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What to look for in 2012: De-risking

March 27th, 2012 Leave a comment Go to comments

By Tim Connor, Genny Sedgwick

Defined benefit plans: De-risking
Given the highlighted areas of concern already discussed, it’s likely that plan sponsors will look ever harder at the idea of de-risking their plans in 2012 and onward. The volatility of worldwide markets has been dubbed the “new normal” by many economic minds. Smoothing mechanisms are losing favor in the financial world, and the International Accounting Standards Board (IASB) has already moved toward a more mark-to-market structure, with the Financial Accounting Standards Board (FASB) likely not far behind. Sponsors have already been “encouraged” by the Pension Protection Act of 2006 (PPA) to take on less risk in their pension portfolios, and now the accounting world is joining in on the push. When you further consider the world of pain that comes with benefit restrictions under the PPA and the ramifications of being at-risk, not to mention higher Pension Benefit Guaranty Corporation (PBGC) premiums the more underfunded a plan is, it stands to reason that employers should be very attracted to pension risk management more so than ever.

Liability-driven investment (LDI) strategies have been one popular approach to mitigate risk by reducing the exposure to the most volatile assets in a portfolio, instead concentrating investments in assets that act more like liabilities, namely long bonds. However, the cost of implementing an LDI strategy is high right now because current yields on bonds are so low. Also, there is still a lost opportunity cost with regard to the impact on financial statements, at least with U.S. GAAP anyway.

Full immunization strategies, bond matching, or even annuity purchases to transfer risk are also good ideas but currently “expensive.” Alternatively, we expect many sponsors in 2012 to embrace other strategies that maintain substantial equity exposure within the pension portfolio. Simply put, they can’t afford not to invest in equities right now. Many sponsors have been interested in the concepts of dynamic hedging, an approach that still allows for significant equity investment with less overall risk. The Milliman Managed Risk Strategy™ (MPS) is one such platform to accomplish this risk management goal. It offers pension plans more than what simple asset diversification can offer. MPS focuses on capital protection and volatility management. Its risk reduction techniques are very easily added as a futures overlay onto a portfolio with no disruption to the underlying investments. The concept is to sacrifice a small portion of the upside potential while eliminating a greater, more disproportionate amount of the downside.

Dynamic hedging strategies such as MPS can accomplish this because of the asymmetric distribution of stock market returns. Theoretically, the concept should find favor with sponsors because avoiding the worst returns has greater economic and practical value than the small slice of lost value of the most spectacular asset returns. After all, significantly overfunded pension plans present their own set of problems. Thus, it makes sense to strive for middle-of-the-distribution returns and avoidance of the long, fat left tail of poor returns.

Next we’ll look at defined benefit plans: lump sums.

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