Managing Pension Risk In A Volatile World
You don’t have to go back too far in time to see when and how the pension industry changed. Just 15 years ago, pension plan management seemed an easier endeavour: high yields on fixed income and double-digit returns in equity markets were the norm and seemed likely to continue for some time. The 21st century has brought the pension industry two very difficult periods, both of which occurred in less than a decade: the dotcom crash of 2000-2002 and the financial crisis of 2008. In both cases, the solvency ratios for defined benefit pension plans fell abruptly. The key determining factor was volatility – not of assets alone, but of assets and liabilities. In both cases, pension plans suffered losses due to changes impacting both assets and liabilities. Falling interest rates increased the value of liabilities while negative returns on most asset classes (with the exception of bonds) contributed to the drop in the funding ratio.
Volatility is now the new normal for the pension industry. The new normal suggests that plan sponsors and asset managers have to adapt their thinking and approach given the new environment. That involves developing an asset mix policy based on the volatility of assets versus liabilities (as opposed to assets only) and adopting a governance framework that monitors the changes in the financial health of plans on a timely and actionable basis.
To improve both governance and risk management, we propose an approach based on three pillars: the asset-liability study, inclusion of alternative assets, and better governance through active monitoring.
Pillar 1 – The Asset-Liability Study
For many plans, risk has traditionally been defined as the risk of the asset manager not attaining established value-added hurdles. This definition was predicated on the assumption that the 60/40 asset mix was appropriate for the long term. Yet, the volatility of the past decade has clearly demonstrated that manager risk constitutes only a small part of the total risk for a pension plan. In fact, empirical evidence suggests that it accounts for less than 10 per cent of the total plan risk, while the majority of risk is related to the asset mix versus liabilities.
The asset-liability study is the starting point to measuring risk as it incorporates both the assets and liabilities in the analysis. It provides an estimate of funding risk volatility which is directly linked to the volatility of the financial status of the plan.
The asset-liability study uses various scenarios to illustrate the risk contained in a variety of different asset portfolios. Two different approaches can be used to create these scenarios: the first is ‘deterministic,’ while the second is called ‘stochastic.’ The deterministic approach uses given scenarios that are determined in advance. An example would be a negative return for the stock market combined with a decrease in rates. These scenarios are predetermined and are designed as a ‘stress test’ to determine downside risk in unfavourable scenarios. The stochastic approach in contrast uses a scenario generator to create 1,000 randomly generated scenarios for each asset class and the probability of each occurring. These outcomes are then applied to both the current and the proposed asset mixes. The input used for each asset class is the expected return and volatility calculated for a 10-year period. These are derived using estimates based on historical and forward-looking projections. Both approaches provide an expected risk and return for both the current and proposed portfolios.
Our recommended approach combines the best of both approaches. A stochastic approach is used to generate the scenarios and then the worst five per cent of the results are used as a stress test for the asset portfolios. The results show the levels of expected risk and return versus the liabilities in the worst-case scenarios for randomly generated outcomes.
Pillar 2 – Alternative Assets
Empirical evidence shows that diversification has a beneficial effect on the risk/return tradeoff. This includes not only the diversification that comes from the asset mix, but also style diversification which arises when more than one manager is used for the same asset class.
Driven by a desire to reduce volatility and/or to increase returns, many plans have introduced greater diversification in their asset mix. These investments have included allocations to alternative asset classes such as real estate, infrastructure, private equity, global bonds, high-yield bonds, agriculture, and timberland. Pension plans have also diversified by geographic region, increasing their allocation to foreign equities such as the U.S., EAFE (Europe, Australasia, and Far East), and emerging markets. Moreover, the diversification in manager style has continued to increase and now includes small cap, mid-cap, hedge funds, absolute return strategies, and low volatility equity. Some of these asset classes are less liquid, a fact that must be considered in overall portfolio design.
Asset classes such as real estate and infrastructure respond differently than equities and fixed income to changes in macro-economic factors such as interest rates, growth, and inflation. As a result, the returns of these asset classes are less correlated to traditional equities and fixed income, so their inclusion is accretive to traditional portfolios. These different characteristics allow portfolios to be designed to address specific needs. An example of this would be the inclusion of asset classes that do well during periods of unexpected inflation. This would be an attractive feature for plans with benefits indexed to inflation. Currently, we believe that infrastructure and real estate continue to enhance the risk/return profile of traditional portfolios. Although Canadian real estate provides an attractive return premium when compared to fixed income yields, certain foreign strategies are even more attractive.
Pillar 3 – Better Governance through Active Monitoring
For most pension plans, the actuarial valuation is the only document which gives a complete overview of their financial health. The actuarial valuation values both the assets and liabilities and provides considerable detail concerning the plan including the funding ratio. Unfortunately, the actuarial valuation is not done frequently. Regulation requires that it be completed at least once a year or once every three years, depending on whether the plan was in deficit or surplus at its last valuation.
From a risk management perspective, the actuarial valuation has limited relevance due to the frequency and timeliness of the information. The numbers presented are historical and not actionable, given the lag time required to produce the report. Gains that might have existed at the date of the valuation may not exist by the time the valuation is completed. In addition, the plan sponsor will have no indication of changes in the plan’s financial health going forward.
To provide for better governance and risk management, real-time reporting of a pension plan’s financial health is required. With real-time reporting, the plan sponsor can take advantage of changes in the financial health of the plan to manage risk. In addition, frequent reporting allows the sponsor to develop a risk management plan in advance and to execute on the plan when required.
Many pension plans are delegating the monitoring and execution of their risk plan to third parties. The result is that the financial position of the plan can be monitored frequently (up to daily) and risk can be managed on a timely basis. This improves the ability to effectuate pre-determined asset class changes on a real-time basis and improves overall risk management for the plan.
A typical risk management plan maps out changes in a plan’s asset mix that are dependent on changes in the financial health of the plan. This is referred to a dynamic asset allocation strategy (glide path) and allows a plan sponsor to change the risk profile of a pension plan in a timely and cost-effective manner. The risk management plan details specific changes in asset class weighting when certain triggers are met, typically based on the funded status of the plan. In this manner, the pension plan can actively manage risk with most plans looking to reduce risk as the financial ratio improves. The proactive management of risk also results in better governance of the plan as the key drivers of a pension plan’s health are identified, actively managed, and reported regularly to the trustees. Under this approach, the plan’s financial health is monitored on a real-time daily basis in addition to the required actuarial valuation.
Market volatility has resulted in significant and rapid changes in the financial health of defined benefit pension plans. Unfortunately, many pension plans have not put in place a mechanism to properly monitor this volatility.
We are recommending the use of a three-pillar approach in order to improve both the governance and management of this volatility. The governance and risk management can be greatly improved by initially performing an asset liability study to determine the current risk of the plan and that of other asset mixes. The use of a delegated approach, combined with a pre-determined risk management plan enables plan sponsors to better manage risk going forward. Ongoing regular monitoring of a plan’s financial health, in addition to the actuarial valuations, is recommended for all plans (not just those that choose a delegated approach) to ensure proper governance and risk management. Plans should also consider the inclusion of alternative assets as increased diversification has proven to be beneficial in reducing volatility and/or increasing returns.
In the new age of increased volatility, there is no secret recipe for plan sponsors to follow, but there are best practices. Our three pillars provide a comprehensive approach to managing volatility that should result in improved pension plan outcomes and better plan governance – key attributes for any pension plan in a world where seemingly anything can happen.
Robert Laughton is an associate partner in the investment consulting practice at Aon Hewitt.