Risk Management for Pension Plans article

1. F e at u r e
Risk Management Trends
for Pension Plans
By L. Gregg Jo h n s o n , E A, M AAA, M SPA, CFA , a n d M i c h a e l D i e s c h b ou rg, C I M A
® ®
“D
on’t put all your eggs in Determining the geometric return that the geometric mean is always equal
one basket” might be the is a bit complicated; however, there is to or less than the arithmetic mean,
oldest rule of investment an easy way to estimate the value. The even if there are no losses, and the
risk management. This adage suggests estimate is the arithmetic return minus magnitude is dependent on the volatil-
diversifying into multiple asset classes one-half of the variance (which is the ity (standard deviation) of returns.
in your portfolio so when one goes standard deviation squared). The esti- Obviously, losses increase the magni-
down another might go up. It’s still the mates in table 1 illustrate that the esti- tude of the standard deviation signifi-
bedrock of most basic risk-management mate is a good approximation. The most cantly, so avoiding losses is paramount.
approaches and was first formalized enlightening aspect of the estimate is But if equal arithmetic returns can be
in modern portfolio theory, created by
Harry Markowitz, which seeks the low- TABLE 1: COMPARISON OF ARITHMETIC AND GEOMETRIC PORTFOLIO
est risk for allocations among multiple RETURNS OF A $1,000 INVESTMENT
asset classes. A B C D
Techniques for managing portfolio Year 1 8% 8% 8% 8%
risks have evolved since Markowitz Year 2 8% 2% ‒8% 24%
and continue to evolve today. Post-
Year 3 8% 14% 24% ‒8%
modern portfolio theory, which focuses
Accumulated Wealth $12,597 $12,558 $12,321 $12,321
on downside risks, grew from modern
portfolio theory (MPT). Value-at-Risk Arithmetic Return 8.0% 8.0% 8.0% 8.0%
and conditional Value-at-Risk techniques Standard Deviation 0.0% 4.9% 13.1% 13.1%
were created. New approaches such as Geometric Return 8.0% 7.9% 7.2% 7.2%
liability-driven investing and dynamic Geometric Return (Est.) 8.0% 7.9% 7.1% 7.1%
asset allocation methods are being used
in pension investing. This article will FIGURE 1: RANGE AND STANDARD DEVIATION OF COMPOUND RETURNS
discuss the pros and cons of these tech-
niques and others to help advisors deal 25.00%
with volatility in pension portfolios.
20.00%
The Math of Winning
One of the crueler vagaries of invest- 15.00%
Compound Annual Return
ing is the effect that negative returns or
returns below a target level have on try- 10.00%
ing to achieve a certain long-range rate
of return. Table 1 shows the accumula- 5.00%
tion from a $10,000 investment at the
end of three years under four scenarios 0.00%
0 2 4 6 8 10
that have the same arithmetic return.
-5.00%
As table 1 shows, the four scenarios
accumulate to three different amounts.
-10.00%
How can that be? The accumulated
value of an investment is based on the Year
Worst Case Best Case Std. Dev.
geometric return on assets rather than
the arithmetic average (mean)—the
arithmetic return is misleading at best.
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2. F e at u r e
and practice. In practice there is.” The
FIGURE 2: RANGE AND STANDARD DEVIATION OF WEALTH
elegant and formal mathematics of
$2,000 MPT has relied too much on theory
Millions
rather than the reality of market move-
$1,750 ments. Experience has proven that in
practice, MPT does not deliver the
$1,500
promised results, particularly when
$1,250 they are needed the most.
Post-modern portfolio theory
Assets
$1,000 (PMPT) focuses on losses or downside
risk to seek portfolios that will pro-
$750
vide the most return for any expected
$500 level of loss or to generally attempt to
accurately measure the potential losses
$250 in a portfolio. Tail risk, or extreme loss
scenarios, are measured using Value-
$0
0 2 4 6 8 10 at-Risk (VaR) to attempt to quantify
how much a portfolio might lose in any
Year
Worst Case Best Case Std. Dev. specified period; or conditional Value-
at-Risk (CVaR), which is the amount of
loss expected given that a loss occurs.
