Monday, October 16, 2006

DOL Advisory Opinion 2006-08a

The United States Department of Labor has released Advisory Opinion (2006-08A) requested by JPMorgan's Investment Bank. This Advisory Opinion provides defined benefit pension plan fiduciaries with greater clarity on the consideration of liabilities and associated risks as part of prudent investment decision making.

US pension plans have generally managed assets with an eye towards maximizing long term investment returns rather than managing pension surplus volatility. The expressed preference has been to sacrifice funding stability with long term funding minimization. Large equity allocations have been characteristic of US Plans, with an equity allocation averaging around 60%. Changes in the pension environment will stimulate interest in asset liability (surplus) management, as indicated by the JPM opinion (which has not yet been posted to the DOL website).

As Plan's mature and increasingly freeze benefits, the proportion of active participants to retirees and terminated vested employees will decline. As this happens, overall plan liabilities become more predictable and facilitate offset by similar duration fixed income strategies. Equity has also been important as an inflation hedge for future wage increases for plans with large active populations. The need for this protection will diminish as active plan populations decline.

Surplus immunization strategies will never be prominent when Plans are underfunded since sponors would prefer to fund from their assets rather than their pocketbooks. As the PPA 2006 regulations effectively force improved funding, the risks and volatility associated with a large equity exposure designed to improve funded status may begin to outweight the theoretical higher expected returns.

Finally, the convergance of US accounting rules with international accounting standards will limit sponsors appetites for the traditional equity oriented pension portfolio exposure. Financial Reporting Standard 17 issued in November 2000 and implemented in 2003 requires market value accounting and income statement recognition of both assets and liabilities. This had consequences internationally. UK pension funds had historically allocated a high proportion of their assets to equities, relative to the US, Japan and other European countries, with a 71% equity allocation in 2000. However, this allocation fell to 56% as UK pension funds switched assets into fixed income securities according to the FSA.

As the imlicit "costs" of higher expected returning equity- centric pension portfolios grows due to the changing pension climate, asset liability management will likely gain prominence. Asset liability optimization and strategies such as duration matching and portable alpha may over time replace asset only optimization as industry best practice. We suspect 2006-08a is one step in defining practice in this new direction for pension plans.

Interestingly, a large segment of the asset management industry now serving plans has little competency in liability analysis or asset liability management. Because of the entrenched asset only optimization practice and with minimal growth opportunity in the defined benefit plan space, industry wide transition to these new strategies will be slow and primarily deployed by the largest plans.



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