Mercer Human Resource Consulting and Mercer Investment Consulting recently met with directors of research and portfolio managers at nine major investment management companies about their approach to analyzing pension finance issues. Together the nine companies manage assets in excess of $1.6 trillion, across the spectrum of growth and value, and large- and small-cap investment styles.
The managers are divided in their thinking about pension finance issues - including whether they have been over- or understated by the news media - and these differences are reflected in the degree to which the managers take pension financial information into account in valuing a firm and its prospective earnings. One point on which they agree, however, is that the issues warrant close monitoring.
"Institutional investors are following the pension funding issue closely, focusing their greatest attention on the discount rate used to value liabilities and the expected return on assets," says Barry McInerney, US leader of Mercer Investment Consulting. "Public companies should be prepared to defend assumptions that are not in-line with general capital market assumptions or with its industry''s norms."
Even deeper scrutiny could be on the horizon. Leading-dge academic research recommends that analysts assess the appropriateness of pension plan asset allocation strategies when valuing a firm and its prospective earnings.
"Companies that make pension financial information easily accessible will win points from buy-side analysts and investors," says Asghar Alam, US retirement practice leader of Mercer Human Resource Consulting. "Providing only the minimum required disclosure may cost a firm credibility with analysts."
Key findings
Mercer''s discussions with the nine money managers yielded the following insights.
Question: Do your analysts consider pension-related financial information in your earnings valuation methodology, and has that changed in the past two years?
Whereas most firms did not focus on the issue as recently as two years ago, seven of the nine firms interviewed now explicitly incorporate pension-related financial information in their valuations. All of the firms agree that the issue has gained a significantly higher profile in their research process.
Question: Do you use reported pension surplus or deficit as an adjustment to firm value, or do you actively develop your own forecasts of pension-related financials?
The nine managers are about evenly split; five adjust firm value for a pension surplus or deficit, while four do not. Of the firms that do make adjustments, three do their own forecasts of pension surplus and funding requirements, two in considerable detail.
Many of the firms check discount rates and expected return on asset assumptions, and penalize those companies with assumptions they consider out of line. This happens most often with "overstated" rate-of-return assumptions.
Question: Did you discount reported pension income in your earnings forecasts during the years of pension surplus?
Three of the firms said they did discount reported pension income in earnings forecasts, while five did not. Of the five that did not, several cited their focus on cash-flow and operating earnings, rather than on net income, as the reason.
Question: Does current equity market pricing reflect your views on how pensions should be considered in firm valuations?
Six firms believe current equity market pricing does not appropriately reflect pension financial issues. Most said they feel that the market is not trading on fundamentals, while two others believe investors are not dealing with the pension funding issue.
Question: Has the press overstated or understated the problem?
The nine money managers are evenly split on this question, with four feeling it is overstated and four feeling it is understated by the news media. The four that feel the press has underplayed the issue also feel the issue is not well understood, and that it is often lumped together with two other issues, "creative" accounting and options expensing.
Several firms mentioned the funding of post-retirement health care coverage as an even larger issue that has received even less exposure in the press.
Question: What are the implications if the US adopts a "mark-to-market" approach as has been done in the UK with FRS17? Six of the firms surveyed said they would welcome the increased transparency, and that they believe it would have a positive impact on long-term development. Some, however, felt there could be negative short-term implications depending on how it is implemented. Two firms said it would be negative from a capital markets perspective.
The identities of the nine investment management companies will remain confidential.