These measures were developed origi-
achieved in two portfolios, the portfolio to deliver the returns you need. Static nally for highly complex investment
with the lowest volatility always will strategies actually may decrease the bank structures that included diverse
accumulate to the most wealth. chances of attaining a fully funded plan. instruments and also are utilized
extensively in hedge fund risk manage-
Investment Risk Portfolio Theory ment. Their application to investment
Many people have heard the adage MPT was developed by Harry portfolios is more suspect because of
that investment risk decreases with Markowitz in 1952 and uses expected the fragile relationships of near-homog-
time—that achieving your investment return, standard deviation, and correla- enous asset classes. PMPT suffers from
goals will be easier the longer you stick tion estimates to produce the efficient many of the same shortfalls as MPT.
with your asset allocation. While this frontier of asset allocations representing
statement is partially true, it misses a the highest return for any level of risk. Best Practices
big issue. The expected return, standard devia- Establishing best practices in building
If you are investing pension assets tion, and correlations estimates can portfolios begins with the development
and attempting to achieve a certain rate be generated from historical data or of an objective process to establish goals
of return, say 8 percent, and you select forward-looking anticipated estimates. and benchmarks of performance. Best
an asset allocation that historically pro- However, the asset allocation outcomes practices should include the following
vides an expected return of that amount, are very sensitive to small changes in steps:
the long-term compound (or geometric) assumptions that lead to artificial asset Establish realistic goals within a
return should approach that number. class limits to prevent unreasonable risk budget. In establishing realistic
Figure 1 illustrates this concept. allocations. The imposition of these goals, the investor or plan sponsor
However, as time increases, the limits makes the allocations generated must articulate what is most important
uncertainty of your accumulated wealth almost pre-determined—the efficient to the situation. The goals might be to
increases as shown in figure 2. If you are frontier of the set of feasible portfolios achieve a consumer price index plus
the sponsor of a pension plan attempting with the desired return or risk is virtu- 3-percent annual return with no more
to fund a liability, this means the uncer- ally a straight line. than 10-percent volatility or, in the case
tainty of the funded status of your plan The limitations of MPT are best of a pension plan sponsor, to achieve
increases with time. Attempting to fund summarized in a quote attributed to the highest funded ratio possible while
your liability becomes a great deal more computer scientist and educator Jan taking no more than a 5-percent chance
difficult than simply selecting an asset L. A. van de Snepscheut: “In theory that the funded ratio will drop by 5 per-
allocation and waiting for the long term there is no difference between theory cent or more during any one year.
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3. F e at u r e
Identify relevant risk metrics. In Monitor progress. Performance is Return enhancers provide for the
the process of setting goals, relevant measured on achieving the goals out- selection of managers or nontraditional
risk measures usually are apparent. In lined in the process rather than focusing classes where alpha ability can be
the example above, minimum annual on the performance of any one manager demonstrated.
return and standard deviation are or asset class. Inflation hedges accommodate
important to the first investor whereas Defining asset classes by function in benefits that are dependent, directly
funded ratio and stochastic probabili- a core-satellite approach is useful when or indirectly, on inflation. Treasury
ties are important to the second. Many considering the potential asset alloca- inflation-protected securities (TIPS)
plan sponsors are worried about the tions that are most likely to achieve or real assets typically are found in this
volatility of the contributions required one’s goals. Figure 3 shows how asset bucket.
by the plan so this is the relevant risk classes can be defined by function. Direct hedges are used to hedge
metric. At the core of all portfolios is the portfolio risk, equity, or fixed income,
Measure current risk exposures. beta or market exposure class. This class either tactically or for leaving on a
The relevant risk measures are quan- consists of equity market exposures and hedge (such as a tail-risk hedge) at all
tified under the current or initially other highly correlated asset classes. times. Futures and options uses are
proposed asset allocation to establish The portfolio is optimized based on growing rapidly and most investors
a benchmark to use for determining return and risk expectations and any have a choice of many hedging options
improvements. necessary allocation constraints. A previously not available to them.
