The Special Case of the Pension Fund


Alan R. Hibben, CA, CFA, ICD.D

Director, HudBay Minerals Inc.
It’s time for boards to take back this complex risk

Many years ago, when I sat on the asset-liability management committee of a large company, we had just finished reviewing all the risks and hedging positions of the organization, appropriately matched up against the board-approved risk management policy. We talked convexity, VARs, rhos, gammas and quite a few decimal places. At the end of the presentation, however, I posed a question to the treasury executives: “Would you ever recommend to a client that it goes long $4.5 billion of equities and short 35-year-duration inflationlinked bonds?” 


After they derided that notion as “wild” and “silly,” I asked why our defined-benefit pension plan was not part of the risk management structure – as it seemed to contain more risk than most of our interest-rate and currency positions. While coherent answers were not quickly forthcoming, it appeared the pension fund was a “Human Resources” matter where risk was contained and managed by the pension fund trustees. 

At the time I found this answer highly unsatisfactory. But I determined that if there were a few years of awful equity returns, the risk might finally start to be noted (and finally, it did). As I now spend much more time on boards and consulting to boards, I am struck by how there is still a divide between our disciplined approach to risk management in most financial and operational areas, and our hands-off attitude to pension risks, especially of the defined-benefit variety. I should mention here that I am not an actuary, nor have I practiced as an accountant for many decades, so I will likely offend both professions, and therefore apologize in advance.

There are essentially four ways to look at pensions and risk:


  1. The Actuarial View: An actuary looks at the pension plan from the point of view of funding requirements. What amount of assets is likely to be sufficient to fund a set of liabilities in either going-concern or insolvency situations?
  2. The Accounting View: The accountant attempts to reflect as neatly as possible a balance between an effective representation of the net assets or liabilities of the firm and the process of allocating benefit costs to appropriate periods.
  3. The Risk Management View: The risk manager attempts to assess the volatility of the value of the firm to the underlying economic variables that affect future cash flows, whether they are assets or liabilities.
  4. The Corporate Finance View: This view encompasses the range of corporate finance issues that surround pensions, from tax efficiency to the theoretical irrelevance of pension asset mix to shareholders.

As can be imagined, directors faced with this range of views, often from well-educated and abstruse professionals can become confused and lose sight of the fundamentals. This is of particular concern when the views are in conflict. Part of the issue arises due to the differing responsibilities of the parties to the plan, the fund, the company, and the information-consuming investors.

A simple example: A company with a large pension deficiency decides to prepay its funding obligation (perhaps to cure a solvency deficiency or utilize excess cash or debt capacity), taking on debt to do so. From an actuarial point of view this clearly reduces the deficiency in the plan, and to the extent invested in an unhedged portfolio, could reduce the deficiency further. By “unhedged portfolio” I refer to assets which have inherent volatility compared to pension liabilities, which act similarly to long-dated real return bonds. (Typically an unhedged portfolio contains equity securities.) From an accounting point of view, and to the extent invested in the unhedged portfolio, this transaction actually reduces future accounting expenses under current U.S. and Canadian GAAP1 . From a corporate-finance viewpoint, the company starts to enjoy positive tax arbitrage (deductible contributions and debt interest, non-taxable equity income) while substantially increasing the risk to the firm (short debt and long assets).

What is a director to think? I believe that, to the extent feasible, directors need to filter out the noise surrounding the actuarial or accounting viewpoints. Both these perspectives have use for solvency and liability management, but fundamentally they are not helpful, and could even be hurtful, in assessing the risk to the firm.


A couple of simple observations:

  1. Generally speaking, the risk to the firm increases when a pension promise is made or changed. For example, when a retirement benefit rate is negotiated in a union contract, the firm is obligated for a future set of employment cost increases that may be more or less predictable depending on future wage rates, inflation and other demographic factors. No subsequent asset-allocation decision can reduce the cost or volatility of this promise. Whether a company provides more contributions to its pension fund or not, a new pension promise involves new costs and new risks. Such costs and risks could be offset or hedged to greater or lesser degrees, but cannot be eliminated. So great care should be taken when such commitments are made, as many of the variables (future wage rate increases, real rates of interest, longevity) are not easily hedged.
  2. To the degree that an equity allocation is made within the pension-fund asset mix, the firm has taken on profile that is not risk-neutral to future obligations. The equity allocation may perform better or worse than the underlying pension liabilities, but certainly it will perform differently. From the perspective of the shareholder of the firm, the asset allocation is now over-weighted to equities and normally such shareholder would rebalance (at the margin) to maintain the desired risk profile (to greatly simplify current corporate finance theory).
  3. The corollary to observation B above is that the search for an optimal asset allocation to the pension fund (a so-called “efficient frontier”) is futile, as it fails to account for the risk-profile preferences of the shareholder, and further fails even to place the risk profile in the context of the firm.

The logical extension of these simple observations crashes headlong into the actuarial and accounting viewpoints of the pension fund. In these perspectives, an increased allocation to equity in a pension fund can be a profitable activity (in the short run) as equities will generally be assumed in accounting and actuarial calculations to exceed the cost of pension liabilities. A director will therefore have to be quite brave to argue against such an increase in risk to the firm. In the short run, a much higher allocation of pension assets to real-return bonds and other “hedging” assets will reduce earnings and increase potential contributions. In my view this is part of the reason that pension funds often fall outside the purview of board-supervised risk management. It is difficult stuff; particularly where doing the “right thing” for risk management may reduce current earnings and increase funding requirements.


So how do we seize back the reins from accountants, actuaries, asset managers and management – all of whom have (apparently) vested interests, both direct and indirect, in increasing the risk to the firm by going long equities to attempt to manage very long-term fixed liabilities? Particularly, management has an incentive to use higher equity allocations and higher funding levels to (in the short run) improve accounting earnings above the “comprehensive income” line.


First, and most importantly, pension fund risks must be brought directly into the board risk-management approved framework. The first element of this framework is to assess the firm’s willingness, capability and capacity to take on the risks implicit in the scheme, even though such asset and liability skills are typically not core to the business plan of most companies and thus are almost uniformly outsourced.


Second, board members should ask their advisors to fully model out the risks to the firm from the multitude of variables embedded within the pension promise and, separately, the asset-mix decisions of the fund. It will be very informative to view scenario analysis of future funding gaps and surpluses, based upon year-to-year analysis, not just the present-value calculations of actuaries.


Third, the board should request that management provide parallel accounting information under the proposed IAS 19 Rules which will start to acclimatize the board and management to the closer to “market value” approach implicit in these new rules coming into effect in 2013.


Fourth, the board should spend much more time with actuaries and accountants reviewing both the point estimates for discount rates used in the determination of the value of pension promises, and expected returns on plan assets used in accounting and funding decisions, as well as the results arising from calculating one, two and three standard deviations from such estimates.


As more directors understand these issues, I believe they will be increasingly concerned with the degree to which underlying risk and volatility in the value of the firm has been masked by accounting and actuarial practice, supported by self-interested management. And I believe this concern will spur on the appropriate debate over the right level of risk, as well as perhaps some belated consideration of whether manufacturers of widgets should be in the business of shorting long-duration promises to invest inequities. Most importantly, boards need to take back the appropriate degree of supervision of this critical component of volatility in the value of the firm.


Alan Hibben is a director of HudBay Minerals Inc. and Discovery Air Inc. but has a day job at an unnamed financial institution. He can be reached at [email protected].

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