Doubling Down on Pension Risk

Given the pension obligations of some of these employers—Nortel, General Motors and Air Canada, to name a few—such losses can have a significant impact on the company’s bottom line and its ability to survive the current economic downturn. “There are too many pension funds who feel ill equipped to deal with the consequences of last year,” Hamilton added.

Of course, the falling markets had a huge impact on pension plan funding levels. But in Hamilton’s view, plan sponsors who failed to manage risk appropriately are also to blame.

Failure to De-risk
Hamilton explained that many pension plan sponsors underestimated the probability of severely adverse events in their risk models and strategies—events that became an alarming reality in late 2008. “They allowed the pension fund to take risks that could sink the organization,” he said. “And I suspect that’s not what the shareholders had in mind.”

Furthermore, Hamilton added, many plan sponsors fail to consider risk in context. Rather than envisioning the true worst-case scenario, they gauge their ability to handle losses based on the current conditions.

“Big losses seldom come at convenient times; they almost always come at difficult times. And it’s hard for people who aren’t in the difficult times to imagine how painful that experience is going to be.”

Roll of the Dice
When finding the fine balance between risk and reward, part of the problem is that it’s human nature to want something for nothing. “I’ve never met anyone who can go through the risk/return tradeoff in any kind of an objective way,” Hamilton remarked.

He explained that many pension plans decide how much risk to take by maximizing the probability of success. Essentially, they attempt to achieve high returns without the associated high risks—clearly, an impossible task.

And when pension investors do experience losses, there’s a natural tendency to play “double-or-nothing” to try to make them up. “People are, in fact, not risk-averse; they’re loss-averse,” Hamilton continued. “They will take risk to get out of the loss that they won’t take to produce the gain.”

Inconvenient Truths
But while chasing returns and downplaying the risks may be a natural inclination, it’s also a losing strategy. Hamilton identified three “inconvenient truths” of pension finance that plan sponsors ignore “at their peril.”

1) In a country where employees retire early and live longer, a good pension plan is usually an expensive pension plan.

2) No scientific law or religious edict requires the capital markets to deliver the returns that a pension fund needs to achieve objectives that are little more than wishful thinking.

3) It is very tempting to overestimate future investment returns.

These truths also apply to investing in infrastructure, real estate, commodities and private equity, said Hamilton—assets that he dubbed “the new golden children in pension investment.” Hamilton noted that many plan sponsors are turning to these assets as new sources of alpha, but that there are real concerns around the lack of track record and consensus on how to value them.

Day of Reckoning
Looking ahead, Hamilton called for greater awareness and disclosure of the risks that pension plans are assuming. He also counseled pension plans in trouble to look at increasing contributions and cutting benefits, instead of forging on in the relentless quest for better returns.

Perhaps the “day of reckoning” for pension funds is nigh.

“In the long run, there is going to come a time—maybe it’s this catastrophe, maybe it’s the next one—where plans will have sufficiently large problems that they can’t be swept under the carpet; they won’t go away,” Hamilton cautioned. “And, ultimately, the amount of risk that the plans are taking will need to be addressed.”

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