Pension plans revisit risk management

The end of 2008 and early 2009 “were a pretty tough year for our plan,” explained Cocchi at the IMN’s annual Canada Cup of Investment Management last week in Toronto. “We were heavily weighted in equities,” he said, while Montreal had started to “de-risk” the portfolio in 2007 by moving a portion of equities, over time, into alternative investments, primarily infrastructure.

Indeed, many pension plans are moving towards alternative investments, according to Janet Rabovsky, practice leader at Towers Watson. One result is that the average investment cost for mid-sized pension plans has gone from 62 basis points in 2002 to around 100 basis points today because alternative investments are more expensive.

However they de-risk, pension funds try to make an orderly transition but things don’t always work out as planned.

“In 2008, the market, unfortunately for us, moved our asset mix towards where we were going,” said Cocchi. “We would have preferred to do it ourselves.”

Market risk is not the only risk pension plans face. There’s also liquidity risk and cash management risk. Pension plans need to have cash on hand to pay pensions. In late 2008, raising cash would have meant selling stocks and corporate bonds at their low point.

A similar situation confronted Cocchi, although this time it had to do with managing currency exposure. A derivatives contract came due, which hedged 50% of Montreal’s currency risk. “We had a very big contract that we had to settle,” Cocchi recalled. “We had to decide where we wanted to take out that liquidity.” It was in Canadian bonds, “where the price was the highest they had been in the past few years.” Still, that led to an unbalanced mix in the bond portfolio, with an overweight in corporate bonds.

For other pension plans, the market bestowed different fates. The Healthcare of Ontario Pension Plan (HOOPP) didn’t make any changes to its asset mix during the financial crisis because it was already moving to a liability-driven portfolio, starting in 2007, explained James Keohane, chief investment officer at HOOPP. That shift reduced equity exposure by 30%.

After conducting a series of stress tests, HOOPP had found that “the existing portfolio exceeded our risk tolerance even under very benign scenarios.” More than that “we were in pretty good shape from a funding point of view,” he added. “When we looked forward we found that the expected return in our portfolio was significantly higher than the required return that we needed to stay fully funded.”

That lends a different perspective to risk, a twofold one. Foremost is whether asset accruals are enough to meet plan liabilities. The second is whether the plan accrues assets above the risk-free rate of return provided by 30-year Government of Canada bonds. As it turns out, HOOPP survived a live stress test in 2008-2009. It “provided us with evidence that we were on the right track,” Keohane noted. “I wish we didn’t have as stressful a test.”

Even so, risk is part of the plan—to earn more than the risk-free rate, HOOPP is looking at 175 to 200 basis points over bond yields, or 6.5%.

“You need to take enough risks to produce the excess returns to fund the plan, but you don’t want to take too much risk and subject the plan to excessive losses,” he said. Those risks need to be translated into terms trustees understand. For HOOPP, the goal is both price of contributions and benefit stability.

Looking at risk from the perspective of a plan’s longer-term objectives may lead to a shift away from traditional benchmarking, suggested Josephine Marks, managing director of pension assets at Scotiabank. Instead of comparing plan results to similar plans—and hoping to outperform them—she said, “it’s a question of changing the mindset.” The shift is from the asset-only mindset to the asset-liability mindset.

It makes a difference. In asset-only space, for example, one risk is higher interest rates. It means the capital value of bonds falls. But, in shifting to the asset-liability space, the greater threat is actually from falling interest rates. Falling interest rates increase plan liabilities. “The dollar impact of rates going down is far more significant,” she said.

That means redefining plan objectives—which can be a hard sell to plan trustees.

To comment on this story, contact us.