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The risk tolerance paradox

January 24th, 2014 No comments

The risk tolerance level many investors expect to achieve over the long term rarely equals the same tolerance investors actually experience over shorter periods. This paper by Ken Mungan and Matt Kaufman describes this paradox, explores the main reason it might exist, and introduces a risk management strategy that seeks to solve the problem.

As more “low volatility” and portfolio risk management strategies hit the marketplace, it will be imperative that advisors and investors explore each strategy to uncover how risk is actually being addressed. Identifying those techniques that address both diversifiable and systematic risk is likely to provide better overall results for investors.

Strategies for reducing retirement plan risk in defined benefit plans

April 1st, 2013 No comments

This blog summarizes a presentation given by Steve Hastings and Mahrukh Mavalvala at the Mid-Sized Retirement & Healthcare Plan Management Conference in San Francisco.

The 21st century has been rough on defined benefit (DB) plans. The days in the ’80s and ’90s of pension plan “contribution holidays” have ceded to the current era of low interest rates and high market volatility, and plan sponsors face many risk factors. The types of risk inherent in defined benefit pension plans—interest, inflation, investment, longevity, and legislative risk—impact DB plans in complex ways, which may not end even if an employer has frozen its DB plan. So what is a DB plan sponsor to do? One answer is to work with its plan consultant to gain a deeper understanding of the issues at hand and the strategies available to alleviate the pain points.

Risk management strategies include both in-plan options (such as plan design changes, investment strategies, and annuity options), as well as settlement strategies (irrevocable actions that relieve the plan of benefit obligations). Plan design modifications, including hybrid and cash balance plans, can reduce longevity risk by reducing pension liabilities, and may transfer some investment risk to participants. Switching to a defined contribution (DC) plan may be another strategy, with the option of maintaining the DB plan as a longevity plan to provide annuity income at later ages. However, changing the plan design is a substantial undertaking that may include special ERISA compliance efforts and communicating what may be an unpopular decision to participants. In some cases, participants have filed lawsuits in response to plan design changes and settlement strategies.

Liability-driven investing (LDI) and tail risk management strategies have grown in popularity as in-plan strategies to manage risk via the plan’s investment policy. However, LDI strategies must balance reductions in volatility with hedging interest rate exposure and meeting asset return objectives—not always easily achieved. Tail risk management strategies, such as the Milliman Managed Risk Strategy™, can protect against debilitating investment losses over a short period of time.

Settlement strategies are another option for pension plan sponsors looking to reduce risk. One strategy is offering participants a one-time, irrevocable option to receive the present value amount of their benefit as a lump sum. Another strategy is purchasing an annuity contract where the insurer will provide the remaining annuity payments; in purchasing such contracts, the plan sponsor has a fiduciary obligation to select a financially strong, solvent insurer. Without plan termination, settlement strategies are only available to cover terminated and retired participants (and their beneficiaries). Ford recently implemented a single lump sum settlement strategy. GM recently terminated a frozen plan and purchased annuities to cover some of the pension liabilities. Verizon also recently purchased annuities for a block of retirees. In light of these and other events, this is an excellent time to reevaluate pension plan risk and risk mitigation strategies with your plan consultants.

Variable annuities see a resurgence in popularity

August 8th, 2012 No comments

This article in The Wall Street Journal (subscription required) takes a look at how life insurers have restructured variable annuities in recent years. Here is an excerpt from the story:

In a trend gathering momentum, the life insurers that sell these tax-advantaged vehicles for investing in funds are competing on the basis of investment choices. That’s what they did in the 1980s and 1990s, before launching an arms race of escalating promises of guaranteed-minimum lifetime income, even if underlying funds tanked.

That competition cost the industry dearly when markets slid in 2008 and early 2009, leading to price increases and less-generous features as insurers sought to repair their balance sheets. With the new offerings, insurers are drawing on the past but adding a twist: They are pitching variable annuities as a smart way to load up on alternative investments.

While many insurers did see losses in 2008 and 2009, those with sufficient hedging in place fared better. Milliman research indicates that hedging strategies saved insurers $40 billion in September and October of 2008.

The Milliman Managed Risk Strategy offers similar risk management techniques to pensions through hedging strategies that seek to maximize clients’ asset growth in bull markets while defending against losses in down markets.

For Milliman’s insight into the variable annuity industry, click here.

Managing risk in the face of uncontrollable situations

April 20th, 2010 No comments

A new article in Financier Worldwide looks at risk management in the financial services industry:

In the lead up to the credit crunch, [financial institutions] were generally guilty of overestimating the upside and underestimating the downsides of a given opportunity. “When recent experience of risk-taking is positive and when the rewards are perceived as high, this is an intoxicating mixture that can lead to unwise exuberance,” says Neil Cantle, a principal and consulting actuary at Milliman. “All too often, people think that they are controlling a situation which they really have not taken the time to understand properly. When trouble hits, it can unravel very quickly and the critical ‘point of no return’ is passed. The problem in complex situations is that time-lags in information flows and action-taking can make it exceptionally difficult to know where that critical limit is – and once you have passed it, then that’s it.” Firms that can interpret complex scenarios and predict their consequences more accurately have a much better chance of reducing risk where possible, and responding effectively to risks that do become a reality.

Read the full article here.

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Beyond caveat emptor for risk managers

April 1st, 2010 No comments

According to a recent article in the Wall Street Journal:

As companies assess the lessons of the global financial crisis and look for ways to safeguard their firms against the effects of another one, demand has surged for risk managers—professionals who analyze the risk in transactions, from investments in treasury bills to credit default swaps, and make recommendations about whether to move forward.

Who will guard these modern guardians of our financial health and well-being, or at least certify that they’re up to the task?

That question is apparently driving a burgeoning movement toward certification for risk managers, owing in large part to the complexity and sophistication of the financial environment. Think “global financial crisis.”

More from the WSJ:

With the profession in the spotlight, several industry organizations are vying to provide a standard certification for the field, which the U.S. Bureau of Labor Statistics predicts will grow in the next several years, in part due to the increasing complexity of financial transactions.

While no certification is required to practice risk management—and many companies don’t require one—there has been a jump in the number of people signing up for certification exams.

Certification not only serves clients—by assuring that their risk managers know their stuff—but also risk managers. It introduces a timely process for keeping up with the changes, and challenges, of the profession.

Certification is not new to the profession, as the article points out. But it’s becoming more relevant given the need to distinguish oneself in the marketplace and, perhaps more important, because of increased legislative, administrative, and media scrutiny of the profession.

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