Evaluate alternatives to improve single risk-and-return metric is deter- Risk diversifiers come in many
the risk profile. Alternative asset allo- mined based on this allocation; it will forms, and several are unique to pen-
cations are identified and risk metrics be used in the remainder of the process sion plans. The most fundamental risk
are measured to determine improve- and will help determine the allocation to diversifier is the fixed-income asset
ments from the initial allocation. An the beta class. class. Because the risk in most portfo-
asset-liability modeling study is com- The following satellite portfolios are lios is dominated by equity risk, adding
pleted to produce the metrics needed to then added: fixed income—which typically has a
evaluate the pension plan. Liquidity accommodates the near- correlation with equity of less than
Implement solutions. The portfolio term (5–7 years) benefit payments or 0.50—is a common risk diversifier. In
allocation needs to be dynamic at the cash outflows while maximizing return; the past, fixed income has been the only
asset allocation level, manager level, or satellite liquidity portfolios are updated real risk diversifier for many investors.
both. annually. Today, more asset classes are available
to satisfy this function with specialized
FIGURE 3: CORE-SATELLITE PORTFOLIO CONSTRUCTION OF ASSET classes for some pension investors.
CLASSES BY FUNCTION Risk diversifiers could be any asset
class that exhibits a low correlation with
the beta portfolio and whose correla-
tion is not expected to approach 1.0 in
Risk anything but the most extreme circum-
Diversifiers
stances. Real estate is a good fit in this
category. Absolute return appears to be
an excellent risk diversifier and could
Liquidity Direct be a very attractive alternative to fixed
Allocation Hedges income. The key here is that it is futile
Beta
to attempt to diversify equity risk with
Market other equity classes—most equity cor-
Exposure
relations are at least 0.70 and it doesn’t
take anything like a crisis for these cor-
relations to approach 1.0. Therefore, all
Inflation
Return
Hedge
equity classes are included in the beta
Enhancers
Allocation portfolio, a single return and risk mea-
sure is used to represent them, and the
real risk reducers are then introduced
into the optimization.
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4. F e at u r e
TABLE 2: DYNAMIC ASSET ALLOCATION BASED ON PLAN FUNDED STATUS
Less than 80%‒90% 90%‒100% 100%‒110% More than 110%
Class 80% Funded Funded Funded Funded Funded
Cash 5% 5% 5% 5% 5%
Fixed Income 35% 45% 60% 70% 80%
Real Estate 10% 5% 5% 5% 0%
Large-Cap Equity 15% 15% 10% 10% 10%
Mid-Cap Equity 10% 10% 5% 5% 5%
Small-Cap Equity 5% 5% 5% 0% 0%
International Equity 10% 10% 5% 5% 0%
Private Equity 10% 5% 5% 0% 0%
Expected Return 7.8% 6.9% 5.8% 5.0% 4.2%
Standard Deviation 11.8% 8.9% 6.4% 4.9% 5.1%
Projected Contributions over 20 Years
95th Percentile $404,478,630
50th Percentile $172,162,360
5th Percentile $61,286,462
Because corporate pension plan
liabilities are now marked-to-market, or
measured at current yields, specialized
instruments are available to lower their
“ T h e pro lif e ratio n o f LDI applicatio n s
am ong co n s ultan ts h as co me to make LDI
appea r mo re o f a pro du ct th an jus t addin g an
”
risk, primarily from decreases in inter-
est rates. Public pension plans are not i nt eres t-match in g as s e t.
required to mark liabilities to market
on the current yield curve, so none
of these opportunities, nor liability- fixed-income instruments of the same The proper way to address interest-
driven investing (see below), is a risk duration as liabilities, the movement rate risk is to configure asset classes
diversifier. of the assets and liabilities would be by function, as described above, then
perfectly correlated and the plan always to investigate the effect of varying the
Liability-Driven Investing (LDI) would remain 100-percent funded. This allocation to the interest-matching
It is difficult to read about pension is the basis for LDI. (Insurance compa- fixed-income class by examining the
investing today without reading about nies have been doing this for years and effect on identified metrics through an
LDI. The concept gained traction call it “matching assets and liabilities.” asset-liability study in the best prac-
through the Pension Protection Act of Pension plan investors apparently tices process. Exposure to interest-rate
2006, which requires corporate pension wanted their own nomenclature.) risk can be clearly evaluated from the
plan liabilities—i.e., the present value of The proliferation of LDI applications metrics and plan sponsors can make
future benefit payments—to be deter- among consultants has come to make informed decisions about the risks they
mined on current yields of investment- LDI appear more of a product than are willing to accept.
