Erosion of DB plans overstated: Fidelity

Despite dire warnings in the headlines of the end of defined benefit plans in the U.S., a recent survey by Pyramis Global Advisors, the institutional money management arm of Fidelity Investments, finds rumours of their demise to be a bit premature.

Most U.S. plan sponsors say they are committed to keeping their plans open to existing employees and have no intention of freezing their plans, despite running into one of the toughest operating environments in recent memory. Last year, pension funds were buffeted from all sides by government regulations and accounting changes.

For instance, 2006 saw the introduction of the Pension Protection Act, which increased DB funding requirements; new accounting rules brought in with the Financial Accounting Standards Board, which force corporate DB plans to recognize pensions as an asset or liability on their balance sheets; and the new rules from the Government Accounting Standards Board, which affect public plans.

Public plans are the most committed to DB plans, with 98% reporting that they have no intention of closing to new employees or freezing their fund benefits for current employees. Corporations were less committed, but three-quarters of the plans responding to Pyramis said they don’t foresee making any changes to their plans. Over the next year, that number is expected to slip, but a strong majority of plans don’t expect to close or freeze their plans within the next three years.

“I can say with high confidence that in ’07 we will continue to hear about, perhaps even some high-profile plans, descending to freeze,” says Peter Chiappinelli, senior vice-president of strategic services for Pyramis Global Advisors. But he notes that there will be many other plans that will stay the course.

For the first time in five years, public DB plans invested in more international equities than corporate DB plans, which have been beefing up their holdings in more stable asset classes like fixed income. The fears of the two types of plans are also quite different. While public plans are worried about how they are going to meet their plan requirements in a low-return environment, corporate plans, regardless of their size, are worried about the volatility their plans might have on their balance sheets.

As Chiappinelli explains, in some cases the plans are bigger now than the sponsoring organization. To illustrate, he says he’s heard tales of companies having to choose between funding a plan and building a new factory.

Although the pressures on corporate and public DB plans are different, they have one thing in common: both face a significant return gap and are struggling to find a solution.

“In the face of new regulatory pressures, many plans were forced to re-examine their investment approaches,” says Chiappinelli. “The concerns identified in this survey show a marked shift in attitudes toward any investment strategy that can reduce volatility or improve returns.”

As a result, plans are loosening traditional constraints in the hope of breaking free from the low-return environment. Shorting is one area pension fund managers say they will explore. Forty per cent of plans believe modest shorting will see meaningful increases in alpha and believe it will work well in the U.S. large cap space, while 16% disagree with those statements. Almost 30% of plans are also looking at allowing managers “free to roam” mandates to search for alpha.

The new 130/30 approach is also gaining traction among plans. The 130/30 approach is based on the notion that “Sell” ratings are not reflected in the long-only world. Put simply, Chiappinelli explains, companies with a “Sell” recommendation are simply not held by a plan. The 130/30 approach would allow a manager to fully implement his or her views by shorting up to 30% of the money invested in a plan and reinvesting the proceeds.

Slightly more than half of all plans are seriously considering this approach and another 7% are already using or expanding their use of 130/30. About three-quarters of large plans in the U.S. are also giving serious thought to the 130/30 approach.

This strong sentiment, however, has not carried over to hedge funds. Most DB plans continue to be cautious when it comes to allocating funds to these investment structures. Four out of five plans have no exposure to hedge funds; those that do have limited their allocation to between 5% and 7%. And of those plans that do hold them, two-thirds say they have no intention of increasing their holdings.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com