retirement

Pension plans have risks, too

Wednesday, March 24
Posted 2 p.m. Eastern

If only you had a defined benefit plan -- otherwise known as an old-fashioned pension plan -- you'd have it made. After all, employers or governments that offer pensions assume all the risks.

Instead, unless you work somewhere that still offers these old timey plans, you probably have a defined contribution plan such as a 401(k) or 403(b). If that's the case, you shoulder all the risks.

Risks that pensions face

But pensions are under a lot of pressure, too. AON Consulting recently released its Pension Risk Management Global Survey which details the risks pension plans face. These are the main ones:
  • Interest rate risk.
  • Longevity risk.
  • Equity market risk.
  • Inflation risk.

Of these risks, the respondents to the survey (41 companies from the financial services industry) identified longevity and equity market risk as the two most difficult to remove. That's odd -- we can't seem to get rid of these risks either! These risks as well as interest rate risk are considered the most significant ones confronted by pension plans globally.

Advantages of pensions

So what kinds of tools can pension plans use to mitigate these risks? To manage equity risk, they can avail themselves of diversified funds of alternatives, portable alpha funds, real estate funds, neutral hedge funds, put options on the market, collar strategies, infrastructure funds and managed futures, to name a few.

To manage interest rate risk, pensions have at their disposal long duration credit bonds, long duration government bonds, interest rate swaps, total return swaps and interest rate futures. And they've got some fancy stuff they can use to manage longevity and inflation risks, too.

See any of these options in your 401(k) plan? Me neither.

The biggest risk

The main problem confronting pensions is funding shortfalls. Hmm. We have that problem, too.

Corporate pensions in particular are suffering because they'd reduced their equity exposure in recent months to 38 percent of portfolio holdings in response to market volatility. This compares to 57 percent equity exposure in public pension plans, according to a recent article in Plansponsor.com.

As a result, last year when the market took off, company pensions didn't rebound as much as public pensions. Beth Almeida, executive director of the National Institute on Retirement Security, says the Pension Protection Act of 2006 causes employers to be more risk averse. They have to account for their plans' assets and liabilities on company financial statements. That means these fluctuations might make their balance sheets look bad when they report their quarterly numbers to shareholders. Public pensions don't have these accounting concerns.

But public plans are also vulnerable to funding shortfalls. A recent study by the Pew Charitable Trusts reveals that state pensions face a $1 trillion shortfall in retiree benefits. Some people believe this is an understatement.

Plansponsor.com today reports on a new study from Greenwich Associates that reveals the average solvency ratio for state funds declined to 80 percent in 2009 from 84 percent in 2008. For corporate pensions, funding ratios fell to 80 percent in 2009 from 101 percent in 2008. Translation: There's not enough money to back up their pension promises.

Individuals lack a backup plan

Pension plans may have it tough, but 401(k) type plans have it much worse. The crux of the matter is this: If public pension plans fail, taxpayers can always bail them out. And if companies that offer private pensions get into financial trouble, the Pension Benefit Guaranty Corporation can step in to make good on their pension promises.

But if workers' retirement plans fail due to poor risk management or funding shortfalls, well, we have to come up with our own Plan B.

(On a related topic, read Bankrate's story about making the pension decision. It's a must-read for people who have hybrid pensions or cash-balance plans. This story explores the pros and cons of taking a lump sum versus getting monthly annuity payments. The decision is another one fraught with risks.)

Questions? Comments? E-mail boomerbucks@bankrate.com.

Read more Boomer Bucks blogs.

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