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Revolutionary risk management for pension plans

November 16th, 2011 Leave a comment Go to comments

By Chris Sill

Investment consultants and plan sponsors find themselves in a tough spot these days. Many plans are underfunded, which is due to the financial crisis and rock bottom interest rates. In order to avoid costly contributions, outsized returns are needed to shore up their funded statuses. However, outsized returns may mean taking on outsized risk. And, if the first financial crisis left pension portfolios crippled, a second one could prove catastrophic.

Who has found a solution? Life insurance annuity providers adopted hedging as an industry standard practice by 2006. Such programs proved 93% effective during September and October of 2008, saving the industry an estimated $40 billion in reserves. Variable annuities, similar to pension plans, promise a guaranteed lifetime payout stream backed with equities. Therefore, the compelling success of these programs for annuity providers can be applied to pension plans as well.

The Milliman Managed Risk Strategy is a multi-faceted futures overlay strategy for pension portfolios that aims to capture, on average, 80% of the upside potential of equities with 25% of the downside exposure.

Using equity futures contracts, some of the most liquid and simple financial assets available, MPS adjusts market exposures in order to provide a risk and return profile that is superior to traditional asset allocation models. Through the combination of the capital protection strategy and volatility management, the MPS adjusts market exposures to maintain a nearly constant risk profile while simultaneously providing a cushion of protection against market downturns.

How risky is my portfolio?
Traditional asset allocation models focus on equity exposure as a proxy for risk. A “moderately risky” portfolio might invest 60% of assets in equities and 40% in bonds. But what if equity volatility is now twice as high as it was when this allocation was initially conceived? Is this portfolio still “moderately risky”? The MPS addresses this problem directly through volatility management. Instead of targeting a certain equity allocation, the MPS targets a specified level of volatility. Thus the risk (volatility) of the portfolio remains constant regardless of underlying market conditions.

Relevant risk management
The MPS realizes that asset risk management is not the same for all pension portfolios. An overfunded plan might have a very different view of risk when compared to an underfunded plan. Focused risk management is needed and that is what the capital protection strategy provides. The capital protection strategy uses futures contracts to create a cushion of protection against market downturns. The result of the strategy is that the protected portfolio is generally less affected by market downturns. This preservation of the asset base will prove even more valuable in the event of a market recovery.

The strength of the cushion is dynamic and reflects your portfolio’s individual circumstances. As markets fall the cushion of protection becomes larger, offsetting a greater portion of the loss realized by the underlying investments. As markets rise the cushion becomes smaller, creating less drag on the portfolio. The strength of the cushion can also be “reset” after extreme market moves. After large market downturns the strength of the cushion is reduced in order to take advantage of subsequent market recoveries. Following the attainment and then retreat from a recent portfolio high-water mark value, the level of cushion is reset in order to help preserve market gains.

Finally, MPS allows the plan to stay with its existing investment and allocation strategy. MPS does offer an effective, revolutionary risk management solution for today’s pension managers.

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