This document provides an overview of risk management strategies and best practices for pension plans. It discusses defining asset classes by function, factor-based risk analysis, volatility as an asset class, liability driven investing, and dynamic asset allocation. The summary emphasizes measuring current risk exposures, evaluating alternatives to improve risk profiles, and monitoring progress regularly. Risk management tools like asset-liability modeling and funded status analysis are also highlighted.

1. Pen-Apps
Pension Applications
Innovation Inspired by Experience
Risk Management Trends
for Pension Plans
Atlanta, GA
770.300.8601
www.pen-apps.com

2. Pen-Apps
Introduction to Risk Management Pension Applications
› What is it?
› Who needs it?
› Haven’t we been doing this?
› What are Best Practices?
› How do I implement good governance?
› What should we consider?
– Assets
– Liabilities
– Assets and Liabilities
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3. Pen-Apps
Pension Applications
Asset Risk
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4. Myth: Investment Risk Decreases over Pen-Apps
Time Pension Applications
› Range and Standard deviation of compound returns deceases over
time
› Range and Standard deviation of accumulated wealth (assets)
increases over time
“It’s tough to make predictions, especially about the future.” - Yogi Berra
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5. Pen-Apps
A Brief History of Portfolio Theory Pension Applications
› Modern Portfolio Theory (MPT)
– Developed by Harry Markowitz - "Portfolio Selection“, The Journal
of Finance, (March 1952)
– CAPM, Mean-Variance Optimization – Highest expected return for
any risk level
– Gains and losses treated equally
› Post-Modern Portfolio Theory (PMPT)
– Created by Investment Technologies and introduced in Rom, B. M.
and K. Ferguson, "Post-Modern Portfolio Theory Comes of Age“, The
Journal of Investing, (Winter 1993)
– Further development by Fishburn, Sortino, van der Meer, et. al.
– Eugene Fama: “Empirical failures of the CAPM invalidate most of its
applications”
– Focus on downside risk measures (losses)
– Suffers from same shortcomings as MPT
“In theory there is no difference between theory and practice.
In practice there is.” - Jan L. A. van de Snepscheut
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6. Pen-Apps
Why Diversify? Pension Applications
› Diversification is designed to normalize returns to reduce
investment risk
› How normal can we be?
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7. Pen-Apps
Why do we need Risk Management? Pension Applications
At the core, a pension fund is similar to a fund of funds. Though individual
managers may incorporate risk techniques for their allocation, risk controls
need to be applied at the total fund level. A risk budget, outlining how much
risk should be taken in the portfolio and what should be done if that level of
risk is exceeded, should be developed.
Pension Fund
Manager Manager
A B
Manager Manager
E C
Manager
D
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8. Portfolio Construction within a Risk Pen-Apps
Budget Pension Applications
› Defining Asset Classes by Function
› Liquidity Allocation
› Market Exposures (Beta)
› Risk Reducers
› Return Enhancers (Alpha)
› Inflation Hedge Allocation
› Direct Hedges
› Factor Based Analysis
› Tail Risk Measurement
› Value-at-Risk (VAR)
› Extreme Tail Loss (ETL)
› Risk Responsive/Volatility Sensitive allocation
› Low Volatility Strategies
› Volatility as an Asset Class
› Equity Hedging with Options
“It is better to be roughly right than precisely wrong” – John Maynard
Keynes
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9. Pen-Apps
Definition of Asset Classes by Function Pension Applications
Fixed Income
Liability Matching
Real Estate
Risk Absolute Return
Diversifiers
Liquidity Direct Futures
Allocation Hedges Options
Beta
Market
Exposure
Options Writing Inflation
Return TIPs
Alternatives Hedge Real Assets
Private Equity Enhancers
Allocation
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10. Pen-Apps
Factor-Based Risk Analysis of Assets Pension Applications
