Pension plans failing to consider the strength of their corporate sponsor may be drawing up a flawed investment strategy as a result, according to research from the Cass Business School and University of Melbourne.
In the paper—“Managing Financially Distressed Pension Plans In The Interest Of Beneficiaries”—David Blake, director of pensions at the Cass Business School, and Joachim Inkmann and Zhen Shi of the University of Melbourne proposed a new asset-liability model taking this into account as well as factoring in the pension’s strategic asset allocation.
“We cannot value the pension obligation without knowing the strategic asset allocation policy of the pension plan.”Currently, valuing a pension’s liability is treated as a separate task from investing the assets, the authors said. Their model merged the two tasks as well as treating pension funds as “an integral part of the company”.
Blake said the model “has important advantages for all stakeholders of the corporate pension plan”. Adding: “Staff taking out pensions will have a clearer picture of the true value of their pension promise.”
“The ability of the pension plan and its sponsoring company to fund the future pension payments promised to the beneficiaries depends on the future values of pension plan assets which themselves depend on the current strategic asset allocation policy of the pension plan,” the authors wrote. “We cannot value the pension obligation without knowing the strategic asset allocation policy of the pension plan.”
Using 2002 data from General Motors’ pension plan as a case study, the authors demonstrated that the strategic asset allocation used at the time was far too risky as it did not take into account the funding shortfall and the size of the company.
At the end of 2002, GM’s pension held assets worth $60.9 billion, or 76% of its obligation to members. The market cap of the car maker was $6.8 billion at the time—less than half the value of the pension shortfall of $19.8 billion.
More than half (55%) of GM’s pension was invested in stocks at the end of that year, the paper shows, meaning the fund was exposed to a volatile—and falling—equity market. Including real estate, the pension had 65% in risky assets.
However, when taking into account the sponsor’s position, as well as the nature and time frame of the liabilities, Blake, Inkmann, and Shi said GM’s optimal bond allocation was 70%, shifting from an aggressive investment strategy to liability hedging.
“Pension plans which are sufficiently well funded to reduce funding risk to a negligible amount optimally choose an asset allocation in our framework which is close to a liability hedging portfolio,” the authors wrote in their conclusion, “but which additionally includes a small allocation to stocks to help keep future underfunding probabilities low as a result of the higher expected mean-reverting return to stocks.”
Related: The Inside Story of GM’s Pension Risk Transfer & Rising Costs to Hit De-Risking Plans in 2015