The last decade has been unpleasant for DB pension plans, even before the 2008 market crash. The Great Recession further exacerbated these challenges as global equity markets tumbled and central banks around the world lowered interest rates to stimulate the global economy. This caused their liabilities to increase while their investments declined. To make matters worse, pension plans today are more mature than they were a few decades ago and it is more difficult for them to recover from a market downturn.
The resulting weakening funded positions of pension plans highlighted the risks inherent in the traditional approach for managing plan assets and liabilities. Pension plan members were faced with a real—and unpleasant—prospect of losing some of their pension benefits.
Pension plan sponsors saw an increase in pension expense, weakening of the corporate balance sheet, and demands for significant cash contributions at a time when cash was in short supply.
Not surprisingly, this has caused many to think about de-risking their pension plans and there has been a shift from long-term asset mix policies focused on maximizing returns to liability aware investment approaches and risk management strategies.
This trend originally started in the U.K. after accounting standards changed to require immediate recognition of gains and losses. The changes to the International Accounting Standards (which are coming into effect in 2013) will also require immediate recognition of gains and losses.
At the same time, changes in how pension expense is reported will remove some of the disincentives to de-risking that existed under current accounting standards. This may make plan sponsors more sensitive to volatility. As a result, we expect that the trend towards de-risking will accelerate and, at the same time, for pension plans to rethink pursuing higher risk mixes.
Immediate de-risking strategies have been discussed for years by plan sponsors. Few significant changes came out of these reviews. One of the reasons is the short-term implication of de-risking. In addition many were expecting the markets to help recover some of the investment losses.
This is where dynamic de-risking comes into play. Target asset mix is changed gradually, in a pre-defined way, as certain triggers are hit. For example, assets can be shifted from equities to a matching bond portfolio as the funded status improves. This approach, which can be compared to a lifecycle fund for individual investors (but based on the funded status instead of the age of the investor), allows the pension plan to dynamically “bank” or “harvest” market gains to help pay for the opportunity cost of de-risking.
Initially, these strategies were difficult—if not impossible—to implement for all but the largest pension plans. Or more simplified versions were discussed that were “point-in-time” de-risking steps but less “dynamic,” and the harvesting of gains a consequence of luck if the trigger date happened to be at a favourable market moment.
Simply put, the required infrastructure and technology needed to monitor the funded status and execute trades were out of reach for most plans.
More recently, however, solutions have become available for implementing dynamic de-risking strategies in a more accessible way. These solutions are designed by organizations that can bring together extensive actuarial knowledge of their clients’ pension liabilities, sophisticated investment consulting services related to ALM and glide path (or de-risking road map) modelling techniques and investment management execution capabilities.
But not all dynamic de-risking solutions are created equal. Here are the key elements required for an effective dynamic de-risking solution.
- Daily monitoring of both the plan assets and liabilities, including impact of daily changes in interest rates. Financial markets change continuously and reduced frequency of monitoring will, ultimately, translate into missed opportunities. If you wanted your broker to sell a stock once its price reaches $50, you wouldn’t ask them to look at the price only once a month or once a quarter.
- Dynamic execution to capture market opportunities. This requires an established investment infrastructure and a team in place to execute trades in a timely and disciplined manner once the triggers are hit. A robust operating platform enables execution of de-risking trades as market opportunities arise and efficient management of rebalancing and cashflow movements to help mitigate slippage.
- Delegation of investment decisions and discipline in the execution of de-risking trades. After all, knowing that a trigger has been hit does not help unless timely action is taken. Additionally, web-based reporting of funded level triggers and trade execution can provide comfort to plan sponsors regarding delegation of implementation.
- Ability to customize the design of the de-risking solution to the needs of a specific pension plan. The needs of large pension plans with significant internal resources are dramatically different from the needs of smaller pension plans. Having a spectrum of solutions that can be executed on the same platform efficiently is essential.
Without delegation, robust infrastructure and technology to automate monitoring and trade execution, implementation slippage can occur due to various reasons such as manual calculations and process delays (approval process, missed notices, staff holidays without appropriate back-up, unclear procedures and emotion). This can cause missed market opportunities or trading when the opportunity in the market no longer exists.
Having a plan in place in advance of when the market provides opportunities for de-risking is essential. And when evaluating your de-risking provider, pay attention to the details and make sure these key elements are in place when you do your due diligence.
Heather Cooke and Hrvoje Lakota. Cooke is a partner with Mercer and business leader-implemented consulting and dynamic de-risking. Lakota is a principal with Mercer and dynamic de-risking solution strategy head consultant.
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