Risk and Return Objectives and Constraints in Defined Benefit Pension Funds
In the realm of pension funds, particularly defined benefit (DB) plans, the primary objective is to ensure pension benefits are reliable and secure for plan participants. This involves managing risk and return objectives under strict constraints. Let's delve into the complexities and challenges associated with DB pension funds.
Introduction to Risk, Return Objectives, and Constraints
All pension funds, including DB plans, are designed to manage risk and achieve a moderate return, tailored to the specific needs of the beneficiaries. These returns are calculated to cover the costs associated with paying out pension benefits when due. Typically, long-term returns projected to be 8% are no longer considered realistic due to various economic factors and changing market conditions. Historical figures, such as those noted by Andrew Carnegie, may not reflect today's modern investment realities.
The Fallacy of 8% Long-Term Returns
Long-term return targets of 8% have been a prevalent assumption in the past, but recent economic events and changing market dynamics make this projection unrealistic. Andrew Carnegie's request for a payment in specific 5 notes exemplifies a time when individuals and institutions had specific, albeit conservative, financial expectations. However, modern banks and investors focus on longer-term money costs and prime rates, which can fluctuate and are not as predetermined.
The Risk of Shortfall
When a pension fund cannot achieve the required returns, it can result in a shortfall — a critical issue that can arise from several factors, including underfunding, promises of high benefits during labor negotiations, or below-target bond market returns. For instance, if a fund was projected to achieve an 8% return but the actual return was considerably lower, a shortfall would occur, leading to insufficient funds to cover the promised benefits.
Constraints in Defined Benefit Pension Plans
Defined benefit pension plans, while valuable, are constrained by several factors. After the Financial Accounting Standards Board (FASB) mandated that corporations disclose the liabilities of pension plans on balance sheets, many of these plans have been eliminated, frozen, curtailed, or converted into other forms. Moreover, for mature employers with a significant number of vested retirees or employees close to retirement, maintaining long-term funding can be challenging, especially when compared to the number of younger employees.
Risk/Return Side: High Rate Assumptions and the 2008 Financial Crisis
Many defined benefit plans have had or still have high rate of return assumptions, which proved challenging during the 2008 financial crisis. The global financial calamity of 2008 was particularly devastating, with many pension plans experiencing significant losses. For example, a pension plan with $100 million in mid-2007 might have dropped to $70 million by early 2008. Assuming annual costs of $10 million to cover benefits and administration, the return needed to cover payouts would be significantly higher during this period.
At a $100 million asset value, the plan needed to earn 10% to cover payouts. But, at a $70 million asset value, the plan needed to earn more than 14% just to cover payouts. These figures often exceed typical annual return rates, necessitating increased contributions or further declines in fund asset values to avoid a shortfall.
Recent examples of significant contributions to pension funds have been observed, but many have fallen into weak positions and started eliminating defined benefit plans. Alternatively, reducing future benefits is an option, though this measure is typically applicable only to newer active employees, who are less likely to have vested benefits.
Revised Rate of Return Assumptions
Many plans have revised their rate of return assumptions, particularly in light of the financial crisis. A decade ago, assumed rates of return of 8% were common, but many plans now aim for below 8% or even 7%. While this reduction in return assumptions is prudent for the long term, it increases projected liabilities. This creates a Catch-22 situation for pension fund managers.
Conclusion
Managing risk and achieving a balanced return in defined benefit pension funds is fraught with challenges. Faced with changing market conditions, regulatory requirements, and the realities of modern financial markets, pension fund managers must navigate a delicate balance. The key to maintaining stability and long-term sustainability lies in astute risk management, realistic return assumptions, and proactive planning.