Generally, reduced exposure to equities, in favour of bonds, will reduce the expected long-term return of an investment portfolio. However, the variation of short-term returns will also be reduced. This is a means of risk control, but an overall reduction in investment return, will result in higher cash contributions from the employer sponsor of a defined benefit (DB) pension plan. Is the trade-off worthwhile? How is the trade-off quantified?
A key issue with risk management of DB plans is that the bear markets that produce deficits and require contribution top-ups also have an effect on the employer-sponsor’s business. In setting a risk appetite, it is important to know how these conditions also affect the ability of the employer to have cash available for contributions. The investment risk profile of the DB fund’s assets should not assume that the ability of the employer to make top-up contributions is constant and independent of the very conditions that created the shortfall in the DB fund in the first place.
A de-risked investment portfolio is one where the characteristics of the assets closely match the characteristics of the liabilities in terms of valuation, duration and liquidity. It does not necessarily mean an investment in so called “risk-free” government bonds because the liabilities may behave differently from government bonds. DB plan future benefit outgoings are uncertain in both timing and amount. Timing is driven by employee turnover and amounts are driven by a range of factors, such as benefit design and salary inflation. No investment portfolio can completely replicate the future cash flows arising from a DB plan, either in terms of the level of benefit, the risk of the cashflow, or the liquidity. But it is possible to construct an investment portfolio with some characteristics of the liability profile, even if there will not be a perfect match. Asset-liability modelling is the technique used to assess the effectiveness of possible alternative investment portfolios. The asset-liability model projects the possible experience of both assets and liabilities (that is, the benefits) under a range of possible scenarios of future investment and inflation experience. The effect on solvency levels and the employer’s contributions is measured and an overall picture of the range of likely outcomes is obtained, including the likelihood of contribution top-up requirements exceeding a specified limit. Asset-liability modelling quantifies the trade-offs for an employer to then judge.
Generally, risks associated with meeting the liabilities fall on the employer sponsors and the experience of the last four years investment markets has caused most employers to at least consider de-risking. However, de-risking is perhaps better described as “right-risking” – accepting risk where there is reasonable prospect of limiting the downside and exploiting the upside. It is unlikely that all funds will follow the same path. Currently, bond yields are low and equities are relatively good value. This makes the decision of when to de-risk even more complex and, in some respects the markets are indicating that more risk could be taken. Yet, economic conditions remain uncertain. Is the world economy about to fall into a long recession? As China’s rate of growth slows how will our investments perform? What will happen in the Eurozone? What will be the effect of massive stimulus spending in the US? What is the best combination of asset classes to hold to meet a given set of future uncertain cashflows out of a DB plan? These are complex issues to consider and the outcomes of decisions have long-term ramifications for both employers and employees. De-risking is not for everyone. Right-risking is mandatory.