Understanding the Risk in Pensions - Financial Analysis

Implications: 1.  The market is grasping a fundamental risk in defined benefit plans.  That risk is in matching the duration of the pension fund's assets and liabilities (i.e.,  immunizing the pension fund).

2.  Accountants need to recognize this asset-liability risk and disclose it.

Analysis: We often forget that pension funds are financial intermediaries.  These funds have liabilities that must be paid with assets.  As with any financial intermediary, a pension fund's asset-liability management is a critical element of the fund's ultimate success or failure.

When financial analysts look at an organization that sponsors a defined benefit pension plan, they must realize that the organization has an imbedded financial intermediary via its pension plan.  The value of the sponsoring organization is directly affected by the success or failure of the pension fund's asset-liability management (i.e., risk versus return).

What we are seeing in the market is simple.  Pension funds are worrying more about matching the duration of its assets and liabilities (i.e., addressing the fund's interest rate risk).  Although we cannot directly see it, I would expect funds are using the noted Treasury instruments to immunize their balance sheets.  This leads me to my final point.

The accounting world must appreciate that pension funds are an imbedded financial intermediary, to its sponsoring organization.  To assess the risk of a sponsoring organization, a financial analysts must understand the imbedded risks in its pension funds.  Accountants must begin to disclose the details (e.g., nature, duration, etc.) of the pension fund's assets and liabilities.  Although not the same in detail, economically pension funds are similar to special purpose entities.