Coverage from the 2009 Risk Management Conference
BY David Service | March 5, 2010
Despite the welcome recovery in equity and fixed income markets, many pension funds will disclose significant deficits at the end of 2009. The horrendous market events of 2008 rendered many traditional pension risk management strategies largely ineffective. Plan sponsors are again facing tremendous increases in costs at a time when their own finances are already stretched. Perhaps it is time to consign the old saw that “pension investment strategies should primarily focus on the fact that pension plans are a long-term commitment” to the dustbin, particularly for corporate sponsored plans, where mark-to-market measures are increasingly driving pension costs.
The risk management craze of the past five years has been liability-driven investing (LDI). While Canadian plans have been interested in LDI, the primary interest was driven by the realization among U.S. pension plan sponsors (based on changes introduced through the Pension Protection Act and accounting rules) that their pension costs are now subject to mark-to-market methodologies. Most Canadian plans sponsors have been managing in the mark-to-market world of solvency valuations since the late 1980s and were implementing long duration bond strategies 20 years ago. Interestingly, a number of plan sponsors thought that the implementation of LDI strategies had solved their main financial risk problem; unfortunately, 2008 showed this was not the case.
A common quandary
LDI strategies did not solve the fundamental financial issue in pension plans: they still carry too much mismatch risk. Most LDI strategies attempted to structure the investment portfolio so that it would help immunize the plan against changes in interest rates –by matching the dollar-weighted duration of the bond portfolio to that of the key liability measure. However, these strategies did not dramatically reduce the proportion of the fund invested in mismatched assets (public equities and alternative asset categories). Even plans that had addressed the LDI issue tended to retain 50% to 65% of the pension fund in these financially risky assets. When the public equity and credit markets crashed and when many forms of alternatives were forced to de-lever, most pension funds experienced 2008 returns in the -15% to -25% range.
Pension plan sponsors continue to be trapped in the age old quandary: they need returns to be sufficiently high for the plan to be affordable in the long-term and they need to be able to live with the financial consequences of investing in the financially risky assets that create those returns. Perhaps it is time to reverse the way in which we attempt to solve this problem. First, we must define clearly what level of pension cost the plan sponsor is able to afford in the long term – the answer is not zero. Second, we must determine how much variability in these costs (particularly upwards) is tolerable. Lastly, we must test that these metrics will satisfy the fiduciary obligation to adequately secure members’ benefits.
Reducing mismatch risk
As most sponsors have found, the current level of cost variability is not acceptable. The only way to adequately address this issue in the long-term is to reduce the proportion of the fund invested in financially risky assets, but this is clearly not affordable at this time. What we must create is a path that will take us from where we are now to this optimal state. How? By dynamically reducing the mismatch risk in the plan as the financial position of the sponsor and the plan permit. Reductions in financially risky allocations will be made based on achievement of key funded ratio targets–levels being set at points where the plan sponsor can afford the impact this will have on the actuarial discount rate assumption used to value the liabilities.
This dynamic de-risking process will likely take more than one market cycle. At the end of it, the plan sponsor should be in a situation where they can afford both the level and variability of the key pension costs.
David Service is Principal with Towers Perrin