Edhec-Risk
Features
Institutional Investment - March 23, 2011

The Elephant in the Room: Accounting and Sponsor Risks in Corporate Pension Plans

As part of the AXA Investment Managers research chair on regulation and institutional investment, EDHEC surveyed corporate pension funds, their sponsors, and advisers to assess how sponsors manage pension risk and how pension funds manage sponsor risk. There are 100 respondents to the survey; they manage pension funds assets of more than Ä730 billion (the assets of sponsoring companies are greater than Ä5.5 trillion).

Sponsors that give their employees pension plans are subject to the risk of having to make additional contributions to make up for shortfalls in pension funds as well as to a more specific accounting risk that arises because of the arbitrary accounting assumptions that differ from those typical of financial economics. In a traditional defined-benefit (DB) pension plan, all of the financial and biometric risks in pension funds are borne by the sponsor (unless it goes bankrupt). Plan assets, however, are managed independently from the sponsor by pension trustees, and the separation of powers prevents trustees from managing these assets in the best interest of the sponsor, which can find it difficult to hedge pension risks in its own balance sheet. It is because of this separation of powers that many sponsors fail to manage pension risks at all; it also contributes to the termination of many traditional defined-benefit plans. Pension plans are subject to the risk of the guarantee from their sponsor disappearing when the sponsor goes bankrupt or is in distress. In most countries, this risk is covered only partly by pension insurance, but the levy charged by the pension insurance scheme would not be reduced if pension funds hedged this risk themselves, in which case the pension fund would in effect pay twice the cost of protection.

Dutch regulation has relied solely on strong funding requirements to protect pension benefits, and only recently has it become clear that this regulation offered only partial protection. In most countries, the risk of either a bankrupt sponsorís leaving an underfunded pension plan or a financially weak sponsorís leading to pension curtailments means that pension funds should hedge the risk of deterioration of the health of the sponsor. Such a hedge, however, is seldom considered by respondents, most frequently because it would be seen as an aggressive move by the sponsor. We argue, however, that the sponsor can also benefit from such a hedge if its contributions are reduced when its health is weaker.


URL for this document:
http://www.edhec-risk.com/features/RISKArticle.2011-03-23.1529

Hyperlinks in this document: