Enterprise Pension Risk Assessing Corporate Risk Profiles When Setting Long-Term Pension Strategies

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1 Enterprise Pension Risk Assessing Corporate Risk Profiles When Setting Long-Term Pension Strategies As many corporations try to determine the appropriate level of risk in their pension portfolios given the characteristics of their pension liabilities, the reality is that the ability to manage this risk and the resulting volatility will vary by organization. For companies with high degrees of capital liquidity, stable cash flows and modest-sized pension plans relative to the overall balance sheet and market capitalization, higher allocations to equities may be not only acceptable but appropriate. Companies that are capital-constrained, with volatile revenue streams, high fixed costs and large pension plans, are likely to be more severely impacted by volatile pension assets, and might want to consider increased fixed income-oriented portfolio allocations. The intention of most pension plan sponsors is to have a systematic pension-portfolio strategy that matches the organization s risk tolerance and ability to both support annual cash contributions and manage swings in balance-sheet values. If that were the case, one would assume there would be consistencies among asset allocations for organizations with similar financial risk metrics such as fiveyear Beta, free cash flows, debt leverage, pension assets to total corporate assets or credit ratings. However, in reviewing the asset allocations of more than 1,200 public companies with pension assets over $10 million, the data show no such consistencies (details can be found in Appendix I). One example is the fixed income allocations based on credit ratings. The chart below shows the allocations barely change regardless of credit rating, yet a company rated A or higher will most likely have a significantly different risk profile than a B-rated company. Fixed Income Allocation by Credit Rating Source: Standard and Poor s, Capital IQ Despite the lessons of the past decade, as well as the increasingly sophisticated risk management tools in place today, there is little evidence to show that corporate pension plan sponsors have moved away from standard asset allocations to more customized allocations that consider the organization s unique risk profile SEI 1

2 Which corporate risks should be evaluated when determining asset allocation? Rather than implement what would be considered a standard pension asset allocation, companies need to better tailor their investment strategies to their ability to manage plan asset volatility and fund unexpected contribution demands. The first step is to evaluate three critical risk areas operational, financial and pension investments. 1. Operational risk can be evaluated through multiple approaches, but at a high level the focus should be on the stability and visibility of free cash flows and the risks and key drivers associated with top line performance. 2. Financial risk is measured by liquidity, defined by surplus cash and available credit, tenor and covenants associated with existing debt structure, refinance risk and potential contingent liabilities. 3. Pension risk is a function of the size of the pension assets and liabilities relative to the corporate sponsor, measured by multiple metrics including: Pension Assets/Market Capitalization Pension Assets/Adjusted Corporate Assets Pension Assets/Book Value Unfunded Pension Obligation/Adjusted Balance Sheet Liabilities 1 Pension Expense/Corporate Income Thresholds of risk tolerance will vary significantly by industry and corporate circumstances. For example, a high margin, low capital expenditure branded food manufacturer, with highly stable cash flows and low leverage, will have a high degree of tolerance for variability of even a large pool of pension assets, and in economic and market downturns will be minimally impacted by increases in required contributions. Conversely, a thin margin industrial distributor, with performance closely tied to the macroeconomic business cycle, will potentially be severely impacted by unexpected pension funding requirements. The company could face potential market and lender consequences from a compressed book equity value, at the same time its available capital is most constrained by financial performance. Why financial modeling needs to be expanded as part of this process When it comes to pension investments, most plan sponsors already utilize sophisticated financial models that use capital markets assumptions to develop a range of expected outcomes based on projected asset returns and volatility, and correlations between asset classes. The outputs allow plan sponsors to make intelligent decisions regarding the trade-offs associated with various pension asset allocation options. However, what tends to be missing from this process is a crucial element determining the impact of these same capital market assumptions on corporate financial performance and the resulting ability of the plan sponsor to meet the financial demands of the pension plan. 1 In order to appropriately measure a pension plan s impact on the balance sheet, the GAAP statements need to be adjusted by adding the full value of the pension assets and pension liabilities to the balance sheet, rather than the net funding gap or surplus SEI 2

