Dynamic De-Risking

Coverage of the 2011 Investment Innovation Conference.

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story_images_ThunderstormIn 2011, the TSX Index declined approximately 10%, and the 10-Year Government of Canada bond yield dropped 1.0%. Declining equity markets and yields are a devastating combination for pension funds because they negatively impact both assets and liabilities. This combination is referred to as a “Perfect Pension Storm” and has has occurred three times in the past decade. Declining equity markets reduces the assets in the pension fund. Declining bond yields increase the liability value of pension funds. The combination leads to an increase in the funding deficit, which likely leads to an increase in required contributions.

Pension committees are still managing their plans the same way after a decade of tough financial results. The focus remains on asset returns, with little attention on the funded status of the plan. There are many reasons why pension funds have not changed their approach. Committee members have changed over the past decade and have not experienced the financial pain due to the first two perfect pension storms (declining bond yields and equity market returns). Pension committees have also been reluctant to make changes to asset mix due to the fear of being wrong. Moreover, the current approval structure within pension committees does not facilitate quick decision-making and, at the same time, pension committees are not sure what changes they should make.

Dynamic de-risking is an approach where the asset mix of the plan changes as the funded status of the plan changes. Typically, this results in less risk (i.e., fewer equities and more bonds) in the plan as the funded status improves. Dynamic de-risking allows a pension fund to de-risk its plan when it is affordable (i.e., when the funded status improves).

The underlying premise of dynamic de-risking is that pension plans will sell outperforming assets and lock in those gains to reduce the likelihood of the deficit increasing in the future. There are three key factors involved in creating a dynamic de-risking solution.

First, the pension committee pre-approves an asset mix schedule that allows the investment manager to alter the plan’s asset mix as the funded status of the plan changes.

The investment manager then evaluates the funded status of the plan on a daily basis. This allows asset mix changes to be made in accordance with the pre-approved asset mix schedule.

Finally, the plan develops a clearly stated financial objective. This could involve reducing the volatility of contributions by 10% once the plan becomes fully funded. Or it could be a target funding level of 110% for an eventual annuity purchase.

Dynamic de-risking differs from traditional liability-driven investment (LDI) solutions because it does not require plan sponsors to make a one-time adjustment to their asset mix. Instead, dynamic de-risking gradually removes market-based risk from the pension plan based on the plan sponsor’s financial objectives and current market conditions. This gradual approach appears to be more palatable because it provides a balanced approach where investment returns and cash contributions are used to close the funding gap.

Soami Kohly is Vice-president, McLean Budden.

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