Two of the hottest topics in pension fund management today are de-risking and whether traditional asset allocation strategies have failed. Two industry experts weighed in on these topics during a panel discussion at the recent Canada Cup of Investment Management, held in Toronto.
De-risking: old tool in a new wrapper?
William Solomon, a consulting actuary who sits on a number of pension committees, including the Canadian Rabbinic Pension Plan, says there’s nothing new about de-risking. In fact, it’s just a repackaged version of a strategy that has been around for decades.
“If you go back to the 1950s when bond immunization was first developed in the U.K. and you look at what’s being done today, there’s not a great deal of difference. There are a lot of new strategies being put forward, but if you drill down into those strategies you can find their roots in products that go back perhaps 50 or 100 years.”
Solomon suggests de-risking is simply an attempt by plan sponsors to “go back to where they were 50 years ago and say, ‘Maybe that group annuity product we had with the insurance company wasn’t so bad after all.’”
Robin Pond, senior investment and DC consultant, with Buck Global Investment Advisors, says the focus on de-risking has been driven by the low interest rate environment and as interest rates came down in the mid-1990s, many pension funds shifted from a going-concern focus to a solvency focus.
“Suddenly when solvency drives your funding, you’re whipsawed by current long bond interest rates,” he said.
Pond notes back in 1981, when long bond interest rates were in the 14% to15% range, investors could have locked in their portfolios and gotten a 15% return. “But nobody did because they were sure they were going to get more [by] investing in stocks. So fast forward 30 years: we know over that 30-year period long bonds have beaten all the stock indices in Canadian dollar terms.
“And now we care about de-risking because we got burned and we know we should have done something we didn’t do 30 years ago. Will the big focus on de-risking and prudent management go away once the interest rates rise?”
The end of traditional asset allocation?
Solomon takes issue with the idea that traditional asset allocation methodologies have failed. In his view, it’s the industry itself that has failed.
“If we look back to the 1980s and 1990s when rates of return were quite robust and pension plans were generating sufficient surplus so that plan sponsors could take contribution holidays, the regulators and consultants [erroneously] promoted this.”
Solomon says industry players would have done well to heed the lesson of a famous story from the book of Genesis. When Joseph realized a famine was coming in the land of Egypt, he advised Pharaoh to store the surplus grain from seven years of plenty for the seven lean years to come. Solomon notes for pensions the lean years came in 2000s, leading to “a lot of hand wringing and fist-clenching about how traditional asset mixes have failed.”
What failed was not traditional asset mixes, but “the system, which didn’t permit and didn’t encourage plan sponsors to set aside funds and continue to fund pension obligations when they had the chance to do so,” Solomon says.
Pond argues there are problems with traditional approaches to asset allocation and welcomes the growing trend towards dynamic shifting of the asset mix in response to changes in funding levels and changes in the risk tolerance of the plan sponsor.
The days of coming up with an asset-liability model, choosing a static asset mix and then forgetting about it for five years until the next asset-liability model is cranked out need to be put behind us permanently, he suggests.
The great paradox
One of the great paradoxes of the pension business is when you can least afford to take on risk, you should be taking on more risk, explains Pond, adding when you can most afford to bear risk, you should probably be de-risking.
“What’s done in practice ends up being more a function of the sponsoring organization’s ability to pay and withstand a negative result. If you don’t have deep pockets you may not be able to take on more risk when the funding is low, because you may not have the ability to withstand the result,” he says.
Solomon suggests there’s a downside to taking risk off the table as the funded status improves, stemming from the new International Financial Reporting Standards (IFRS) rules.
“I suspect many of the asset mix decisions being made today are driven by the IFRS rules. Pensions are now a direct hit to the corporate balance sheet and CEOs whose income and bonuses are tied to the profitability of the company may be reluctant to have that profit fluctuate dramatically from year to year, so they are looking to implement pension investment strategies that will produce less volatile results for accounting purposes. I’m not sure that’s necessarily the best way to manage pension plan assets.”