quality bonds. Because interest rates are just adding an interest-matching asset.
so low, the liabilities of pension plans Additionally, most consultants have Dynamic Asset Allocation or
and the underfunding of plans (liabili- indicated that LDI is used to “de-risk” a Defined Benefit Glidepath
ties in excess of assets) are at histori- pension plan; however, LDI addresses Another popular topic in pension
cally high levels. only a single risk (interest-rate expo- investing is dynamic asset allocation,
Now that liabilities of corporate pen- sure) while many risks still remain in also called defined benefit glidepath.
sion plans are inversely related to interest the assets and liabilities. LDI also seems This approach seeks to achieve closely
rates, there exists an opportunity to to be presented as a solution to an matched fixed-income assets to liabili-
directly match the movements of assets underfunded pension plan. LDI itself ties at the time the plan becomes well-
and liabilities. For example, if a plan were cannot directly help the underfunding funded. Acknowledging that return
100-percent funded and invested only in of a pension plan. Continued on page 16
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5. F e at u r e
Johnson–Dieschbourg
Continued from page 15
is important when the plan is under- happening primarily because the com- returns is the surest path to having the
funded and that some investment risk monly accepted static approach to asset resources to distribute required amounts
will be taken to help achieve improved allocation and asset management is not to pensioners.
funding, the roadmap or glidepath for working. Indeed, the static approach is
asset allocation will be based on the based on a number of assumptions and L . Gr e g g Jo hn s o n , E A , M A A A , MSPA ,
funded status of the plan. Plans with theories that all too often are proving C FA ® , i s m an ag ing p r in c ip al of
lower funded status will have higher false in common practice. Consequently, P e n sio n Ap p lic a tio n s . He e ar n e d a
allocations to beta or alpha-generating the math of losing is forcing a move to B B A w ith ho n o r s in a c tu ar i al s ci e n ce
assets, gradually moving to matching a more dynamic approach that focuses f r o m the Univ e r sit y o f Te x a s an d
fixed-income investments as funded more on success than on theory. The key a Ma s te r s o f Fin an c e f r o m Ge org i a
status improves. An asset-liability study to the success of this dynamic approach S t a te Univ e r sit y. C o n t a c t him at
can optimize the glidepath based on a is a collaborative effort among all inter- lg r e g g j o hn s o n @ p e n - ap p s .c o m .
metric identified by the plan sponsor, ested parties, plan boards, consultants,
and this optimized glidepath will be actuaries, and investment managers to Michael D ie schbourg, C I M A®, is
included in the investment policy state- achieve the liability objective of the plan manag ing director at BRO ADM ARK
ment. Table 2 illustrates an example of a rather than market-focused goals. Better Asset Management . He earned a BB A
glidepath based on funded status. tools for describing portfolio behav- from Loyola University of Chicago
ior will help. But the most important and ser ve s on I MC A’s Board of
Conclusion improvement is the establishment of D irectors a s well a s the editorial
The funding crisis in pension plans is a new core that seeks to avoid large boards of Investments & Wealth
causing plan administrators, consultants, drawdowns while still maintaining Monitor and the Journal of Investment
and asset managers to rethink traditional equity exposure. The avoidance of large Consulting. Contact him at
approaches to return and risk. This is drawdowns while maintaining adequate mdie schbourg@broadmarka sset .com.
Gillespie–Curwood
Continued from page 11
Mina, J. 2005. Risk Budgeting for Pension Plans. Disclaimer: This document is issued by is not a reliable indicator of future
RiskMetrics Journal 6, no. 1: 9–34. Russell Investment Management Pty performance.
Russell Investments. 2012. De-risking Risk: Ltd ABN53 068 338 974, AFS Licence Nothing contained in this material
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Management, But Still Face Challenges information for wholesale investors only securities, or investment advice, nor an
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Pensions & Investments, Part 2. http://sup- to your objectives, financial situation, of any investment, nor a solicitation
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Schmid, M. A., and Q. Nguyen. 2012. A Total this information is appropriate to your material is proprietary and may not be
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