A Framework for Managing Pension Risk
Over the past decade, the risks associated with their companies’ defined benefit (DB) pension arrangements have steadily moved up the worries list of corporate treasurers. While the exact form of corporate pension DB provision differs between jurisdictions, in most instances the challenges faced are similar. Increasing longevity, volatile market conditions, a more complex regulatory framework and the trend towards mark-to-market valuations of liabilities have all contributed to the impact on corporate profits, cash flows and balance sheets and, in many instances, the long-term viability of defined benefit arrangements. As a result, we are witnessing in many markets a trend towards defined contribution (DC) pension provision or hybrid funds that combine DB and DC features.
However, while this may deal with the future, it does not help treasurers get to grips with the risks associated with the company’s existing DB schemes. The exact nature of these risks, again, will vary depending on jurisdiction and company, but issues that keep treasurers awake at night include:
Increasingly, we are also seeing pension fund liabilities affecting financing prospects as well as the ability of companies to undertake corporate transactions. So what, if anything, can treasurers do to tackle these challenges?
While the above-mentioned concerns are unlikely to go away overnight, the good news is that, as pension fund liabilities are maturing, the long-term outlook for DB pension funds is becoming less murky. This is particularly true in the UK where a growing proportion of funds are now closed to both new and existing employees. Consequently, the separation from the sponsor and the path towards final self-sufficiency or buyout is becoming clearer. This greater clarity is matched by significant progress in terms of the investment solutions that leading providers can offer. While the exact roadmap proposed will differ depending on the pension fund’s individual circumstances, we believe they all share a number of common features.
Over the past decade, there has been a concerted move in the large DB pension fund markets, such as the UK and the Netherlands, to focus pension funds’ investment strategy more clearly around the ultimate goal of being able to pay out members’ pensions as they fall due. While liability-driven investment (LDI) is now a well understood concept, the greater maturity of funds and acceptance of market based measures has led to increased clarity and agreement over what the best measures of liabilities actually are. Uncertainty over issues such as longevity and regulation over inflation measures (such as the recent retail price index (RPI) and consumer price index (CPI) moves in the UK) remain. But, overall, LDI now allows pension fund board to:
The recent credit crisis and the increasing maturity of liabilities have further strengthened the desire for de-risking among both trustee boards and sponsors.
Effectively, investment management of a pension fund should, where possible, be run as a treasury-style operation with a direct link to liabilities. Overall, we are seeing a much greater willingness by trustees to embrace more efficient use of capital. Indeed some of the leading pension funds are already run on a quasi treasury style basis. This entails a more dynamic and market-aware approach to risk and return management through asset allocation and inflation and interest rate hedging.
It also extends to an explicit emphasis on ensuring that pension funds benefit from the best risk management systems and expertise available. The aim here is that the complete range of risks are fully understood and quantified. Consideration can then be given to hedging less desirable risks in the context of the cost, while risks that are expected to be rewarded by investment performance are deliberate, diversified and appropriately scaled.
In practice, many pension funds lack the in-house expertise to monitor the more complex investment and hedging strategies that are now needed. Enhanced governance is crucial to allow pension funds to act quickly and flexibly to changing market circumstances. In most instances, traditional governance structures have much longer decision cycles, meaning that trustees often miss opportunities to reduce risk or enhance returns.
A growing number of pension boards are therefore revisiting their governance and decision making arrangements using one of the following options:
The last option is widespread in the Netherlands and increasingly commonplace in the UK.
Within the above parameters pension funds have access to a wide range of strategies and tools to develop a sustainable and holistic solution that meet their specific needs. When considering opportunistic risk mitigation, this often involves the use of phased or trigger-level based strategies towards a pre-agreed goal (‘journey management’) as well as de-risking approaches that exploit relative value opportunities. This translates into a reduced reliance on the static long-term assumptions derived from an ALM study and greater awareness of market valuation. By undertaking a dynamic medium-term asset allocation (MTAA) funds can avoid bubbles and capture opportunities.
A constant across all strategies is the increased sophistication of the instruments being used. While traditionally many pension funds would have shied away from the use of derivatives, they are now widely accepted as necessary for the efficient management of investment portfolios. Some more recent innovations by pension funds include the use of instruments such as swaptions, synthetic equity or repurchase agreements coupled with a greater emphasis on the quality of risk management and market access offered by the provider.
With most schemes still in deficit on a buyout basis, growth assets remain a pivotal part of the strategy to manage the cost to the sponsor of running the scheme. However, funds seek to achieve much greater diversification across equities and alternatives. This quest to achieve better returns per unit of risk is also breaking down the traditional barrier between active and passive investment. Smaller funds may seek to achieve this through the use of a bundled multi-asset approach such as diversified growth investing where a manager allocates dynamically across asset classes. Overall, we see an increased uptake of techniques such as risk budgeting across hedging instruments, matching assets and return strategies to maximise the total portfolio’s overall net information ratio.
While interest rate and inflation risk can be hedged, longevity risk remains an area of ongoing uncertainty. Some steps are being taken towards the development of a longevity swap market, but to date most efforts have been focused on the more predictable pensioner liabilities. Treasurers still have to contend with an evolving regulatory landscape. This extends to the DC area. For instance, in the UK, companies have to get to grips with the implications of the National Employment Savings Trust (NEST) and the associated auto-enrolment rules.
Finally, corporate pension provision is one of the few areas within the treasury function’s remit where treasurers have not been able to rationalise operations across multiple companies and jurisdictions. However, despite significant regulatory constraints, we see a growing number of local trustee boards engaged in a dialogue with the group treasurer about migrating their pension schemes onto a single platform.
As pension liabilities have become more clearly defined and have greater impact on corporate profitability, the need for a dedicated ‘treasury-style’ approach to risk and investment management has increased and the need for active governance becomes crucial. While the requirement to avoid any potential conflict of interest means that treasurers now have a more arms’ length relationship with the pension fund, we believe they can continue to play a valuable role in ensuring the pension fund reaches its agreed end-destination safely and cost-effectively. In particular, they can help ensure that the trustee board is fully informed of the framework and tools they now have at their disposal to reduce their dependence on the sponsor and achieve self-sufficiency or discharge the liabilities.