BC: Do you think we’ll throw caution to the wind when things come roaring back?
DW: People are talking about absolute return strategies, but if markets change, will they stay the course? There are a number of larger institutional investors with longterm horizons who need to build capital and produce real returns, not react to each twinge in the market— they probably will. Others will not. Part of the problem with corporate plans is the accounting, which currently entails a major smoothing exercise. With some assumptions, like expected return on assets, you can actually create income by taking on risk, so there’s a potential enticement to take on more risk to create income. I think [that] was not fully understood by users of company financial statements. The first step taken by accounting standards setters is to get more transparency around how sponsors come up with assumptions such as the rate of return, and the extent of investment risk via disclosure of the sponsor’s pension plan asset mix.
BC: Now the big push is on to adopt mark-to-market valuations…
DW: That’s the direction now. As I said before, part of the challenge for corporate pensions deals with the accounting practices; other major issues revolve around the lack of clarity around the nature of the pension arrangement. Who owns the surplus? That’s critical.
When things were going well, pension accounting was invisible. The economic shift in 2000 focused everyone’s attention on governance and corporate reporting. People started to question the fact that companies were reporting pension income and assets when, if you did the math and dug through all of the detail in the notes to the financial statements, you saw the plan was actually in a deficit. Accounting standard setters are revisiting the entire pension accounting model: the first step is to provide more disclosure of the asset mix and investment strategy. This will shed light on the extent of mismatch between assets and liabilities. It should also give an indication of the risk taken to support the assumption for the rate of return. This increased transparency will lead to a better understanding of the company’s pension-related risk.
Another intention of the new disclosure [standards] is to show the impact of smoothing on the pension expense recorded by companies; [that is,] to show the impact of all gains or losses on a mark-to-market basis and arrive at a market value-based measure of income. Underneath this, companies should show their longerterm smoothing adjustments, therefore [giving] people some sense of the true impact of volatility due to pension operations.
BC: It seems that pension plan governance is an elusive beast—nothing is ever absolute or guaranteed.
DW: I think the bar for pension plan trustees is definitely high: it’s far harder to find value in the marketplace now, and the liability benchmark is much more difficult in this environment. Where are you going to get this absolute return? It’s going to take a lot more skill and diligence to navigate this new environment. I think that is going to be a major challenge for defined benefit plans and smaller pension plans that don’t have the resources. If plans don’t step up to this challenge then something will need to give, whether it is benefits being cut, or switching to a DC plan, in which case we’ll be looking at another set of challenges.
BC: Any advice for plan sponsors?
DW: [Plan] sponsors should keep an eye on what is unfolding in the U.S. The SEC is currently reviewing the pension accounting of several large corporations, based on the size of their pension fund compared to the company market capitalization. [They’re] trying to get to the bottom of the basis for assumptions, such as their rate-of-return assumptions; whether they’ve moved over the years and by how much; and the discount rate used for valuing the liability. Depending on the outcome of this review, we could see even further scrutiny of pension accounting by investors, audit committees and boards.
James Lewis is a contributing editor of BENEFITS CANADA.