Balancing Act
Managing financial risk – strategies and implementation

By Zainul Ali, senior asset consultant, Towers Perrin HR Services

Few would debate that defined benefit (DB) pension plans are becoming more significant relative to their sponsoring organizations’ core business operations. Yet plan sponsors are only slowly moving towards assessing their DB plans in a total enterprise risk context and away from the isolated and parochial view that is mostly the practice today.

Like any subsidiary, a pension plan should be managed in a way that reflects the impact on the financial measurements that matter most to the sponsoring organization. Investment policy, which guides the decision on how to invest the capital set aside to support pension obligations, is one of four policy areas available to a sponsor to manage the cost of its retirement program. The others are benefit policy, funding policy and accounting policy, and all four are so connected that changing any one policy will likely affect the others. Understanding how investment policy interacts with key corporate financial metrics is critical in the development of effective investment and risk management strategies.

What to hedge?
Liability-driven investing (LDI), although not a new concept, has gained much attention of late as a tool for managing pension plan risk. LDI strategies attempt to manage volatility of the funded ratio by hedging or minimizing the interest rate and inflation sensitivities of pension liabilities. What is often missing from the discussion, however, is the question of which liability to hedge. Of relevance are five key liability measures: going-concern, solvency, windup, accounting and economic liabilities, with significant differences among the various measures. Plan sponsors typically manage more than one liability measure. For example, if volatility of pension expense, which affects corporate earnings, is a high management priority, then the appropriate risk benchmarks would begin with accounting liabilities for corporate objectives and an economic or windup liability for gauging benefit security. Identifying the appropriate liability measure, through discussion with senior corporate management, is key to reconciling pension plan risk with corporate financial objectives. This is the starting point for any asset/liability study.

Within the pension plan, assets can be managed in a two-dimensional framework, a risk management decision and a return enhancement decision. Risk management drives the decision of how much to allocate to assets that behave like the liabilities, while return enhancement seeks optimally diversified beta exposure and uncorrelated sources of alpha to reduce pension costs. The funded position of the plan will largely determine the allocation between financially non-risky assets (e.g., bonds) and financially risky assets (e.g., equities). Given the disutility of building surplus, a sponsor’s risk preference will typically diminish and result in more bond investments as funded positions increase.

The right exposure
The exposure to financially non-risky assets may be increased using derivatives (e.g., swaps contracts) as an overlay on the physical fixed-income portfolio without disturbing the policy asset allocation. Swaps may be utilized to match a target dollar duration of the liabilities, but some implementation challenges exist, such as the thinness of the Canadian swap market for nominal and real-return bonds. However, the use of infrastructure investments as a proxy for real-return bonds (RRBs), delayed settlement bonds and U.S. swaps contracts may be mitigating factors. Execution of International Swaps and Derivatives Association (ISDA) agreements for swaps may be seen as complex and requiring legal review. Another challenge stems from cash flow settlement issues and plan sponsor discomfort with leverage, use of derivatives and counterparty risk.

To summarize, DB plans are becoming increasingly important relative to their corporate sponsor’s business operations. Risk within a pension plan should be managed in the context of a total enterprise risk management program, while benefit security and key corporate financial measures must be considered. Risk within a pension plan should be managed in the context of a total enterprise risk management program that includes benefit security and key corporate financial measures. Hedging interest rate/inflation sensitivity of the liabilities may be improved with leveraged strategies using derivatives to match a target dollar duration of the liabilities. Hedging interest rate sensitivity is important, but is only one element of risk management. Given improved funded positions, an asymmetric risk/reward trade-off for building surplus and current levels of interest rates, the more imminent risk may be too much exposure to equities.