Say Goodbye to Market-Based Risk

Coverage of the 2010 Risk Management Conference.

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2007 candlesWhat is risk? There are many answers to that question—standard deviation, beta, value at risk, tracking errors, debt/equity, number of holdings in a portfolio, said Wayne Wilson, vice-president of Lincluden, speaking at the 12th annual Risk Management Conference in Muskoka, Ont.

But it’s not just one of these, he said. “It’s all of the above and none of the above.” Risk, he said, depends on your situation and what your goal is in addressing these risks going forward.

“We have to look at risk in a pension plan in a similar fashion.” In the recent past, modern portfolio theory looked at risk in terms of market-based theory—beta, tracking errors—he continued, but we’re now starting to look at pension plan liabilities.

Liability driven investing is changing the way plans manage bonds, he said. Market risk and value added are being replaced by interest rate risk to actuarial ratios and in some cases pension cash matching, he continued.

Equity Investing

Even though the bond landscape is changing, equity investing seems to be continuing on the same basis, he said. Equities don’t have the same ratio-matching properties to liabilities; they are largely labelled as mismatching and viewed purely as a return vehicle, he continued.

But since pension plans need equities for returns, they need to diversify their equities as much as possible. Equities should be used from the point of view of what you’re hoping to achieve within the plan, Wilson explained. “Equities will always be volatile.”

Long-term return of equities is very attractive but the pattern is not, Wilson said. In fact, over the 100-year history of the Dow Jones, there were four decades in which there was no return in equity markets—a pattern, Wilson maintains, that is unhelpful to pension plans.

So when considering risk, plans sponsors need to remember the following:

  • Risk is situational and should be managed relative to the organization’s liabilities and their impact on the financial risk.
  • The organization’s focus should be strong and affordable benefits.
  • Bond management is shifting from market-based risk to managing financial risk.
  • Although equities continue to be managed to market-based risk, they should move to consider financial risk as market-return patterns are not helpful.
  • Low beta approaches may better address pension financial risk (but at some opportunity cost).
  • A number of documented anomalies seem to offer better financial risk protections to pension plans.

Brooke Smith is managing editor of Benefits Canada. brooke.smith@rci.rogers.com

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