The implosion of the subprime mortgage market in the United States and the subsequent drop in global equity markets recently has left many pension funds wondering about the long-term implications for their funding status.

Stock markets around the world took a beating and a panic sent investors running for the doors. By August 21, the S&P/TSX Composite Index had lost 9.5% since its peak of 14,629.76 in mid-July, but had fallen just 4.8% since the end of June. The TSX’s late-summer drop meant that equities were relatively flat for the year as of mid-August.

Fortunately, the damage to pension funding levels seems to have been minimal, according to Paul Forestell, worldwide partner and leader of the Canadian retirement professional group at Mercer Human Resource Consulting. “Because bond yields have come up, pension plans on the whole are better funded than they were at the end of [last] year.”

“While pension funds may not have direct exposure to the financial instruments that created the problem, they’re going to be affected by it simply because of the contagion effect on the other markets that they are invested in,” says Greg Malone, a principal with Eckler Ltd.

The only pension funds that could have some actual exposure to the subprime mortgage market are larger funds, says Towers Perrin’s Steve Bonnar, a principal with the firm. But he says the typical plan has virtually no exposure to any kind of mortgages, let alone a subset of the mortgage market.

However, a global credit crunch that followed the turmoil in the equity markets did affect the Caisse de dépôt et placement du Québec, which held $1.7 billion in a short-term debt instrument called asset-backed commercial paper(ABCP)at the end of 2006. The lack of liquidity was so bad that the Caisse, along with a number of other financial institutions, helped organize a bailout of the ABCP market.

Still, the market correction wasn’t surprising considering how well stocks have performed over the past few years, says Bonnar. From the beginning of 2003 through June of this year, the compound annual return was more than 20% for the Canadian equity market, he says. “It’s nice when you can get it, but you shouldn’t expect that to continue. At some point you expect some shakeout. Markets are volatile and we’re just seeing that.”

The market volatility isn’t just a problem for defined benefit(DB)plans, but for defined contribution(DC)plans as well. Fixed income investments have also been affected in the wake of the credit crunch and buyers no longer wanted to be at the front of the line to pick up ABCP. Some funds offered by DC plans do have exposure to this type of debt and Malone thinks plan sponsors would be well advised to take a look at the money market and fixed income funds they may be offering and may decide if any changes need to be made.

Even the “safest” of all investment choices is no longer considered safe if it holds non-bank sponsored ABCP. And money market funds are often held by DC plan members. If they don’t make an investment choice, a money market fund was the default option for 40.2% of plans, according to The Canadian Pension Fund Directory’s 2006 Benchmark Report, up from 34.6% in 2005.

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National Bank, Industrial Alliance and Desjardins Group recently announced they would purchase all the ABCP holdings from their subsidiary mutual funds, while Scotiabank, BMO, and TD Bank said their money market funds do not have any exposure to non-bank sponsored ABCP.

While the markets have been tumbling and there has been a lot of panic selling, one plan sponsor—with both a DC and DB plan—who asked not to be identified says plan members have been very coolheaded. “I’m not aware that they have been adversely reacting. To my knowledge, our employees have been very calm and stable about it and nobody has been coming to me.”

For DC plan sponsors, Malone says communication with members is important at times like this. Members should be reminded about the link between their personal risk tolerance and their investment time horizon, and about the effect of dollar cost averaging.

And he recommends DB sponsors should initiate a dialog with their investment managers and consultants regarding their direct and indirect exposure to the subprime crisis. “As always, when reviewing investment strategy, the focus needs to be on the risks. If sponsors have developed strategies to manage or minimize risk, this is an opportune time to see if those strategies are working,” Malone explains. “For those plan sponsors who haven’t evolved their investment and asset allocation strategies amidst a host of investment challenges, the latest events may be impetus to do so.”

Primer on Subprime

What are subprime mortgages?

Subprime mortgages have are given to people with low credit scores. They can vary from interest-only loans for a five- to 10-year period or an initial low fixed rate loan that converts to a variable rate after two to five years. The U.S. federal funds rate jumped from 1.25% in June 2004 to 5.25% in June 2006. Those holding a subprime mortgage experienced a huge increase in mortgage payments and many just couldn’t pay.

Why is this affecting the rest of the market?

A lot of the subprime mortgage debt was repackaged and collateralized and sold to various hedge funds and institutional investors. The problem is they were priced for perfection as if nothing was going to go wrong and the fact is many of these were very risky loans, says Janet Rabovsky, a practice leader, investment consulting at Watson Wyatt.

What is asset-backed commercial paper?

Asset-backed commercial paper(ABCP)is a short-term debt instrument backed by assets, such as car loans and credit-card receivables. It is usually bought by institutional investors and money market funds.

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