Thought Winter 2008

Pension Assets: Managing Through Turbulence

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The long-term implications of the market turmoil are still unclear, and much of what follows is more a consideration of questions than answers.

Brian Donahue, FSA
Managing Director, Compensation and Benefit Strategies

The volatility and instability of U.S. capital markets has left no one untouched. In this article, we review the issues market turmoil presents for sponsors of pension plans. We believe that many of the long-term implications of the market turmoil are still unclear, and much of what follows is more a consideration of questions than answers.

Defined Benefit Plans - Immediate Risks
Sponsors are generally focused on problems identified in securities lending programs and money market funds. We will not pretend to identify each asset or asset strategy that has been put at risk by market turmoil. Rather, we will focus on fiduciary risks the market turmoil presents. As a general matter, sponsor-fiduciaries will want to consider a review of plan assets and asset strategies with a view to assessing risks, sooner rather than later. Critical, in that regard: document the review process and act deliberately where a conclusion is reached that action is necessary.

PPA Funding Rules
For DB plans, a critical regulatory issue is the application of the Pension Protection Act of 2006 (PPA) funding rules in the context of turbulent markets. The turmoil will affect both the valuation of liabilities and assets. Let's start with assets, as both the issue and the solution are more obvious there.

Valuation of DB Assets
Under PPA, asset values may be "averaged" over (up to) two years. The Internal Revenue Service has interpreted PPA to require "literal" averaging rather than actuarial "smoothing." Generally, averaging systematically understates asset values, whereas smoothing, which assumes a level of asset growth over time, does not. For many sponsors, the IRS interpretation of the PPA averaging rules simply means that they will mark assets to market - use current fair market value - rather than employ averaging. If the IRS's position is not reversed by Congress, sponsors will be faced with the unhappy choice of an averaging regime that will usually understate asset values over the long term (but likely give a better short-term result) or using fair value, which removes the downward bias but marks to an extremely volatile market.

Valuation of DB Liabilities
PPA rules for valuation of liabilities are more certain. The yield curve used for valuing liabilities is generally based on yields on corporate bonds rated A, Aa and Aaa. Sponsors have several choices, including yield curves based on 24-month averages and a one-month yield curve-in effect, using (close to) spot rates. However, several problems with respect to yields can be identified. First, in the context of a flight to quality, credit spreads (Treasuries vs. Corporates) have widened dramatically. Corporate rates are, arguably, "artificially" high. Of course it could also be argued that the rates on Treasuries are "artificially" low. Second, the solvency shakeout we're now going through will no doubt result in a downgrade of the ratings of some companies, whose bonds will then fall out of the universe of bonds rated A, Aa and Aaa. Third, the reduction in liquidity we are experiencing will make all prices during the illiquidity period less reliable. What does all this mean for PPA valuations for calendar-year plans? Sponsors that are cash-stressed may have an opportunity to reduce 2009 funding, by choosing a one-month December 2007 yield curve for 2008, thus allowing use of a (possibly "artificially" high) December 2008 yield curve for 2009. Alternatively, sponsors that are volatility averse have even more reason to use a 24-month rate. Bottom line: analysis of yield numbers for the end of 2008 will be a critical element of some sponsors' PPA funding analysis.

Defined Contribution Plans
DC plan sponsors address problems created by the market turmoil at one remove. Participants are bearing the brunt of the reduction in asset values and a comprehensive uncertainty about valuations. What should a sponsor do?

DC Plans - Immediate Risks
Generally, comments above with respect to immediate risks for DB plans are also applicable here. Certainly, the viability of money market funds, for instance, will be a critical issue. Sponsors will want to consider a review of the effect of market turmoil on plan funds. And, again, critical to this process: documentation and deliberate action where a conclusion is reached that action is necessary.

Communications to Participants
Let's begin with the observation that generally, under current rules, in plans that allow participants to elect an asset allocation from a menu of funds, sponsor-fiduciaries are only responsible for the prudent selection and periodic review of the funds/fund managers in the fund menu. Many sponsors undertake to do more. In the context of market turmoil, sponsors may want to consider providing information and "generally accepted" investment guidance. We would stop short of telling participants not to sell, but discussion of the risks of disinvesting in the middle of a market cycle may be appropriate.

Derivatives and Hard-to-Value Assets
The market turmoil has thrown many valuations into question. Pressure on valuations increases fiduciary risk and may drive sponsors out of certain markets. But-derivatives have been used to enhance returns in a variety of investment strategies. Perceived weakness in these markets may cause plan sponsors to shy from them, thereby reducing overall returns. All of which is to say, valuation of hard-to-value plan assets is an emerging issue. The market turmoil brings this problem into high relief. What the outcome will be is not at all clear.

Unanswered Questions
With respect to DB plans: will the turmoil lead more sponsors to adopt asset-liability strategies? Did those strategies actually perform better through the crisis? And, perhaps, the biggest question of all-how will DC plan participants fare? If there is a widespread tendency of participants, through this turmoil, to sell low (and implicitly, buy high), what does that imply for the movement away from DB plans and to DC plans? Will the DC-DB performance gap (currently estimated to be around 100 basis points) widen? Will a widening performance gap call into question, for some sponsors or policymakers, the wisdom of the transformation of the American retirement system from DB to DC? The answer to all of these questions: it's still too early to tell.

For more information, please visit our Website at www.jpmorgan.com/wss