Managing Financially Distressed Pension Plans in the Interest of Beneficiaries
Research from Cass Business School offers a new way to value pension plans that takes financial risks into account, helping staff obtain a clearer picture of the security of their promised pension.
How should we value the pension obligation of a corporate defined pension plan in financial distress? This is the question posed by research from Cass Business School, City University London, which offers a new way of valuing pension plans whilst taking into account financial risks.
The plight of US vehicle manufacturer General Motors during 2002 is examined. In a climate of falling stock markets and falling interest rates, here was a company whose pension assets had decreased to $60.9 bn, while its projected benefit pension obligation had increased to $80.1 bn, resulting in a funding ratio of 76%. Employees of the company would have been quite justified in fearing for the security of their promised future pension.
The researchers derive an asset-liability model that simultaneously determines a funding-risk-adjusted discount rate and an asset allocation that is fully consistent with this discount rate. This means that it is possible to determine a value for the pension obligation that is consistent with the asset allocation and hence the risk exposure assumed by the pension fund. This stands in marked contrast with current practice, in which the valuation of liabilities and the investment of pension assets are treated as separate tasks.
Applying this model to the General Motors scenario would have demonstrated that beneficiaries of the General Motors plan should have expected a reduction in their pension wealth in the order of 15-20%.
Professor Blake said "This approach has important advantages for all stakeholders of the corporate pension plan. Staff taking out pensions will have a clearer picture of the true value of their pension promise.
"Our approach also increases transparency for the sponsoring company and - especially - its shareholders who are now better able to plan for future contributions into the pension plan and to value the sponsoring company more accurately. A revision to the accounting standards that report the valuation of corporate defined benefit obligations is a clear policy implication from our analysis."
The research therefore should help staff obtain a clearer picture of the true value of their pension promise. It should also be of interest to regulators.
The full research paper will be published in The Journal of Risk and Insurance. A draft version of the paper is available for download below.