Do traditional pension risk management strategies actually lead to greater risk?
Steven Berkovi questions whether traditional ‘de-risking’ strategies of selling equities to buy bonds are as effective in pension risk management today.
When it comes to pension risk management, traditional de-risking strategies may not always be the most effective. Risk management strategies are a part of everyday life, even if we are not consciously aware that we are doing it. Most are common sense – look both ways before you cross the road, always wear your seat belt, don't eat too many sweets.
These are all very sensible strategies, but something seems to have gotten lost when it comes to pension funding. The majority of pension funds are still taking too much risk, probably more than they can afford.
Traditional de-risking: hoping for the best, preparing for the best
The majority of pension risk management strategies involve selling growth assets (often equities) and buying matching assets (mostly bonds) when the time is right. This is often when a funding ratio trigger is hit.
Implicitly, this means that trustees have to continue to take too much risk at the outset of the strategy. They do so in the hope that equities will continue to rise whilst interest rates (mainly real interest rates) rise faster than is already expected – or at least stay on their predicted path. If this ideal scenario plays out then the funding ratio will rise, the triggers kick in and de-risking starts.
When things don't go to plan
So what happens if equities don't go up or interest rates fall? The overall picture just gets worse. Because you are taking too much risk already, the deficit starts spiralling out of control. It's also worth bearing in mind that these same pension risk management strategies also lead to de-returning. This might not be a phrase you will find in the dictionary, but it should be there – at least in the pension fund dictionary.
So what is de-returning? As you sell your growth assets and buy matching assets, you start to reduce the ability of the overall growth assets to help remove the deficit. For instance, you reduce the expected return on the portfolio. This means that Trustees put more pressure on the sponsor, often at times when they need it the least.
Pension risk management where you might not lose everything
No one starts their pension risk management journey thinking they could lose it all. Ok, so you may not, but you could lose more than you bargained for. In order to avoid this, a change to the plan is required. Not just a change in trigger points or time frames, but something a bit more fundamental -a change in philosophy.
Consider this; what happens if growth slows down or we head into another recession? Different combinations of investments can be used to deliver positive returns across a range of economic conditions. Which in turn helps to add balance to your portfolio.
Adding some real diversification is just one way to help a pension scheme withstand shocks. Strategies that don't all move together in the same way and at the same time mean a pension scheme isn’t just relying on good times to deliver. This will help to reduce the risk in your pension scheme and, if done in the right way, means that you don't need to reduce the return on your portfolio either. This is pension risk management without de-returning, which is good for trustees and sponsors.
Find out more about pension risk management
If you would like more information on pension risk management strategies for DB pension schemes, please get in touch with us. Or take a look at our services page to find out more about what we can do for you.