What to Do When You’re Fully Funded | Chief Investment Officer

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It came as a welcome surprise to the president of Air Canada that his company’s pension plan had hit full funding at the end of December. “[I] always expected to settle the problem,” said Calin Rovinescu at a press conference in January. “But frankly, I would have thought it would take another year or two to get there.”

The Air Canada pension plan had been $4.4 billion in the red not too long before, but thanks to a rise in interest rates, a 14% investment return, and reductions in early retirement provisions, that deficit was brought down to zero in January.

Rovinescu is not alone in finding himself in a more comfortable accounting position. Many pension funds are creeping towards that golden fully funded status. Data from Towers Watson released last month showed the aggregate pension funded status of 1,000 defined benefit providing employers in the US leapt from 77% at the end of 2012 to 93% a year later.

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To put this in perspective, since 2000, the Fortune 1,000’s aggregate funding position has drifted from a high of 124% to a low of 77%. Today’s 93% is the highest funding level achieved since 2006, when pension funds recorded an aggregate of 99%.

Mercer’s data, meanwhile, based on S&P 1500 company pension funds, showed a 21% improvement in funding status over the past 12 months, with the aggregate funding status reaching 95%. That equates to more than 80% of US pension underfunding being eliminated since the beginning of 2013.

If the picture is a little less rosy on the other side of the Atlantic, it is just due to accounting differences.

The corporate pension lifeboat, the Pension Protection Fund, said UK pension funding on an insurer-buyout basis had improved slightly between March 2012 and March 2013: The funding ratio rose from 83% to 84%. However, corporate bond movements across the year and various stock market rallies finally permitted UK CIOs some respite: By November 2013, funding had rocketed to 93%.

After one of the worst periods in financial history, reaching fully funded status is no longer a pipe dream. Now, CIOs have to consider what to do when they get there— and how to avoid the mistakes from the past to ensure they stay.

What Happens Next?

How CIOs react to the news that they’ve reached fully funded status (after popping the champagne corks) largely depends on their endgame. Is achieving buyout the ultimate goal? Or is keeping the fund self-sufficient the aim?

Hitting that 100% funded level (or 105% if you’re in the Netherlands) is not a cliff event. The game doesn’t stop once you get there.

There are three top things that should be on every CIO’s to-do list as they approach becoming fully funded. Firstly, keep de-risking, but don’t de-risk entirely. Secondly, consider the cash-flow situation and adjust accordingly—not forgetting about the potential for further government or regulatory increases. And thirdly, don’t become complacent.

Consultants agree that, for now, most plans will continue with their de-risking strategies. Ari Jacobs, senior partner at Aon Hewitt, says most US plans now have glide paths that invest using strategic decisions to increase the amount of fixed income or liability hedging assets.

“The thing to consider is how and when you make those decisions,” he says. “Do you do them slowly, over time? Or try and do it all in one shot? Do you worry about gaining access to markets?”

Many pension funds choose to increase their hedging allocation as they become better funded. So does that mean you should be fully hedged at the point of being fully funded? And if so, what assets should you buy towards the end of the glide path?

“When we look at hedging strategies, you increase your hedge ratio as you improve, but you need to become more sophisticated,” says Jacobs. “When you have a low hedge ratio, you’re looking at duration matching; as you increase your hedge ratio, you want to focus more on credit.”

As the ratio gets higher, CIOs should ensure the plan is taking fewer risks, Jacobs continues. “As you go further into the 60%-, 70%-hedged range, you’re moving to a pure mark-to-market basis. You need to view risks differently as the hedge ratio changes your exposure to risks. The exposure to duration risk is high when you’re at 40% hedged, and your equity exposure might well be high.”

De-risking also means looking at pension-risk transfers. Pensioner buy-ins—where an insurer offers a policy to take on some of the pension’s liabilities while the trustees and CIO continue to manage the fund—have grown in popularity, particularly in the UK. They are seen as a good way to remove some of the liabilities once a better funding ratio has been achieved.

The move is also often seen as a step along the path of achieving a full buyout, although not all funds will achieve that aim. While the capacity of insurers to provide buyouts is not a concern yet, it could well be in the future.

But if you’re not in a position to buy out or execute another form of pension-risk transfer, what are your options?

Peter Martin, head of manager research at JLT Employee Benefits in the UK, says there is a point where pension funds undergo an evolution, from balance sheet management to managing cash flows. “What we think of as liability-driven investment [LDI] is a transition phase,” he says. “The money in LDI at the moment will ultimately need to evolve into this steadier, self-sufficient, cash-flow matching-type policy. Swaps will be a part of that, but what they will do will change.”

This “cash-flow choreography,” as Martin has christened it, was highlighted by a number of consultants. Ultimately, it boils down to investing money “so it naturally matures at the point you need it,” says Martin. “It’s not an exact science, but you can think about it in broad terms: I need cash month in, month out, to pay the pensioners.”

