Helen Prior looks at building a stable funding ratio, using alternative approaches, for a safer way to reduce liabilities.
With new finance regulation taking effect over the next few years, it is important for investors to maintain a stable funding ratio.
Right about now, alarm bells should be ringing. "Why?" you ask, “We appear to be in a long period of steady growth with low inflation. Things are good, people are optimistic, what could possibly go wrong?”
Believe it or not, all this stability is actually storing up instability. As the late economist Hyman Minsky identified, "Stability is destabilising". Times of prosperity can persuade firms, workers and investors that recessions and crises are a thing of the past. As a result, they are willing to take on more risk.
For defined benefit pension schemes, the objective is to achieve a stable funding ratio with as little risk as possible. With that in mind, it is never the wrong time to ensure the investment strategy is robust and resilient. Rather than just investing for the good times, consider the impact of the good, the bad and the different.
There are three key strategies you can use to achieve a stable funding ratio:
1. Avoid the big bets
Most pension funds are still taking one or two big bets, with a lack of liability hedging often being the biggest one.
Although interest rates are low, if you continue taking this bet you need to be conscious of maintaining a stable funding ratio. Ideally, you would assign an expected return and risk to the position. You would also consider the sizing of the position against other risks in your portfolio.
Many believe that interest rates will only go up from here, but just look at the yields available in countries such as Germany. Can you really afford rates to fall from here?
2. Add some real diversification
Investing in assets that primarily do the same job doesn't really add much in the way of diversification. This is typically the case for a lot of active equity managers in portfolios. To really obtain diversification it is important to add strategies that don't all move in the same way, or at the same time.
For example, combining equities with high yield and a relative value multi-asset portfolio could be a step in the right direction. Many of the tools that can be used may not always be as familiar, but that doesn't mean that they are always more risky.
3. Be bold
Not every asset or investment is going to perform at all points in time in an economic cycle. The obsession with asset benchmarks means that you are essentially being forced to hold something, whether it does well or not. Dealing with this can involve two actions:
First, you should change your benchmark to mirror your fund's liabilities, if you haven't already. Second, be prepared to make even more changes to your portfolio along the way.
This strategy means that you can reference each decision you make based on whether it will add value against the liabilities, or reduce risk. This will help to create a more stable funding ratio in your portfolio.
Making more changes to your portfolio simply involves capturing return when you think it is available and looking to avoid losses. It probably sounds easier than it is, but the first step is a change in mind-set.
Conventional is risky
We need to make pension funds more robust and resilient to successfully contribute to a stable funding ratio. Being alternative and thinking outside the box in this way is a good thing. In this case, being conventional may well be more risky.
By considering the points above, you are already on the road to reducing risk and maintaining stability.
Find out more about achieving a stable funding ratio
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