Pension sponsors are spending a lot of money on underfunded pension plans. It’s a painful process and a pressing concern as both public and corporate pensions face increasing public and regulatory scrutiny.

Volatility in the funding status of corporate pension plans is a distraction from core business efforts. This distraction likely will intensify if the rules of the U.S.-based Financial Accounting Standards Board converge with those of the International Accounting Standards Board, thereby requiring pension gains and losses to be recognized in profit-and-loss statements by 2013. Although public pensions are not subject to corporate accounting standards, they do face increased scrutiny in the media and in capital markets for their unfunded liabilities and return assumptions.

The changing pension environment accentuates the importance of funding ratios. One way pension fiduciaries are managing these changes is by devising glidepath strategies. Simply put, they are figuring out how much money they need to put aside every year to close funding gaps while gradually derisking the pension plan in an attempt to reduce funding volatility. When a plan is underfunded and there is time, pension plans can afford to be more aggressive. As the plan gets closer to being fully funded, pension fiduciaries are considering less risky asset allocations.

The Role of Alternatives

If only it were that simple. The losses endured by many institutional investors in 2008 were a painful reminder that the path to full funding is not a smooth one. Pursuing high returns can result in uncomfortable volatility and, if compounded by less-than-optimal diversification, pension funding volatility increases while funding ratios drop.

The potential for alternative investments such as commodities, real estate and hedge funds to help decrease funding volatility and diversify plan assets — while seeking to close the funding gap — has made them increasingly interesting to pension plans.

Here’s the rub. Investing in “complex,” “risky” or “hard-to-value” alternative investments can overstretch the knowledge and resources of even experienced fiduciaries. For pension fiduciaries — who are typically appointed because of their positions of corporate authority or as labor representatives — a lack of familiarity or comfort with nontraditional investments can result in underexposure. Fiduciaries might think they are protecting themselves and the pension plan by not considering alternative investments, but they may be doing a disservice to the beneficiaries.

Status Quo Not an Option

Under the Employee Retirement Income Security Act (ERISA), corporate fiduciaries are held accountable for errors of both commission and omission and are responsible for advancing the interests of pension beneficiaries. Diversification is a critical fiduciary objective under ERISA and an important reason for considering nontraditional investments for your plan.

Evaluating a variety of diversifying strategies, including alternative investments, is an important part of a fiduciary’s role. As the pressure to improve funding of pension liabilities continues to grow, ever more information about alternative investments is available through conferences, publications and courses. Another option for small and midsize plans is to outsource these responsibilities to more seasoned teams.

The clock is ticking. As pension plan fiduciaries evaluate different glidepaths to full funding, they cannot use a lack of education or experience as a defense against not fulfilling their fiduciary responsibilities and considering the full range of diversifying strategies. Ignorance is no excuse.

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