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11. Pen-Apps
Volatility as an Asset Class Pension Applications
Correlation Coefficient Jan-1990 to Mar-2012
S&P Russell Russell Russell MSCI
VIX 500 2000 3000 Midcap EAFE
VIX 1.00 -0.65 -0.62 -0.66 -0.66 -0.51
S&P 500 -0.65 1.00 0.81 0.99 0.93 0.74
Russell 2000 -0.62 0.81 1.00 0.87 0.93 0.66
Russell 3000 -0.66 0.99 0.87 1.00 0.96 0.75
Russell Midcap -0.66 0.93 0.93 0.96 1.00 0.73
MSCI EAFE -0.51 0.74 0.66 0.75 0.73 1.00
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12. Hedging Equity with Volatility Options Pen-Apps
and Futures Pension Applications
Further normalization of returns
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13. Pen-Apps
Pension Applications
Liability Risk
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14. Pen-Apps
Regulatory Environment Pension Applications
› Private Pensions
– Subject to Pension Protection Act (PPA) of 2006
– Marked to market liabilities based on current fixed income yields
– Introduces interest rate risk
– Use of current yields provides Liability Driven Investing (LDI)
opportunities (de-risking)
› Public Pensions
– Not subject to PPA, state law determines contribution
– Uses Expected Return on Assets (EROA) to discount liabilities
– No matching asset - limited ability to de-risk
– GASB move towards partial mark to market
– Moody’s proposed adjustments to state and local pension plans’ data –
use corporate bond index discount rate and market value of assets (no
smoothing)
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15. Pen-Apps
Regulatory Environment (cont’d.) Pension Applications
› GASB
– Statements 67 & 68
– Amendments to Statement 25, Financial Reporting for Pension Plans
– Major provisions follow Exposure Draft
– EROA used through asset sufficiency date, municipal bond rate
thereafter
– Small effect on liabilities as interest rate application is on longest benefit
payments
– Net financial position will move from footnote to balance sheet
› Moody’s proposal
– Liabilities based on corporate bond rate
– Asset smoothing eliminated
– Uniform 17-year level dollar amortization of unfunded liability
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16. Pen-Apps
How Long Will Your Assets Last? Pension Applications
Source: BHA Consulting, Atlanta, GA
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17. Pen-Apps
How Long Will Your Assets Last? Pension Applications
Source: BHA Consulting, Atlanta, GA
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18. Pen-Apps
Pension Applications
Assets and Liability Risk
Best Practices: Analyze These Together
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19. Pen-Apps
Risk is in the Eye of the Beholder Pension Applications
Risk: Potential that a chosen action
will lead to an undesirable outcome
Risk Factors
Undesirable outcomes for Investment Interest Rate Assumption Demographic
pension plans Risk Risk Risk Risk
Return on investment will lag
benchmarks or peer groups √
Return on investment will lag EROA √
“Wrong” asset allocation √
Contributions will rise significantly √ √ √ √
Contributions will exhibit high
volatility √ √ √ √
Funded ratio will drop √ √ √ √
Funded status will drop √ √ √ √
Plan will run out of assets √ √ √ √
Others?
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20. Comprehensive Risk Management Pen-Apps
Process Pension Applications
› Establish realistic goals within risk budget
› Identify relevant risk metrics
› Measure current risk exposures
› Evaluate alternatives to improve risk profile
› Implement solutions
› Monitor progress
“Facts do not cease to exist because they are ignored.” - Aldous Huxley
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21. Pen-Apps
Risk Management Tools Pension Applications
› Funded Status Analysis
› Asset-Liability Modeling Study
› Liability Driven Investing (LDI)
› Dynamic Asset Allocation or Defined Benefit
Glidepath
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22. Get to Know the Growth Rate of your Pen-Apps
Liabilities Pension Applications
Improvements in Funded Status may be attainable
with lower return/lower risk strategies
What Asset Return was needed
EROA = 7.0% Actual to keep Funded Ratio from
falling?
