Setting a Framework: Risk Management in a Low Return Environment
IN PRINT ARCHIVE CIR Winter 2001
|Setting a Framework:|
|Risk Management in a Low-Return Environment|
|David Service - Principal, Towers Perrin|
|The current low-return environment requires a re-evaluation of our views on pension plan risk to ensure that plans can better serve their sponsors while continuing to meet the needs of members.|
In the aftermath of the current bear market, many pension plans will have seen their surpluses evaporate, and sponsors will need to develop new strategies for controlling financial risk. The issue for the future is the degree to which cash injections will be required to make up for poor investment performance.
The 1990s provided exceptional returns. Contribution holidays were abundant, and plan sponsors could depend on investment performance to control required contributions. Now we face a major shift. Portfolios that worked so well in the '90s are unlikely to generate sufficient return to offset the natural growth of liabilities in the '00s; plans will need cash injections.
Traditionally, senior executives have viewed pension plans as stand-alone entities due attention only after triennial valuations. Now, U.S., Canadian and European accounting standards are increasing pension plan visibility, with more impact on corporate earnings and balance sheets. These plans are more like corporate financial subsidiaries - sizable ones at that. Towers Perrin surveyed fiscal year 2000 data from 40 of Canada's largest companies. Pension expense exceeded 5per cent of operating income for 30 per cent of them. Employer cash contributions exceeded 5per cent of cash flow from operations for 40 per cent of them. Pension assets exceeded 20 per cent of corporate assets for half.
If you view a pension plan as a stand-alone entity, it makes sense to measure its performance in relation to its peers and assess its managers in terms of a benchmark index. If you view the plan as a financial subsidiary, the measure shifts to its cost. Assuming a plan will require cash injections, its quartile ranking - the focus of many trustees and managers - becomes far less significant than the pattern of those injections and their impact on the sponsor's coffers.
In future, we may need to focus less on the total return delivered by an investment strategy and more on the pattern on which those returns are delivered. Consider a company in a cyclical industry whose corporate profitability lags the capital markets by 12 to 18 months. The pension plan will typically deliver bad news about its portfolio performance just as the company's earnings slump - when it can least afford a significant cash draw or a hit to the income statement. Why not match manager style to the timing of the sponsor's need for returns? This might favour a value style or hedge fund manager who offers superior performance in down markets but lags the equity market in up markets. This approach would undermine the cult of the quartile and divorce managers from beta. (That is if corporate directors and pension trustees are to understand the rationale. This will be an ongoing educational challenge.)
The low-return environment also calls for reconsidering active versus passive management. When the S&P 500 churned out 20 per cent per annum, the additional 1 per cent that an active manager might deliver was not worth the regret should the manager fall short. This 1 per cent return becomes more enticing when the market offers just 8 per cent or 9 per cent.
However, the fundamental point, is that a pension portfolio should be judged not on how it does in general, but rather by what it does for the sponsor. Ongoing globalization will increasingly shift production toward plants that operate most cost-effectively, and the pension plan represents an increasing part of that cost structure. The days of measuring investment results relative to how others did likely died with the bull market of the late 1990s. In the future, each plan sponsor will adopt a unique and integrated risk management strategy that measures performance relative to the achievement of quantified financial objectives. *