The risk relationship

Having a pension risk management process in place enables employers to plan and respond effectively to changing conditions. While there is no single best-in-class strategy for risk management, adopting one that is best suited to your particular circumstances is a starting point. Overall, a good process involves identifying risks and objectives for the sponsor, meaningful analysis, the implementation of a customized solution and its ongoing monitoring.

The Purpose
The ultimate goal of a successful pension risk management process is to increase the value a plan sponsor brings to its stakeholders. Value can be created by removing unrewarded risk from the equation. For instance, many DB plan sponsors face interest rate risk due to a mismatch of their plan assets and liabilities. It is unrewarded because being exposed to interest rate risk does not lead to higher expected long-term returns or lower expected contributions.

Creating value is not necessarily synonymous with slashing costs. Sometimes an initial investment is needed in the hope of future returns. For example, the initial investment associated with a conversion from a DB to a shared-risk plan is expected to lead to greater value by bringing more cost predictability to the sponsor and by providing employees with an increased degree of certainty of final target benefits and better governance compared with traditional defined contribution (DC) plans. These conditions tend to have a favourable impact on employee attraction and retention.

Influencing Factors
There is no one-size-fits-all pension risk management process, however. In fact, there are many factors that point to why this is so.
Nature of the plan – Consider the type of plan—whether it is a pure DB plan where most risks rest with the sponsor or a jointly trusteed plan where risk is shared or a DC plan where most risks rest with the employees.

Status of the plan – Sponsors of closed DB plans will have a much shorter time horizon and tend to be more risk-averse than sponsors of open plans.

Plan maturity – Plans with a large proportion of retiree liability tend to see greater fluctuations in contributions than younger plans.

Nature of the sponsor – Is the sponsor in the private or public sector? To what extent can volatility in pension contributions be passed down to customers?

Competition – What plans are competitors offering, and what risks are they facing?

Flexibility – Can plan design or investment policy easily be changed? What about considerations for unionized environments?

Importance of the plan – What is the impact of pension risks on overall business? How important is pension within a total rewards policy?

It is important for plan sponsors to consider all sources of pension risk and consider how these risks affect the sponsors through their cash flows, profit and loss (P&L) statements or balance sheets.

Risks fall under four headings: liabilities, assets, design and governance (including administration). Risks under the first three can be quantified using an asset liability study (ALS). Risks under the fourth are assessed using scenario analysis or stress- testing methods.

Identifying Risks and Objectives
An ALS is a powerful tool for identifying and quantifying risks. While it should not be perceived as the solution itself, it is an important part of the process. In order to pinpoint which risks to manage, sponsors first need exposure to a multitude of scenarios that will provide them with useful insights into the risk the company faces from the pension plan. It is important to choose appropriate plan metrics so that the risk measures are relevant to the audience. Plan metrics can include total employer cash contributions, accounting pension expense or present value of future contributions surplus level. But the choice of metric will depend on what is key to the client. A good dialogue with sponsors to try to understand their business is key in developing appropriate pension plan metrics. Consider the following questions.

• What are the potential downside and upside risks for the sponsor? (liquidity, relationships, operating continuity, value, major acquisition, etc.)
• For quantifiable risks, what is the preferred risk measure? (cash or P&L-based, EBITDA, shareholders’ equity, cash flow, etc.)
• What are the techniques used to quantify risks? (standard deviation, value at risk, conditional tail expectation, stress-testing, etc.)
• Is risk appetite defined? (yes—bottom up for each risk, top down as a whole—or no)
• Does the board receive a quarterly risk report? (What pension metrics would be useful for the board to see?)

From this discussion, and armed with the preliminary results of an ALS, appropriate goals for the pension risk management exercise may include one or more of the following:

• minimize total contributions to the plan over the next 10 years until full settlement;
• reduce contribution volatility;
• reduce the likelihood of worst-case contribution scenarios;
• improve the funding ratio; and/or
• limit accounting pension expense volatility.

Tackling the Main Pension Risks
Canadian DB pension plan sponsors need to deal with the two most important pension risks: interest rates and equity markets. Because these risks do not affect assets and liabilities in the same way, they have led to great volatility in cash contributions and pension expense, especially over the last decade.

In order to better manage these risks, plan sponsors can look at a pension fund as an amalgamation of two components: liability driven investing (LDI) and growth. Each component deals with the management of specific risks.

