What is the worst outcome for beneficiaries of a defined benefit pension plan? Simple. The worst outcome is not receiving the monthly benefit promised by the plan's sponsor. This can happen if a plan is not properly funded and its sponsor becomes insolvent. Given the potential of this combination of events to harm beneficiaries, sponsors could be expected to take steps to reduce this risk. Instead, many sponsors' investment strategies ignore and often enhance the risk. For example, according to a study by Pensions and Investments, the 200 largest corporate defined benefit plans allocate an average of 65 percent of their assets to stocks.1 As Figure 1 shows, corporate bankruptcies frequently increase at times when equity markets struggle.
Figure 1 // Correlation of U.S. Stock Market and U.S. Corporate Bankruptcy Index
Source: Bloomberg, Standard &Poor's. January 31, 2000 –July 31, 2013
The tendency of bankruptcies and bear markets to overlap shows that there is a real likelihood that some sponsors may go bankrupt while their plans are underfunded, which can mean reduced benefits for plan participants.
So what can sponsors do to better protect those beneficiaries? Investing in assets with a low or negative correlation to the sponsor's success may reduce the possibility that pension fund asset values will drop when a sponsor risks bankruptcy.
THE MOST EFFECTIVE STRATEGIES ARE THE LEAST PRACTICAL AND PRUDENT
If the sponsor wants to reduce risk in this way, it can do so by purchasing "insurance" against itself. This insurance can be obtained through shorting the company's stock, purchasing put options on that stock, or buying credit default swaps tied to the company. While these investments are likely to provide beneficiaries with considerable protection if the company becomes insolvent, there are a host of other reasons why these investments are not practical or prudent. If the plan sponsor never becomes insolvent, these strategies will put a drag on the pension fund's overall performance due to their cost and lack of payout. It is also difficult for a corporate treasurer or chief financial officer to convince their board that shorting the company's stock is a prudent decision.
REALISTIC AND EFFECTIVE STRATEGIES TO PROTECT BENEFICIARIES
Since shorting company stock is probably not the best idea, let's focus on strategies that are much more prudent and still effective in protecting beneficiaries. Figure summarizes various investment strategies that corporate, public, and Taft-Hartley pension plan sponsors can implement.
Exhibit 2 // Realistic Investment Strategies to Help Protect Beneficiaries
|PLAN SPONSOR TYPE||INVESTMENT STRATEGY||EXAMPLES|
|All Corporate Sponsors||Avoid stock or bond investments with high correlation to company success||
|Highly Cyclical Corporate Sponsors||Avoid investments that are highly cyclical that may struggle when the company struggles||
|Corporate Sponsors Tied to Commodities||Avoid direct investments in those commodities or other investments with high correlation to those commodities||
|Public Sponsors||Avoid investments that have a high correlation to the success of your tax base||
|Taft-Hartley Sponsors||Avoid investments that have a high correlation to the success of your tax base||
HOW TO ASSESS CURRENT STRATEGY
Plan sponsors may wonder how effectively their current investment strategy protects plan beneficiaries from the effects of a potential bankruptcy. There are both quantitative and qualitative ways to answer this question. A simple quantitative approach looks at a plan's historical funded status and compares it to the historical stock price of the sponsoring company. If the correlation is high, the exposure of beneficiaries to risk may also be. In Figure 3, we've applied this analysis to U.S. corporate defined benefit plans by measuring the correlation of the Standard &Poor's 500 Index and the funded status of pension plans sponsored by the companies that make up the S&P 500. The correlation between the two over the past 12 months is a very strong 0.91. This shows that, as a whole, the success of U.S. corporations is highly correlated to well-funded pension plans. When corporate profits are struggling and the S&P 500 Index falls, it is very likely that pension plans' funded status will worsen and create
Exhibit 3 // Performance of the S&P 500 and Funded Status of its Component Companies' Pension Plans
Source: Bloomberg, Standard & Poor's, BNY Mellon ISSG. July 31, 2012–July 31, 2013
On the whole, U.S. corporations are doing very little to protect beneficiaries from the threat posed by corporate bankruptcy, but that is not necessarily true of all companies and all plans. We encourage all plan sponsors to use this analysis to determine if they need to do more. The inherent conflict between sponsors and beneficiaries sometimes causes those sponsors to lose sight of their purpose in investing pension assets and of whom they serve as fiduciaries. Pressure from corporations, taxpayers or unions also sometimes leads plan sponsors to forget that they must serve the best interest of plan beneficiaries. Analyzing how well they are protecting beneficiaries from bankruptcy can help them refocus on their true duty as pension plan fiduciaries.
1 Pensions & Investments, February 4, 2013: Based on the aggregate asset mixes for the top 200 defined benefit plans.
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