Report suggests alternative investment allocations could be impacted by new pension accounting rules

You don’t have to be a licensed accountant to figure out that many pension funds are being squeezed from both sides.  Assets are down and lower future return assumptions mean the present value of those assets is down even further.  And pension liabilities are up due largely the same thing: low discount rates leading to higher present value of future liabilities.   These phenomena have conspired to create what Michael Moran and Abby Joseph Cohen at Goldman Sachs called “challenges and changes” for pensions in 2011.  Anyone who manages the overall health of their pension fund, or anyone who thinks they can help the managers of those funds get out of their pickle, should definitely read this report.  What follows is a quick taste of what you’ll find in the report.

Despite the hysteria surrounding pension under-funding over the past decade, the report ^[2] begins by showing that the average funded status was actually over 100% in both 2007 and 2008 – for US pensions at least.  However, the market calamity of 2008 means that average funded status is now around 82% with the median approximately 75%.  As if that weren’t bad enough, pension funds are beginning to acknowledge that their traditional return assumptions will have to be revised downward even further than they have been already.  The chart below from the report shows that average expected return assumptions have fallen around 1% since 2002.

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Of course, a tiny drop in the expected future annual return will have a dramatic impact on the present value of the fund’s assets, and thus on its long-term funding gap.  The report contains several examples of public pension funds (totaling over $550 billion) that have recently dropped return assumptions.  In 2003, says Goldman, 95 of the pension funds of S&P 50 firms used a return forecast of 9% or higher.  By 2009, that number plummeted to 3.  You can imagine how these recalibrations alone would open up a funding gap the size of the San Andreas Fault.

One way of dealing with this is to decouple fund returns from market returns.  Or, as Goldman says,

“This means that plan sponsors have a greater incentive to have assets with characteristics similar to the characteristics of the plan’s liabilities.”

This means a shift into less volatile assets such as fixed income and alternative investments.  We’ve chronicled the shift out of long-only equities several times over the past few years, so regular readers will find the chart below showing a drop in equities and corresponding increase in fixed income and alternative to be vaguely familiar:

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But while this was clearly the trend up to and including 2008, check out what happened in 2009:  Equity allocations bounced back a little, fixed income allocations dropped like a rock and, through it all, “other” jumped by over 50%. This indicates that, although Goldman classified non-fixed income assets as “risky” for the purposes of the report (and hedge funds as even riskier “Level 3″ assets), allocators seem to be increasing hedge fund allocations as part of their “de-risking” strategy. Go figure!

It’s easy to assume, like we did, that much of the precipitous drop in long-only equity allocations was a passive effect of falling markets.  But the chart below from the Goldman report shows that it wasn’t just “actual” equity allocations that were falling, it was the “target” allocations themselves.

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Okay, you don’t have to be an accountant to understand the challenges facing pension fund portfolio managers, don’t worry.  But you might actually need a CPA to figure out the implications of these challenges for the plan sponsors such as the S&P 500 companies who likely now regret ever starting a pension plan.  It turns out that pending accounting changes could impact the future of pension plans far more than either the return assumptions or the discount rates applied to liabilities.

The report explains how pending changes to international accounting rules (i.e. the International Financial Reporting Standards  or “IFRS”) could make their way to US plans.  One such change would do away with the ubiquitous return assumptions that got plans into a bind in the first place.  These changes, says Goldman, will remove the incentive to see the world through rose-coloured glasses and pave the way for pension funds to abandon what many believe is an overly-optimistic perspective.  If this were to occur, Goldman Sachs says a “powerful incentive for some plans to maintain exposure to equities would be removed” and we would see an acceleration in the aforementioned move out of the asset class.

The pending proposals would have pension plans recognize profit and loss on pension funds in the period they occur.  But to avoid the resulting excessive volatility, that profit or loss would be recognized as other comprehensive income and would therefore not directly impact the company’s bottom line every year.

Again, not directly.  But if the running balance in that “other comprehensive income” account is negative (i.e. if the fund was under-funded), then the company would have to recognize an “interest charge” for the balance – as if it was borrowing the money from outside. If, on the other hand, the balance was positive (i.e. if the fund was in surplus) then the company would recognize interest income from its pension fund.

This sounds like a win for sponsors since many are currently amortizing the full value of recent losses.  Using the new standards, they would no longer have to amortize those losses and would only have to recognize the “interest” on the resulting funding gap.  But as Goldman points out, without the benefit of being able to recognize 8.5% returns, regardless of actual returns, many plans would actually be worse off in the short term.  (The firm includes a simple example of how the accounting would work.)

Had the IFRS proposal been instituted in the US in 2009, 34 S&P 500 companies would have seen a hit to net income in excess of $100 million.  Even more-so, two of them would have seen a hit of more than$1 billion.  We’d venture to guess that most of these companies would likely lobby against such a proposal.

The bottom line is that pension fund portfolios aren’t managed in isolation.  Asset allocation can increase or decrease funding gap and the accounting treatment of that gap can, in turn, drive the asset allocation decisions made by US pension funds.  Advocates of alternative investments would be well advised to keep an eye on this evolving story. As always, the impact hinges on whether you believe alternative investments are “risky” or they are part of an overall “de-risking” strategy.