Utility companies are at a crossroads when it comes to managing their pension plans. They must determine the best ways to continue to offer this benefit while controlling the impact these plans have on the overall financial health of the organization.

For years, pension plans have been managed in a financial vacuum, held at arm's length from corporate strategy and finances. For a long time, these plans were safe, predictable, and self-funding.

Over the past five years, poor market performance and declining interest rates have turned pension surpluses into deficits. As a result, rising pension costs continue to be a growing problem for the utility sector, with the negative impacts felt in key areas of corporate finance such as cash flow, profitability, and credit ratings.

Competitive Necessity?

While companies in other industries continue to look for ways to freeze or terminate their defined-benefit plans, the majority of companies in the utility sector remain committed to these plans. This is a reflection of the high value their workforce places on defined-benefit pension plans, thus making it a competitive necessity in attracting and retaining employees.

However, more and more publicly traded utilities are saying that higher pension costs have affected corporate earnings. As organizations experience increased scrutiny from credit and equity analysts, pensions have moved up on the corporate agenda. Boards are becoming more actively involved in pension decisions, and many financial executives spend a considerable amount of time on pension plans-potentially distracting them from other business initiatives.

Further complicating matters is the fact that there are now heightened disclosure requirements. The Financial Accounting Standards Board (FASB) is considering changes to the accounting rules that would eliminate the elements that have allowed companies to artificially smooth over investment gains and losses. Additionally, proposed legislation could reform pension laws and result in increased expenditures for plan sponsors. As a whole, pension plans now are affecting key strategic decisions such as mergers and acquisitions, competitive positioning, and capital expenditures, with the strain on finances limiting the ability of many companies to invest in new initiatives and manage outstanding financial arrangements.

As the financial and strategic risks involved in pension finance grow, many utility companies have continued to manage their pensions in the same way they always have-expecting market conditions to improve and ultimately fix the problem. Now, faced with the reality that the traditional model of relying on strong investment returns isn't a "quick fix" for their current pension woes, many CFOs are realizing that the model needs to change.

The true solution lies in managing risk by trying to control the volatility around the pension plans and the impact the plans have on the sponsoring organizations. The focus on aligning all aspects of the pension plan with overall corporate strategies allows organizations to reduce volatility and risk, and to create clear accountability for pension partners, thus helping to make pension plans a predictable and more affordable benefit.

Why the Traditional Model Fails

The traditional pension management model is not designed to address today's biggest challenges for plan sponsors: volatile and unpredictable contributions. In some cases, this volatility creates uncertainty, which then creates a lack of flexibility in decision making.

The same traditional success metrics no longer can be relied on to relieve these new financial and subsequent operational pressures. Traditionally, common success metrics focused solely on the organization's return vs. peers, and return vs. benchmark. Clearly, these important metrics should continue to be evaluated in any model. However, success based on these metrics alone doesn't control the volatility. How can risk be managed when additional metrics, such as impact of contributions on cash flow and impact of pension expense on operating income, aren't aligned with the traditional metrics?

With responsibilities spread across actuaries, consultants, investment managers, board members, and internal executives, a holistic view of the pension plan becomes difficult. Typically, plan sponsors analyze assumption changes by working with an actuary or investment consultant, creating a very fragmented process. It also can take a lot of time to get output back from the actuary, and even then it's still only one view.

Simply put, the traditional model is fragmented, time-consuming, and ineffective. In the end, the only employee held accountable is the CFO. A fundamental re-engineering of the way pensions are managed is required.

The Future of Pension Management

The future model for managing pensions should aim to manage pension-related risk the same way other financial risks are managed. By adopting a pension-management model aimed more at mitigating pension risk, plan sponsors may be able to control volatility, manage rising pension expenses, assign clear accountability, meet corporate strategies and maintain a healthy pension plan that they control. Based on the emerging issues facing plan sponsors in today's pension environment, four critical considerations can help plan sponsors better align pension strategy with corporate strategy throughout a plan's lifecycle.

Managing Volatility

• Plan volatility can cripple a business if left unchecked. Under the traditional model, plan sponsors are held captive by market fluctuations and inconsistent investment returns. The new approach aligns pension finances with organizational goals, analyzing current and potential market scenarios and the impact these will have on pension plans and financial statements.
• For example, coordination of asset and liability analyses with a focus on funding requirements will lead a cash-flow focused plan sponsor to an asset allocation decision that supports the sponsor's cash-flow view. While other impacts (e.g., accounting expense) should be considered, the sponsor first should focus on the metrics that are most important, without equal weighting to other metrics. This analysis must be conducted on a modified stochastic basis, allowing the user to perform stress testing and "what if" scenarios-a different approach from the traditional "asset/liability study." By making more informed and strategic financial and pension decisions, organizations benefit from increased predictability.

Outsourcing Pension Management

• In the traditional model, plan sponsors remain accountable for all aspects of the pension plan, including full fiduciary responsibility for the selection and oversight of every manager, meeting all compliance standards, and timely and accurate administration. However, because responsibilities vary across a number of different providers, accountability is unbalanced.
• The new approach seeks to share some of the accountability, allowing the plan sponsor to focus on the overall business. This can be accomplished by engaging a co-fiduciary to manage the assets. The co-fiduciary will take responsibility for selection of managers within asset classes and will share equally in responsibility, and liability, for the resulting investment structure, thus creating opportunities for financial executives and board members to leverage their expertise in managing other areas of the pension plan.

Manage Actively, Align Often

• Corporate strategy can change quickly based on market conditions; pension strategy should follow suit. The traditional model often is slow to respond to market scenarios and effect changes to plan management. CFOs no longer can afford to use annual reviews, which are several months out of date, to evaluate the plan and consider changes to plan management.
• The new approach focuses on managing the plan more dynamically. By aligning all components of the plan, plan sponsors can calibrate against market shifts and potential scenarios that affect the plan.
• This analysis requires re-measurement of plan metrics on a current and regular basis; for example, using a quarterly funded status measurement incorporating recent interest rate and liability changes, as well as recent market performance. Doing this regularly, and particularly any time economic measures have changed significantly (, discount rate changes), provides CFOs with the ability to make immediate and timely decisions that may help control volatility.

The New Performance Metrics

Under the current model, rate of return remains the dominant metric, even though the negative impact of pension plans on overall finances has worsened for utility companies. Rate of return no longer can be used as the sole measure of plan success. The new approach aligns additional pension metrics with corporate metrics to help achieve overall plan-sponsor goals.

Consider the pension effect on earnings per share (EPS). The new model would align the EPS goal for the organization with the pension metric that most affects it-in this case the FAS 87 expense. The instrument portfolio would be constructed to meet a plan's fiduciary responsibility while also limiting FAS 87 expense volatility. This is just one example of a goal-setting and measurement process that a plan sponsor could utilize.

As the impact of pension problems reaches deeper into areas of corporate finance, the current model for managing pensions will not meet company or employee needs. Utility companies must be willing to adopt a nontraditional approach to the way they manage their pension plans if they want to secure both the long-term financial health of the organization, and the plan.