Jacobs prefers to call it liquidity management. “Most plans pay out 7% to 10% of their assets in any given year, so the cash needs for the plan are real, but they’re not enormous,” he says. “You need to be nimble to create cash or buy into the fixed income markets when you need it.”

This step also requires that you consider any future contributions coming into the fund. How much can the plan sponsor put in over the next decade? Will you need to come back and adjust that?

As an example, in the US, plans have had to deal with a change in Pension Benefit Guarantee Corporation fees. New legislation will see the variable premium—levied on the underfunding level of the plan—triple by 2016. That could encourage the plan sponsor to put more money into the plan ahead of that date, Jacobs says.

Don’t Get Cocky

The third step is not to become complacent. The risks, as previously noted, change as you approach self-sufficiency, meaning CIOs can’t switch off when they reach the Holy Grail of being fully funded.

“It’s a bit like that fairground game where you push one head down and then another one pops up,” says John Towner, director at investment consultants Redington.

“In your typical risk analysis, you have some large, dominant risks such as interest rate and inflation. If they’re taken out, as they probably would be when you reach a higher funding level, the other funding risks become more pronounced.”

Basis risk—the risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other—is one Towner often looks for with his clients. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual selling date of the asset.

Aon Hewitt’s Jacobs also warns not to let accounting dictate your decisions, “I know there’s some real attachment to the earnings that come from the accounting rules in the US, but they shouldn’t drive your decisions, as they’re probably not economically based,” he says. “And you shouldn’t assume that being fully funded means it’s time to settle your liabilities. Being fully funded doesn’t necessarily mean you can get out of the plan without any more dollars being thrown at it.”

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The asset management business—as we know because we like to hope we understand it—attracts more than its fair share of intellectually gifted individuals. This is because it is an exceptionally interesting business; it is highly compensated; and it is complex—which rewards those with the ability to handle complexity.

Some measure of ruthlessness is no doubt useful in any career, and asset management is no exception. But it is typically a small part of the mix. In stark contrast, ruthlessness, whether or not it is accompanied by any other talent, always seemed to this observer to be a recipe for riches on Wall Street. How many of us have watched utterly vacuous individuals, with no patent attributes other than a willingness to ride roughshod over people, thrive at Street firms?

And yet the vacuous, no matter how ruthless, will likely not thrive in asset management. It is, at heart, a people business. That is its charm.

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All this musing stems from a comment expressed to me in frustration recently. A successful institutional asset management firm is looking for a new chief executive, and the individuals tasked with the search were aghast at the quality of the candidates they were interviewing.

But the more I thought about it, the less surprised I was. To be at the helm of an asset management firm today involves an extraordinary range of characteristics. It requires clarity of vision, for—perhaps even more than usual—the industry is in flux. It calls for inordinate people skills to shepherd portfolio managers and analysts, where egos are legendary. It demands sales skills: At an asset management firm, the CEO has to be the firm’s chief salesman. It helps to be -likeable.

How many executives have these skill sets? In a business that attracts the intellectually gifted, this is still a high bar. Even so, this is the thing that matters, because great chief executives make great asset management firms. Indeed, great chief executives make great asset owners, too. Nothing matters more to continued success than the individual who runs the company. These are not periods of rising tides where mediocrity is rewarded; in the next decade, the race—whether the metric is returns or assets gathered—will be won by the swift.

Space (and a measure of tact) precludes me from listing the all too numerous examples of men (yes, men: The female executives who have risen to the top of their asset management organizations have clearly had to be smarter and more driven than the men around them, and boy does it show) who have done nothing with the firms they ran.

But instead of listing mediocrities, let’s look at an individual who in his time was considered a superlative asset management executive: Putnam’s Larry Lasser. Certainly ruthless, and arguably a visionary, too. But hardly a salesman or a shepherd. Putnam thrived, and then suddenly, circa 2003, did not. That’s Lasser’s legacy.

In its essence, this column is really a reminder of how rare the talent is that can successfully run a large asset manager or asset owner. In my view, the individuals who best exemplified these necessary talents have now left the scene: Nick Lopardo, the rough-edged CEO of State Street Global Advisors, and Harvard’s Jack Meyer. Both had their detractors, to be sure, but both did extraordinary things with the opportunities they were presented.

Perhaps the most interesting chief executives in the space today can be found among the small handful of hedge funds and private equity firms that have cracked the institutional space, and their reward has been exceptional financial success.

And yet there is another, perhaps largely untapped, source of talent for tomorrow’s chief executives: asset management start-ups. In a recent meeting in the ETF space, I found myself sitting opposite as thoughtful and insightful a thirty-something CEO as I can remember meeting. If this is the last time you read about Bruno del Ama and Global X Funds, then this columnist is a poor judge of character.