The LDI component reduces inflation and interest rate risk. It contains physical securities (nominal bonds, real return bonds and coupons) and derivatives (swaps and futures).
The growth component reduces the expected required contributions through higher expected returns. It contains various asset classes and strategies (traditional and non-traditional) in order to reduce the equity market risk.

Breaking down the portfolio helps plan sponsors and trustees better understand and assess the effectiveness of each of the components in managing the main risks.

The LDI component can be optimized by matching duration of assets and liabilities. Because a lot of pension plans are underfunded, matching duration using physical bonds may not provide sufficient “fit” between assets and liabilities to reduce interest rate risk. Pension plans can remedy this by including interest rate derivatives (swaps, forward contracts, repo market) in order to get exposure at different points on the yield curve and to improve the fit. Direct investment in such derivative products has traditionally been accessible only to the large pension funds (more than $500 million) due to required resources and expertise. But recently, many providers of investment services have offered pooled products that bring the power and the advantages of leveraging to small and medium-size pension funds.

The growth component can be optimized by including asset classes (e.g., commodities, infrastructure, real estate) or strategies (e.g., managed future, global macro) that have a low correlation with equities.

The Glide Path
A major decision for the sponsor involves determining what percentage of plan assets will be allocated to these two components. The ALS will provide the best mix between the two by optimizing the risk/reward relationship for a metric that represents the sponsor’s primary objective from what has been established as the plan’s solution. However, the sponsor may have short-term constraints that prevent it from immediately implementing such a mix.

For example, let’s look at a DB pension plan closed to new entrants, with a 75% solvency ratio and 70% equities and 30% bonds. Let’s assume the plan sponsor’s primary objective is minimizing the volatility of employer contributions. As seen in the chart above, moving 100% of assets to the LDI component would be the best way to meet that goal, but short-term employer contributions would increase to an unacceptable level. The plan sponsor may prefer instead to progressively implement a de-risking strategy by gradually moving assets from the growth component to the LDI component as the solvency ratio increases and the plan matures.

At the beginning of the glide path, not a lot of assets are allocated to the LDI component (30%), but with the use of derivative products, the plan sponsor can still be protected against shifts in interest rates. The growth component allows the sponsor to potentially reduce cost through investment in asset classes and strategies that add return above liability return and reduce equity market risk.

Another advantage of the glide path is, it allows the pension committee’s views to be reflected in the strategy. For example, a committee may believe interest rates will rise or the stock market will pick up.

Implementation and Monitoring
The success of the glide path strategy depends on two factors in particular: one, the ability to quickly respond once the trigger points are met (solvency funded ratio in the example above) and two, constructing a liability proxy that closely mirrors the true liability of the plan.

For the first, it’s likely that many plan sponsors will be open to outsourcing the execution aspect of the glide path to a third party that has the capabilities to handle it. The consulting firm needs to be independent from the underlying investment managers retained for the LDI and growth components.

It would be important to rewrite the Statement of Investment Policy & Procedures (SIP&P) to include details about the glide path trigger points so that the retained firm can order the move from growth to LDI once they are reached.

For the second, in order to be able to act in accordance with the SIP&P, a plan sponsor needs to have a good estimate of assets and liabilities if not on a daily basis, then at least on a monthly basis. Obtaining the assets should not be an issue (except for non-marketable securities). The third party must have the capabilities to build and track a good liability proxy.

A pension risk management process involves four key steps:

1. identification of risks and objectives of the plan sponsor in dealing with them and the plan;
2. meaningful analysis;
3. design of a solution; and
4. implementation and ongoing monitoring.

It is not a linear process. It is very much a back-and-forth process between the consultant and the plan sponsor since very often plan sponsors require meaningful analysis before they can formalize and commit to their goals. At best, a process like the one described helps plan sponsors bring pension plan objectives under the overall umbrella of corporate objectives and instill discipline and focus into pension management. BC

See PDF version for additional charts.

André Choquet is a senior consultant, financial risk consulting, with Aon Consulting in Toronto. Étienne Dubé is vice-president, financial risk consulting, with Aon Consulting in Montreal. andre.choquet@aon.ca; etienne.dube@aon.ca

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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the October 2010 edition of BENEFITS CANADA magazine.