When the title of the annual report for the largest pension plan in the country begins with “Let us explain,” it’s clear that something has gone very wrong. The investment industry has watched in horror—with plan sponsors looking over its shoulder—as the global economy staggered from the subprime debacle to the credit crunch and, ultimately, into the abyss of the global financial crisis. While it has yet to fully play out, there are lessons to be learned. There’s also a great deal of discussion around what the pension industry needs to do to prepare for a possible redux.
In last year’s Top 100 Pension Funds report, most consultants and plan sponsors were confident that the perfect storm of 2001/02 wouldn’t hit again—or, at least, that the risk management strategies gleaned from that episode would help protect investors from any rough market conditions to come. But as we’ve since discovered, that’s not how things have come to pass. Risk, it turns out, was severely undervalued. Complex derivative products were tied to questionable mortgages and weren’t fully understood by brokers or investors. And credit—already an endangered species—became even more elusive once the markets realized what had happened. At that point, the idea of risk management was moot: crisis management became the order of the day.
Black Swans and Red Returns
The greatest pain that plan sponsors are feeling today is, not surprisingly, due to the equities markets. Negative returns are in the double digits—as much as -30%, for some—causing solvency funding to plummet and turning asset/liability ratios upside down. Rather than looking for opportunities to reap returns, many institutional investors are preoccupied with stemming the bleeding. So, what happened to risk management?
“What everybody found out last year was that the risk management models that were being used in the industry—and this was not unique to the pension industry—didn’t necessarily appreciate how bad the tail events could be,” says Paul Forestell, leader of the Canadian retirement group with Mercer. “Also, everybody had good intentions about implementing risk management, but there was still not a consensus about what that actually meant and how to effectively implement it for a pension plan. So I think most people, while talking about it and studying it, hadn’t gotten around to actually implementing significant risk management around their asset/liability mismatch before June 2008 when markets started to head down.”
Whether the global financial crisis qualifies as a “black swan” event, as some have defined it, Forestell can’t say. But he concedes that current risk models put such an event at one in 100 years, prompting questions about the assumptions these models are based on. “I guess the question is whether the risk models were right or not,” he explains. “Was it a one-in-100 event? Or is it a one-in-20, and we just didn’t appreciate how bad a one-in-20 could be?”
Forestell feels that the pension industry needs to be more appreciative of the toll such events could take on pension plans and that new risk management techniques are needed, along with timely implementation. “I’m a pessimistic actuary,” he says. “My view is that it could happen again, and people need to be ready for it.”
| The Numbers If 2007 was a tough year for pension funds, 2008 was a catastrophe. Total pension assets for the Top 100 fell by 16.8% over the previous year. Overall growth—viewed as paltry in 2007 at 3.8%—was non-existent in 2008. Only six plans managed to avoid losses. The best performer was the Public Service Pension Plan (No. 4), with an increase in assets of 11.3% from 2007. The Royal Canadian Mounted Police Pension Plan jumped 14 spots from No. 65 in 2007 to No. 51 in 2008, while the City of Montreal Pension Plan slipped eight spots from No. 37 to No. 45. The University of Toronto (No. 67) also took a big hit, down 30.6% from 2007. Newcomers to this year’s Top 100 list include Molson Canada (No. 84), United Food and Commercial Workers Union Pension Plan (No. 89), Manulife Financial (No. 94), Maple Leaf Foods (No. 98) and the University of Ottawa (No. 100). |
Double or Nothing?
Preparing for such an event requires an understanding of what brought it about in the first place—which, according to Malcolm Hamilton, a pension consultant with Mercer, was in part the willingness of plan sponsors to take on too much risk. “They allowed the pension fund to take risks that could sink the organization,” he said at a May CFA event in Toronto. “And I suspect that’s not what the shareholders had in mind.” Now facing significant losses, some plan sponsors are considering double-or-nothing strategies to try to make them up. “People are, in fact, not risk-averse; they’re loss-averse,” said Hamilton. “They will take risk to get out of the loss that they won’t take to produce the gain.”
This approach, while ill-advised, may make sense for an individual gambler playing the tables in Las Vegas. But what about institutional investors with mandates to provide benefits to hundreds or thousands of plan members?