Year 1 2 1 2
AL (000’s) $450,867 $452,350 $450,867 $452,350
NC $5,331 $5,331
Bft Pmts $26,894 $26,894
Liability Return 5.4% 5.4%
Assets $219,788 $228,444 $219,788 $220,500
Contributions $31,064 $31,064
Asset Return 2.0% (1.5%)
Sample pension plan as of January 1, 2010
Funded Ratio 48.7% 50.5% 48.7% 48.7%
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23. Pen-Apps
Asset Liability Modeling Study Pension Applications
Comparing Alternative Asset Allocations
Based on Liability Funded Status
130.0%
Funded Status of Liabilities in 20 Years
120.0%
110.0%
100.0%
90.0%
80.0%
70.0%
Potential Mix 1 Potential Mix 2 Potential Mix 3 Potential Mix 4
Alternative Asset Mixes Considered
5th - 25th percentile 25th - 50th percentile 50th - 75th percentile 75th - 95th percentile
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24. Pen-Apps
Liability Driven Investing (LDI) Pension Applications
If Interest Rates go
Risk is rates:
Up Down
Liabilities
valued at a No change No change N/A
static rate
Marked to
Market Down (Good) Up (Bad) Falling
Liabilities
Fixed Income
Down (Bad) Up (Good) Rising
Assets
Liability Driven Investing
(LDI) examines the net effect
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25. Pen-Apps
Dynamic Asset Allocation Pension Applications
Less than 80% - 90% 90% - 100% 100% - 110% More than
80% Funded Funded Funded Funded 110% Funded
Cash 0% 0% 0% 0% 0%
Fixed Income 35% 45% 60% 70% 80%
Large Cap Equity 20% 15% 10% 10% 10%
Mid Cap Equity 15% 15% 10% 5% 0%
Small Cap Equity 10% 10% 10% 5% 0%
Intl Equity 10% 10% 5% 5% 5%
Real Estate 10% 5% 5% 5% 5%
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 Twenty Years
95th Percentile $404,478,630
50th Percentile $172,162,360
5th Percentile $61,286,462
Note: Only asset mix is changed. All other assumptions remain the same.
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26. Pen-Apps
Summary Pension Applications
› Plan sponsors should engage consultants who can measure
portfolio and asset-liability risk and provide asset allocation
approaches that specifically address risk management of the
total fund.
› Board/Trustees should have quantifiable information about risk
exposures of their fund and set specific risk tolerance guidelines
based on realistic goals
› Risk tolerance limits should be incorporated into investment
policy.
› Few consultants have all the resources necessary to provide these
solutions – we are uniquely qualified and experienced to provide
solutions that can be understood and implemented.
› Contact us to discuss providing these important services to your
pension plan.
“The difficultly lies not so much in developing new ideas as in
escaping from the old ones” – John Maynard Keynes
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27. Pen-Apps
About Our Firm Pension Applications
Pension Applications was founded by L. Gregg Johnson to provide actuarial consulting and asset
allocation services to pension plans for a reasonable cost.
In his almost thirty years of practice in defined benefit actuarial services, Gregg has worked on a wide
range of private and public pension plans. He has extensive experience consulting with plan sponsors
reviewing current status of plan, potential plan changes and effect of asset allocation on plan
funding. Having completed almost 100 asset-liability modeling (ALM) studies for pension plans, Gregg
specializes in this practice area. He has worked in the ALM area for more than ten years and is a frequent
presenter at industry panels on the topic.
Gregg has been involved in many plan design aspects, including incorporating and comparing defined
benefit and defined contribution values and presenting these results using varied and innovative
techniques. These analyses have assisted sponsors in modifying benefits to deliver more appropriate
levels and to save costs.
Gregg graduated with Honors from the University of Texas with a BBA in Actuarial Science and from
Georgia State University with a Masters in Finance. He is an Enrolled Actuary, a Member of the Society of
Pension Actuaries (MSPA), Member of the American Academy of Actuaries (MAAA), an Accredited
Investment Fiduciary® (AIF®) and holds the Chartered Financial Analyst (CFA) designation.
Gregg’s email is LGreggJohnson@pen-apps.com.
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28. Pen-Apps
Pension Applications
Innovation Inspired by Experience
www.pen-apps.com
www.pensionapplications.com
Email: info@pen-apps.com