Understanding and managing pension fund risk
by Dr. Ros Altmann
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This is a challenging time for pension fund trustees. They are being bombarded with new investment ideas – and a confusing array of seemingly conflicting advice. At one extreme, they are being told that pension liabilities are bond-like, so they should be switching out of equities and into bonds. At the other extreme, they are being urged to use swaps, hedge funds, venture capital, commodities and even art, in order to diversify their assets and improve portfolio efficiency.
We need to recognise that pension fund investing is not easy and there is no one right answer for every scheme. It is not just a question of putting as much as possible into equities and waiting for them to ‘outperform’ over time. Of course, equities are expected to outperform bonds, but this is not sufficient. Some equities will perform poorly (the risk premium reflects the fact that some companies will fail) and outperforming bonds is not the same as outperforming pension liabilities. Pension liabilities may be ‘bond-like’ but they are not bonds. Bonds cannot match the salary inflation, longevity and duration characteristics of pensions. Furthermore, once a scheme is in deficit, trustees need to outperform their liabilities, not just match them and it is highly unlikely that bonds could do this.
In fact, switching to bonds could make pension funding worse, not better. There seems to be some muddled thinking on risk. Bonds will reduce risk in terms of ‘volatility of return’ but only at the expense of much reduced expected returns. Pension fund risk is about far more than standard deviation – it is about not being able to pay the pensions. Unless a sponsor can be relied upon to continually increase contributions each year, trustees need to find ways of reducing the risks in their portfolio while still allowing upside potential.
Essentially, they need an asymmetric return profile – protecting against sharp falls in the funding ratio, while still allowing strong returns over time. Swaps overlays could insure against unexpected movements in interest rates and inflation, while freeing capital to invest in a diversified portfolio of return-seeking assets which are not highly correlated with each other. With the downside protected, alternative assets and absolute return focussed funds can provide a more efficient portfolio than relying on just one source of alpha and beta from equities.
Of course, there are significant practical problems of implementing swaps overlays (administrative issues, ISDA requirements, pricing and valuation problems, collateral management). Investing in alternative assets requires large amounts of governance time and top investment advisers. For trustees who cannot manage the administration of swaps and derivatives, some firms are launching bespoke or pooled products which can offer both swaps overlay and high potential returns in one fund. This is the next generation of products for trustees, going beyond pooled LDI funds, which do protect downside, but cannot offer upside. I expect more of these will be launched in future, as trustees grapple with the realities of overcoming deficits and the challenges of paying members’ pensions.