Shifting the burden of risk

Publicly traded companies more likely to take risks with employee pension plans.

By Hanit Kaur

New research from the Beedie School of Business predicts that corporate pension plans of public companies could be altered in future to place the risk of protecting pension investment on the employee – meaning employees may soon need to become finance experts in order to prepare for their retirement.

The research, carried out by Beedie School of Business associate professors of finance Christina Atanasova and Evan Gatev, is the first ever study on pension funds to focus specifically on the key disparities between the investment decisions made by publicly traded companies and private ones. It was published in the April 2013 issue of Journal of Pension Economics and Finance.

The researchers warn that employees of publicly traded companies that offer Defined Benefit (DB) pension plans are more at risk of being moved to an alternate plan like Defined Contribution (DC) than their counterparts in private companies.

The study argues that publicly traded companies often take higher risks to bridge the liability gap of these funds and put the old-age financial security of its employees at peril. Conversely, private companies that offer similar plans take a more conservative approach in managing these pension funds.

It notes that a pension fund‘s appetite for risk taking depends primarily on the changes in the funding status and the employer’s contribution toward the assets. The magnitude of risk-taking is significantly higher in publicly traded firms than privately held funds.

There are nearly 14,000 employer-sponsored pension funds in Canada and almost 80% of members of these plans are covered under DB plans. As Atanasova points out, this study becomes all the more vital in Canadian perspective, with almost 90% of businesses in the country privately owned. “These are the businesses that drive growth, so it is really important to understand how they make decisions,” she says.

Under the DB plans, the employers have to set up assets in trusts to be able to fulfill the guarantee (the pension liability). The sponsoring companies invest the pension funds in assets with different risk and rate of return such as safer bonds and riskier equities, real estate and hedge funds. Funding or the funded status of a DB pension plan is a measure of assets that a company sets aside to pay its pension beneficiaries.

Accounting rules require that any deficit (the gap between pension assets and liabilities) from the plan is included in the sponsoring firm’s income statement.

Atanasova says since liabilities from a pension fund can sometimes comprise a huge proportion, pension managers at publicly traded companies are concerned with any deficit from the plan reflect on the income statement. This would be interpreted negatively by shareholders and credit rating agencies, and lead to the share prices plummeting, which in turn would impact managers’ compensation.

“All these things are creating incentives for pension managers to seek higher returns to cover the funding deficit by investing more and more funds in riskier assets,” says Atanasova.

Besides personal incentives for pension managers, the governance structure of pension plans also perpetuates speculative investment strategies.

In terms of investment strategies, big companies suffer from familiarity bias, on which Atanasova has also conducted a study. She argues that corporate-sponsored research and development-intensity, and land and buildings-intensity increase DB pension plan investment in private equity and real estate and mortgages, respectively. Pension plans, however, should optimally underweight assets correlated with their sponsor corporate assets. To over-weight such assets is analogous to individuals investing in the stock of their own employer. The performance of pension plans with portfolio tilts significantly lags the performance of the average plan, creating risk for their pension beneficiaries.

The study further notes that since private companies are much smaller in size they are more concerned with cash management, and therefore adopt less risky strategies in order to keep pension funds in order rather than risking insolvency. This incentive is even stronger for firms where managers have substantial ownership stake, because a low-risk pension plan can lower the total risk exposure of owner-managers who are not well diversified.

The parameters of the study are more unique as they examine pension plans’ total risk taking as opposed to the conventional approach of comparing returns to average benchmarks of investment classed. This approach paved the way for examining the disparity in risk taking.

“With these parameters we took a hard look at risk dispersion at over a period of time and how big the spikes are in downturns and upward swings,” Atanasova says, adding the study found the investment returns on pension funds of private companies had much less volatility.

The research observed a data of almost 21,000 DB U.S. corporate pension plans. Atanasova says she had to rely on American data due to the way pension funds are regulated in Canada.

According to a Bank of Canada paper, pension funds are variedly regulated at federal or provincial levels depending upon the jurisdiction of their business area. The companies are required to file an actuarial report at least once in three years as opposed to mandatory annual filing in the U.S.

“With actuarial valuations filed only once in 3 years there is a lag in data,” Atanasova notes, adding different laws make it difficult to make a generalized comparison. However, she insists these findings are very relevant in Canada.

Besides Canada, the study has generated a lot of interest in the UK and Cypress (where Atanasova has presented her findings) with both countries dealing with the effects of the 2008 financial crisis on their pension systems.

“I think in the coming future we will see a lot of these corporate pension plans being frozen or altogether shifted to Defined Contribution where risk of protecting pension investment shifts to employees,” Atanasova predicts.

She also anticipates major reforms in terms of transparency and accounting for Canadian pension plans. She notes that ideally the private sector would step up and provide sustainable retirement compensation schemes instead of shifting responsibility to their employees or the government.

Defined Benefit and Defined Contribution pension plans.

Defined Benefit: the employer sponsoring the plans guarantees the employees a fixed amount of pension benefit based on their salaries (when they retire), age and number of years with the company.

Defined Contribution: has a fixed contribution usually based as a percentage of the employees salary (usually employer matched). Retirement income is entirely dependent on how the portfolio/market performs over the vested period – so an employee who has no interest in finances needs to be actively involved.