What is somewhat puzzling now is that the position of pension plans has not improved. The problem, however, is that interest rates have not gone up over the last four or five years. When the storm started, low interest rates were seen through the same prism as the market—over time they would surely recover.
NEW REALITY
How, then, will pension plans deal with this new reality? In my view, the new realities require pension plan sponsors and members to more clearly and carefully address the concept of risk. In the past, sponsors and members were led to believe in the magic of the market. When viewed from this perspective, the belief was that over time the market would always do well. So well that asset appreciation would inevitably be enough to both ensure and improve benefit levels.
In a relatively high interest rate environment, this type of thinking led away from the concept of managing risk. The notion appeared to become one of absolute faith that the equity markets would deliver the promise in an almost automatic fashion.
Another surprising feature is that investment managers often invested without any sense of what the liabilities of a particular pension plan were. To be sure, investment managers operated within the confines of a plan’s Statement of Investment Policies and Procedures, but how many had a clear understanding of what the promised benefits were and whether the investment mix was appropriate for that purpose?
We can now see interest rates—not equity returns—appear to be the most important variable in the pension equation. The fact that pension plans continue to labour suggests that plans lost sight of the importance of managing this variable. Pension plans are, of course, responding to the new environment. Talk of asset and liability matching was almost unheard of when the perfect storm began. Now it is becoming a more and more dominant theme.
Living with the new normal will require careful thinking by plan sponsors. What is the best way to manage low interest rates? Should plans seek higher rewards? If they do, it would seem axiomatic that this will mean a plan taking on higher risk.
A final concern for plan sponsors is this: plan members look to the plan to provide the benefit that was promised. To the extent that plan sponsors fail to provide what was promised, the more likely it is that plan members will pursue a legal remedy to protect their benefits.
Some sponsors may be left to defend their positions by saying that they were the victims of an unforeseen event(low interest rates)or that they felt that they were secure because they abided by the then-prevailing orthodoxy. Against this will lie the argument that sponsors will be seen to have failed to take account of liabilities when they made their investment decisions.
These arguments will lead to a critical analysis of how advisers performed their functions and in whose interest they were acting. From a legal point of view, the future course of litigation in this area will be interesting to follow. In the meantime, sponsors need to carefully address the issue of risk.
For a PDF version of this article, click here.
