Managing DB plan risk

Hrvoje Lakota, principal, retirement, risk and finance with Mercer Canada explained that mismatching assets and liabilities is the key source of risk for DB pension plans, as liabilities are impacted by interest rates, inflation, and longevity of plan members.

While liabilities behave like bonds, pension plan assets are usually invested in a mix of equities, bonds, and alternatives, and behave very differently than liabilities. Such a mismatch can spell big trouble in the face of deteriorating market conditions, such as those encountered in September of 2008.

Lakota said that finding investments that move in synch with liabilities—such as certain bond portfolios—and respond to movements in interest rates in a similar way to pension plan liabilities is a good way to eliminate some of the future volatility.

In order to do this, the portfolio requires similar characteristics as the plan’s liabilities, particularly the duration. The longer the duration the greater the change in value when interest rates change.

Risk
A plan will be exposed to interest rate risk when it has a mismatch in the duration of its liabilities and its bond portfolio, said Lakota. A matching duration will reduce, but not eliminate, a plan’s risk exposure as most plans have 50% to 60% exposure to equities. De-risking then requires moving much of the equities investments into liability-matching assets.

“Of course, there is no such thing as a free lunch,” he said. “Liability-matching assets often have a lower expected rate of return which increases the expected level of future contributions. In essence, the choice for plan sponsors is lower, more volatile contributions or higher contributions which are expected to be more stable.”

Who is de-risking?
Plan sponsors who now better understand their risk tolerance level given the experiences of last year and are feeling the pain are prime candidates for de-risking, as are sponsors who have recently closed a DB plan.

However, there are many plan sponsors who are not de-risking their plans. Many are still comfortable with the amount of risk taken on, and some plan sponsors have decided that the cost of de-risking is too high. Timing is also an issue, as many plan sponsors question whether now is the right time to de-risk their plans and are watching other plans to measure their success. And as always, cost figures into the equation, as lower risk strategies often result in short-term increases in pension expense.

Let me count the ways
According to Laurier Perreault, business leader of investment management with Mercer Canada, there are many ways to de-risk a pension plan.

Aside from doing nothing in the hope that market conditions will improve and bring assets back to their previous value, the most common way plan sponsors can de-risk is to make an immediate change to asset strategy, such as purchasing annuities for all liabilities. “This is a simple, straightforward approach which can be effective in the right environment,” said Perreault.

Or, plan sponsors can make steady reductions in equity exposure, such as 2% per quarter, shifting to bonds or liability-matching assets. This approach brings a certain discipline to the process of de-risking, he said.

Getting dynamic
A more hands on process called dynamic de-risking involves sudden shifts in assets at specific, opportune times.

“Dynamic de-risking is a new innovative approach to de-risking that allows plan sponsors to chart a path for meeting its financial goals for the pension plan,” said Perreault. “It operates on an opportunistic basis resulting in de-risking asset shifts that are tied to when progress has been made toward financial goals.”

Two common challenges of dynamic de-risking are the need for timely decisions and an ability to remain committed to the strategy.

“Opportunities to de-risk often present themselves in short windows, and if the existing governance structure requires committee consent on decision making, the process needs to be very efficient,” he said. “Since most committees meet once per quarter and require more than one meeting to reach a consensus, the window of opportunity often closes before the decision is finalized.”

The dynamic de-risking approach addresses this by approving up front the triggers which will result in asset mix shifts being made. When those triggers are hit, the process can be executed without further approval.

A second challenge is maintaining the de-risking process in the face of strong equity returns, he said. Discipline and commitment are required to continue the de-risking process during a market upswing. Dynamic de-risking avoids this by automatically executing asset shifts when progress is made towards meeting the plan sponsor’s financial goals.

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