As funding liabilities continue to climb for many defined benefit (DB) plan sponsors, financial risk management is drawing increasing attention. Mercer has introduced a new strategy for pension plans that aims to increase expected returns while decreasing the funding volatility of a DB plan.
According to Bill Ham, national partner with Mercer in Toronto, only a few plan sponsors have extensive financial risk management strategies in place. The reason, he explains, is that they quickly grasp the value of such a strategy but lose interest when it comes to implementation. “There is myriad legal documentation, lengthy analysis and ongoing specialized management required to maintain the strategy,” says Ham. “It’s easy to see why many plan sponsors would look for easier solutions.”
However, a new approach could remove the burden of implementation and management from the plan sponsor. Ham claims that Mercer’s strategy will work for all pension plans, regardless of size.
Main Risks
The key financial risk of a DB plan sponsor is the level of volatility of the required funding, according to Ham. Within this, there are two primary financial risks: interest rate risk and market risk.
“In other words, it is the growth of plan assets relative to the growth of plan liabilities that is the fundamental driver of funding volatility,” he says. “This is your firm’s key pension plan risk. Your investment strategy is the lever you can pull to manage this risk.”
Ham says that despite the stark divergence between assets and liabilities, one positive effect of the global meltdown is the impact it has had on investment strategy.
“Much more emphasis is now being placed on the concept that assets must not be managed in isolation,” he says. “Plan sponsors need strategies that manage assets in relation to the growth in plan liabilities.”
Laurier Perreault, business leader, investment management with Mercer in Toronto, explains that the strategy is based on a liability benchmark—a bond allocation that captures the characteristics of the plan’s liabilities, including their duration.
“The investment strategy of a DB plan will drive a certain long-term expected return,” he says. “In addition, every investment strategy drives a certain level of volatility in the funding of the plan.”
Strategy Steps
Mercer’s strategy involves three steps. It uses a typical DB plan portfolio construction of 60% equities and 40% bonds as a template.
• the bond portfolio is adjusted to match the duration of the liability benchmark, which allows the fund to capture a slight increase in expected returns (7.5%) and a slight decrease in funding volatility (10.9%). “This is the low-hanging fruit that most plan sponsors should consider,” says Perreault.
• Perreault takes the 40% of assets that are in physical bonds and splits it into two pieces. The first piece represents 10% of the 40%, which remains invested in physical bonds based on the liability benchmark. The remaining 30% is transferred into two new funds consisting of synthetic bonds structured to mimic the benchmark.
This provides bond exposure equal to 100% of the plan assets while maintaining 60% equity exposure. The exposure of the fund grows beyond 100% of the fund assets, raising the fund’s expected return from 7.5% to 9.2%. Meanwhile, the funding volatility of the fund falls from 10.9% to 10.1%.
• Equity exposure—and therefore, expected returns—are intentionally reduced, thus significantly reducing funding volatility.
“Reducing the equity exposure from 60% to 36% results in a reduction of expected returns from 9.2% in step two back to 7.5% (the returns from step one).” Meanwhile, the funding volatility has been reduced from 10.1% to 6.1%.
“Each plan sponsor will have its own goals and objectives,” says Perreault. “Some will seek to maximize risk management, while others will look to capture a combination of a reduction in financial risk along with a higher expected return. The balance between the two is up to them.”
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