3 Organizations can significantly benefit from a careful analysis of corporate historical data, which can establish appropriate correlations between the drivers of pension asset and liability changes - market returns and interest rates - and the drivers of corporate financial performance. Using these historical relationships and additional multivariate financial drivers, organizations can project performance scenarios for both the pension (assets and liabilities) and corporate financials, under matching economic environments. The ability to stress test the pension portfolio alongside corporate financials provides a dynamic view of how pension volatility and corporate performance interact. The benefits include a thorough understanding of the downside risk associated with pension allocation alternatives in the context of a corporation s balance sheet, income statement and cash flows. What plan sponsors should seek to avoid, in the pursuit of pension plan returns, is to take on an unacceptable level of pension risk that could financially constrain the corporation in the face of a market downturn. In pursuit of an additional basis points in annual returns, plan sponsors can often find themselves required to contribute a significant portion of their available cash flows to the pension plan, at times of declining earnings, due to market losses in the pension portfolio. This approach is illustrated below by modeling two pension allocation alternatives for XYZ Company, a large integrated metals company. It has a large pension plan, and its core business is highly correlated to market indices. Rather than evaluate the trade-offs associated with varying asset allocations based exclusively on return and variance within the pension plan itself, corporate performance over this same time period is modeled as well. Overlaying the results identifies potential stress points and crystallizes the corporate risk posed by aggressive pension investment approaches in certain poor performance scenarios. In the downside scenarios for this particular organization, an overweight to equities could cause the pension to consume significant operating cash flows, at a time of financial stress and limited access to capital. Knowing this, the organization could look at modifying the portfolio through fixed income options to better match assets and liabilities and ultimately cushion risks posed by the pension plan, without significantly changing projected mid-point funding levels. XYZ Company Current Three-Year Corporate and Market Performance Mid-point Performance Projection Downside Scenario S&P Return (CAGR) 8.0% -10.0% Revenue $1,294.9 $1,590.8 $1,014.9 Revenue Growth (CAGR) 7.6% -9.2% EBITDA $257.4 $292.3 $ SEI 3

4 Corporate & Pension Model Projection Pension Allocation Pension Metrics XYZ Company Current Overweight Equity Portfolio Mid-point Performance Projection Downside Scenario Modified Portfolio Mid-point Performance Projection Downside Scenario Pension Assets/Adj. Corporate Assets 16.2% 17.8% 14.4% 17.2% 17.9% Pension Assets/Book Value 92.2% 51.7% 56.5% 60.9% 70.5% PBO/Adjusted Balance Sheet Liabilities 26.1% 32.1% 24.9% 33.4% 33.4% Pension Expense/Corporate Income 25.1% 7.0% 78.3% 8.8% 47.4% Contributions/Operating Cash Flows (3 years) 19.7% 90.2% 7.1% 64.6% Funded Status 75.1% 84.9% 57.7% 81.8% 72.0% Funding Gap (Surplus) $90.2 $57.0 $169.0 $68.9 $111.9 Leverage Metrics Debt/EBITDA 2.4X 0.4X 2.4X 0.4X 2.4X Unfunded PBO/EBITDA 0.4X 0.2X 1.3X 0.2X 0.4X Debt + Unfunded PBO/EBITDA 2.8X 0.6X 3.7X 0.7X 2.7X Conclusion The above is just one example of how this type of analysis can provide a much greater benefit to establishing long-term pension strategies. The recent increase in plan asset values caused by a rebounding stock market and significantly increased contributions, combined with improved corporate performance, rising cash balances and access to inexpensive debt provides plan sponsors an opportune time to review their strategies. Corporate managers need to use the events over the last ten years as a basis for reassessing their asset allocation strategies. Only by carefully evaluating the variability of pension investment strategies in tandem with the potential variations in sponsor corporate performance, can plan sponsors identify their tolerance for risk. This approach will lead to a more tailored pension investment strategy for the corporation s specific financial circumstances. This information is for educational purposes only. Not intended to be investment, legal and/or tax advice. Please consult your financial/tax advisor for more information. Information provided by SEI Investments Management Corp., a wholly owned subsidiary of SEI Investments Company. SEI SEI 4

5 APPENDIX I The research below was completed by SEI Institutional Group in July 2012 and studied asset allocations of pension plans for more than 1,200 public companies. All organizations had pension assets of at least $10 million and the numbers were from fiscal year The charts below show a sampling of results using a random selection of 250 of those companies in each chart. The intention is to illustrate the lack of correlation between the two factors in each chart. 5-Year Beta Beta is defined as the correlation of specific corporate plan equity performance with the overall market. Companies with higher Betas might want to consider somewhat lower equity allocations, as their overall risk factors are likely to be more heavily impacted by a downward movement in the market. These companies could be faced with the need to make additional contributions to their pension plans at a time they could be most challenged to do so. Free cash flows (Operating cash flow CAPEX/revenues) Companies with high free cash flows have greater flexibility to make additional contributions to their pension plans if they become underfunded due to adverse market conditions SEI 5

6 Debt Leverage (Net Debt/EBITDA) Highly leveraged companies are typically more challenged in making up pension shortfalls without constraining other strategic uses of capital. A company with limited available cash and access to credit should have a more strategic allocation to avoid unexpected new capital claims. Pension Assets/Total Corporate Assets & Pension Assets/Market Capitalization A company with a larger pension plan relative to its corporate balance sheet and its market cap will have a lower tolerance for variability of pension assets, as the impact on the overall capital structure and valuation will be significant SEI 6