De-risking through dynamic asset allocation: though defined benefit pension plan sponsors cannot control the market, they can temper their fund's exposure to it. The first step: understanding how bad "bad" can be and taking appropriate action.

AuthorLawrence, Stewart D.
PositionPensions

As financial executives are well aware, the recent economy showed that managing risk can be a devilish proposition. Although defined benefit (DB) pension plans could not have been completely sheltered from the crash of 2008, it did demonstrate that event risk was not being properly managed and that the plans were highly exposed to risky assets, even though they were regarded as well funded.

While DB plan sponsors cannot control the market, they can temper their pension fund's exposure to it. They first need to understand how bad "bad" can be and then take action to mitigate the impact of extreme outcomes.

By examining the inherent risks and economic consequences of possible future events, plan sponsors can determine the degree to which risk is acceptable and what must come "off the table." In essence, DB plan sponsors need to understand the answers to three questions: What is the plan's current risk profile? How might that profile change as the funded status of the plan improves/deteriorates? What actions can be taken to change that profile and what will it cost?

Plan sponsors can generally use three approaches to mitigate the financial risk of DB plans:

Plan Design. Normally, unacceptable risk arises not from the accrual of additional benefit liabilities but from benefit promises that have already been made and the assets accumulated to support them. While plan design changes may be viewed as an application of the advice "when you find yourself in a hole, stop digging," they often have little short-term impact on the risk profile.

Moreover, changing the plan design is not viable for plans that are frozen. Funding. Funding the plan to cover 100 percent of the cost of annuities to pass all risk to an insurer is usually cost-prohibitive and an inefficient use of capital. A less-costly approach might be to develop a policy to contribute a level annual amount that exceeds the minimum legal requirement and create a buffer to mitigate future volatility.

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While this may lessen minor volatility, extreme shocks can deplete the buffer in a year. Further, using this approach without changing the investment policy will probably be financially inefficient. Investment Strategy. This is a key consideration for all plan managers, and is the focus of the remainder of this article.

Surplus Management

Volatility of funding requirements, P&L and balance sheet metrics are driven less by absolute changes in assets or liabilities than by the relative change in each. That is why the recent financial period was a "perfect storm." Assets declined because of market conditions that affected essentially all asset classes while declining interest rates drove up liabilities.

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With current accounting and funding rules requiring quicker recognition of these changes, an efficient de-risking strategy needs to focus on assets and liabilities by setting portfolio risk in accordance with the actual funded status of the plan, using a holistic approach...

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