistic approach
The body of rules and laws under which pension plans are organised has a huge impact on the management of sponsor and accounting risks in pension plans, so regulators should try to design ways to enforce a sustainable pension system. Because respondents fear costly changes and respond by closing their defined benefit pension plans, policymakers should avoid regulatory uncertainty and having stakeholders think that the cost of providing pensions will increase markedly. Juan Yermo and Clara Severinson argue that “pension policymakers should pay more attention to international pension accounting standards…, as accounting standards are a major driving factor in the decision of many corporations to discontinue their [defined pension plans]. Companies with relatively modestly sized pension plans can have pension obligations that dwarf the size of other obligations in their financial statements”. Prudential regulators, when they adopt a risk-based approach, should try to take a holistic approach and to include sponsor risk in the risk assessment of pension fund. The design of traditional defined-benefit plans seems to offer sub-optimal governance arrangements, because it is the sponsor, not the pension fund, which bears the financial risk involved in the pension fund’s investment policy. At the same time, the pension fund’s primary risk is that of bankruptcy of the sponsor, a risk seldom entirely hedged. All participants should seriously consider hybrid alternatives to traditional defined-benefit plans and formally assess how different liability structures impact the ability to manage risks in pension plans: research should focus both on optimal contract design for pension plans and on solutions to problems of managing pension risk. Samuel Sender is an applied research manager at the Edhec-Risk Institute ©2011 funds europe

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