U.K. leads the way on risk management

Aon’s Pension Risk Management Global Survey of 41 global financial services organizations that provide risk management services to U.K, U.S., and Canadian pension plan sponsors finds that 58% of respondents identified interest rates as the biggest issue facing DB plan sponsors between now and 2013, followed by longevity risk (21%), equity markets (15%) and inflation (6%).

According to Aon, the survey results emphasize three key guiding principles, to which pension plan sponsors must pay close attention:

1) diligently measuring and monitoring all risk types;
2) setting asset mix and investment structures that are suitable to the plan design and individual needs; and
3) having solid skills and knowledge of risk management best practices.

Despite the positive stock market performance in 2009, pension plans globally still face funding shortfalls, the impact of which is significant and differs by stakeholder group.

Such underfunding has resulted in a heightened awareness of risk and raises the question of whether or not plan sponsors and members clearly understand pension plans and the associated risks.

Risks and trends
Respondents identified the major risks facing DB pension plans as follows:

• Interest rates
• Longevity
• Equity market
• Inflation

Longevity and equity market risk were identified by respondents as the two risks that are the most difficult to eliminate. After interest rate risk, these are also the two most significant risks that pension plans face on a global basis.

Plan sponsors have been unsuccessful in eliminating all pension plan risk for a number of reasons, including insufficient current funding and lack of understanding of the risks. Respondents say they expect sponsors to seek to remove interest rate, inflation and equity market risks over the next 12 months.

“The main barrier to interest rate and inflation hedging has been the very low level of real interest rates,” says Lucy Barron of Insight in the U.K. “Many funds have been delaying implementation and putting policies in place in anticipation of higher future interest rates.”

Aon says that it has seen increased sophistication among larger U.K. DB plans as they seek to hedge unrewarded risks while simultaneously maintaining or increasing exposure to rewarded risks, such as equity markets.

“Historically, the risk management products and solutions available to plan sponsors in the U.K. have been more advanced than those in the U.S. and Canadian markets,” says Brendan George, senior vice-president and global survey lead. “However, recent advancements in the U.S. and Canadian insurance and fund management industries give plan sponsors in North America sufficient choice today.”

Canadian outlook
Aon’s report breaks down the various sources of risk faced by Canadian plan sponsors as follows:

Respondents identified interest rate risk as most crucial, but managers expect to see a growing focus on both equity exposure and inflation exposure over the course of 2010. Inflation risk—considered easy to hedge in the U.K.—is a different animal in the Canadian market, ranking first in terms of being difficult to hedge, similar to equity and longevity risks.

Canadian DB plan sponsors are retaining some of these risks in their portfolios due to the current funded status of their plans and the associated costs. Lack of understanding of the risks is also a critical factor.

Interest rate risk
Aon’s data suggest a growing demand for interest rate risk management is expected over the next three years as the funded status of plans improves and as sponsors seek to reduce financial statement volatility.

Currently, the preferred approach for managing interest rate risk is the physical holding of long duration bonds in the portfolio, but an increasing proportion of providers (40%) expect to offer derivative-based solutions such as swaps and futures.

While presently out of favour, interest in hedging with swaps is expected to increase once credit spreads are closer to their historical levels, explains Paul Purcell, managing director at BlackRock Asset Management Canada Limited. “Now that swap spreads are back to more normal levels, they become a more interesting and credible option for hedging purposes.”

Equity risk
Plan sponsors are slowly realizing that too much of their risk budgets may be allocated to equities. However, they still seem hopeful that a healthy equity exposure will help to reduce the large funding gap, should markets rebound substantially.

The two most popular ways to mitigate equity risk are investments in alternative asset classes and portable alpha strategies. However, an increasing number of respondents are expecting to use derivatives, such as put options or collars, in the short term.

Longevity risk
The Canadian market for products that hedge longevity risk is “underdeveloped with few offerings,” as only large plans are showing any interest in such instruments, say the report’s authors.

Currency risk
While currency is a significant issue for Canadian pension plans, with most having currency exposure in the 30% to 40% range, there is no clear industry trend with respect to managing currency risk. As Aon explains, some believe that exposure to foreign currencies is an unrewarded risk and should therefore be hedged, while others feel that currency exposure increases portfolio diversification.

Passive currency risk management with a fixed hedge ratio is the most common strategy used by those who manage this risk.

Inflation risk
Inflation risk is an important issue for certain Canadian DB plans—particularly public sector plans that are indexed to inflation. However, because of an underdeveloped and illiquid market for inflation swaps, government real return bonds and investments in commodities are the preferred means of mitigating this type of risk.

The report’s authors believe that the pension risk industry in Canada is still in its infancy but is on the verge of taking off.

“We expect increased activity in interest rate risk hedging over the next few years, as plans’ funded status improves and solutions are made available to smaller plans,” notes the report. “Plan sponsors are also likely to invest time, resources and effort in the areas of currency and equity risk management. We believe the focus should be on eliminating unrewarded risks (interest and currency) and achieving an excellent diversification of the equity risk component.”

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