Managing Embedded Investment Risks

Coverage of the 2010 Investment Innovation Conference.

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217992_caution_buried_cableSolving fundamental and dynamic risks in pension funds, post-2008, is paramount. A number of embedded risks are contained within pension funds that must be addressed with sensible investment solutions. To help solve these risks, pension funds need a solutions-based investment manager, which means that the investment discipline is aligned to the solution being used to solve the problem.

The problems faced by all defined benefit (DB) and defined contribution (DC) plans include:

1. Purchasing power risk: ensuring that retirees are able to purchase the goods and services enjoyed today, tomorrow;

2. Funding ratio or asset/liability ratio risk: ensuring we have sufficient assets to meet our future liabilities and protecting the ratio between those assets and liabilities; and

3. Longevity risk: where retirees outlive the mortality assumptions of their defined benefit plan or their savings under a defined contribution pension scheme.

Some investment disciplines can be used to help solve these problems. A global government bond long/short investment strategy can be used to create wealth as real interest rates rise to protect the purchasing power of investor monies. Inflation-linked bonds are no longer providing the true purchasing power protection required. These bonds use government indices for their inflation index, manipulated for several decades, which no longer reflect the true cost of living we all face. Additionally, inflation-linked government bonds are very expensive as demand exceeds supply; therefore the real return on these bonds is very poor and in specific cases, offers a negative real return.

When managing the funding ratio of a pension sponsor, cash-flow matching could cause greater investment problems. Unless a fund is in surplus, in the range of 120% to 130%, cash-flow matching will lock in the funding loss and not give pension sponsors an ability to achieve surplus. Additionally, if one leverages, by using swaps, and the strategy goes wrong, the funding ratio deficit will worsen. We use an outcome-certainty structure with options to protect the value of assets in relation to their liabilities. Building a portfolio this way enables pension funds to manage the volatility of their benchmark, and seek out absolute real returns or alpha to achieve fund surplus.Michael Hyman Video

Longevity risk is a developing market, although a colossal risk. We have seen longevity swaps and bonds created, but feel these instruments will be mainly used by insurance companies to manage their Solvency II exposures and funding requirements to meet the new regulatory capital requirements. We believe there will be deferred annuities or deferred longevity bonds created, but this will take time. In the meantime, more efficient portfolio management, managing the risk budget more professionally, can be a very helpful technique in managing longevity risks in the near term until appropriate retail products become available.

We also see three fundamental, economic and financial forces that will impact all of our abilities to retire.

The expanding middle classes throughout the world will crowd out commodities, consumables and money for generations to come;

1. The weight of global indebtedness of our industrial societies will cause a greater competition for global capital and will add to the crowding-out effect of the expanding middle classes; and

2. Increased government intervention throughout the world, and the impact of its eventual removal due to:

a. Central banks printing more money

b. Sterilizing or not sterilizing current account surpluses held in emerging countries (or rather emerged countries)

c. Fiscal and trade policies and

d. Capital control

These will have an enormous impact and upward pressure on real interest rates.

Lastly, for those looking to inflationary pressures, the monetary event is now taking place in China. Inflationary forces will be resurrected via a number of channels, which include commodity prices and monetary policy (i.e., printing money) as the velocity of money increases.

We live in a very different world than the one we left behind in 2008. The lessons we have learnt? Manage our investment risk and get back to the basics of asset/liability management and real interest rates.

Michael Hyman is president, chief executive officer and chief investment officer, River Plate House Capital Management Inc.

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