IN PRINT ARCHIVE CIR Winter 2007
By Zainul Ali, senior asset consultant, Towers Perrin HR Services
Few would debate that defined benefit (DB) pension plans are becoming more significant relative to their sponsoring organizations’ core business operations. Yet plan sponsors are only slowly moving towards assessing their DB plans in a total enterprise risk context and away from the isolated and parochial view that is mostly the practice today.
Like any subsidiary, a pension plan should be managed in a way that reflects the impact on the financial measurements that matter most to the sponsoring organization. Investment policy, which guides the decision on how to invest the capital set aside to support pension obligations, is one of four policy areas available to a sponsor to manage the cost of its retirement program. The others are benefit policy, funding policy and accounting policy, and all four are so connected that changing any one policy will likely affect the others. Understanding how investment policy interacts with key corporate financial metrics is critical in the development of effective investment and risk management strategies.
What to hedge?
Within the pension plan, assets can be managed in a two-dimensional framework, a risk management decision and a return enhancement decision. Risk management drives the decision of how much to allocate to assets that behave like the liabilities, while return enhancement seeks optimally diversified beta exposure and uncorrelated sources of alpha to reduce pension costs. The funded position of the plan will largely determine the allocation between financially non-risky assets (e.g., bonds) and financially risky assets (e.g., equities). Given the disutility of building surplus, a sponsor’s risk preference will typically diminish and result in more bond investments as funded positions increase.
The right exposure
DB plans are becoming increasingly important relative to their corporate
sponsor’s business operations. Risk within a pension plan
should be managed in the context of a total enterprise risk management
program, while benefit security and key corporate financial measures
must be considered. Risk within a pension plan should be managed
in the context of a total enterprise risk management program that
includes benefit security and key corporate financial measures.
Hedging interest rate/inflation sensitivity of the liabilities may
be improved with leveraged strategies using derivatives to match
a target dollar duration of the liabilities. Hedging interest rate
sensitivity is important, but is only one element of risk management.
Given improved funded positions, an asymmetric risk/reward trade-off
for building surplus and current levels of interest rates, the more
imminent risk may be too much exposure to equities.