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The Actuary The magazine of the Institute & Faculty of Actuaries
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Pensions: Stronger, fitter, faster

The turbulence experienced over the past year in the global financial markets has again firmly focused the attention of both sponsors and trustees on the level of risk they are running in their pension plans. The focus has increasingly shifted to the adoption of more efficient investment strategies taking into account the circumstances of both the pension plan and the sponsor, with innovative financial tools being used to manage the risks more effectively.

Corporate sponsors and trustees can sometimes have opposing views when it comes to pension plan funding. Trustees’ focus is generally directed towards maximising the probability of meeting member benefits and protecting members’ interests. The corporate’s objectives can be different, for example, to reduce the volatility in their future pension contributions — thereby ensuring that the probability of paying in excess of their committed schedule is kept to a minimum, and to ensure the profit and loss and balance sheet volatility is reduced to an acceptable level. However, an open dialogue between the sponsor and trustees regarding funding and investment strategy would enhance the optimisation of the plan’s strategy as it takes into account both of their objectives.

The buyout approach
An area of growth has been the insurance buyout market — the ultimate method for sponsors and trustees to remove their pension risks by transferring them to the insurance environment. However, very few sponsors are currently in a position to be able to pay the buyout premium, especially in current market conditions. As a result, they have started putting plans in place to target a buyout funding level in the future and to implement a buyout at that point, if pricing is attractive. Until the externalisation occurs, sponsors and trustees face the challenge of managing the investment and liability risks internally.

A risk-budgeted approach
A widely recognised approach is the use of a risk-budgeted framework for the creation of an efficient portfolio. This allows pension plans to quantify their level of risk more effectively, and to identify and hedge unrewarded risks, reallocating the risk budget to asset classes where the best rewards are expected. This has meant that trustees’ focus has shifted towards employing investment strategies that specifically target their liabilities as the benchmark to manage their asset portfolio.

A risk-budgeted approach normally consists of the following:
>> Liabilities as the benchmark — taking risks where you expect to be rewarded and hedging unrewarded risks
>> Optimisation of the return-seeking portfolio — introducing diversified sources of return to minimise specific asset class risk
>> Portfolio protection — adopting costefficient downside protection strategies on the return-seeking portfolio to protect the funding level.

Liabilities as the benchmark
The investment strategy should be designed to reduce the mismatch risk between the assets and the liabilities. Some of the principal risks faced by a pension plan are interest rate and inflation risks, which are largely unrewarded in the long term. In order to remove these two risks, trustees can adopt a hedging strategy through the implementation of interest rate and inflation swaps. The hedging structure should be designed to match the plan’s liability cash flows, incorporating the existing bond portfolio to optimise the design. The risk reduction effect of this hedge is demonstrated by a shift to the left of the efficient frontier, for example, to achieve a given expected future funding level, the plan can do so by taking less risk.

Hedging interest rate and inflation risk is becoming a fairly common phenomenon for pension plans. However, this still leaves one largely unrewarded risk that can now be hedged — longevity risk. Over the past few years, longevity risk has received an increasing amount of attention, with academic and industry research consistently indicating that people are living longer and that this trend is expected to continue. Trustees are now increasingly focusing on measuring and managing longevity risk effectively.

There are two options to hedge longevity risk in a capital markets format, namely a customised hedge and a standardised index hedge, with the end-investors taking on the longevity risk. Each has different advantages and disadvantages but the decision ultimately comes down to a tradeoff between hedge effectiveness and cost.

A customised hedge can provide a complete hedge against longevity risk and it is tailored to reflect the actual longevity experience of the members of the pension plan. It is typically structured as a cash flow hedge in such a way that the net cash flow (liability cash flow and hedge cash flow) is fixed with respect to changes in longevity/mortality.

By contrast, a standardised index hedge is based on the longevity experience of a broad longevity index, such as a national population index, but calibrated to match the sensitivity of the actual liability (reflecting the specific pool of members) to changes in mortality rates. It is often structured as a hedge of value, rather than a hedge of cash flow, so that any increase in the value of liabilities due to changes in mortality rates would be offset by a compensating payment provided by the hedge. In other words, the net value of the liabilities at a future date (liability value and hedge value) is locked in.

Unlike a customised hedge, a standardised hedge does not completely eliminate longevity risk, because of the basis risk between the pension plan’s longevity experience and that of the longevity index’s mortality. This means the degree of risk reduction, while still significant, will be less than 100% and hence there will be some residual risk remaining after hedging. However, this basis risk can be reduced to acceptably small levels by calibrating the standardised hedge to match the mortality sensitivity of the plan’s liabilities — providing hedge effectiveness between 85% and 90% as illustrated for a specific pension plan in Figure 2 below.

While customised hedges can provide complete risk mitigation, they are generally more costly, more cumbersome to adjust or unwind, and provide more counterparty credit exposure than a standardised hedge. They also require detailed data on the benefit structure, demographics and mortality experience of the pension plan to be disclosed to the endinvestors. In addition, customised hedges are sometimes implemented on a first-life-only basis, providing only single life cover for a joint life benefit — another form of basis risk. Standardised hedges, on the other hand, are more economical, less complex, potentially much more liquid and do not require disclosure of data to the end-investors. The key disadvantage is that standardised hedges do not completely eliminate the longevity risk, but they do reduce the exposure significantly.

Optimisation of the return-seeking portfolio
With the unrewarded risks having largely been removed, the next step is to optimise the asset portfolio to ensure that the return-seeking assets produce the best risk-adjusted returns. Traditional pension plan asset allocation consisted of equities, bonds and sometimes a relatively small allocation to property. The focus has now changed substantially, with trustees looking for diversification from alternative asset classes to reduce their over-reliance on listed equity markets and to reduce their funding deficit with its associated dependence on a sponsor covenant.

The introduction of alternative asset classes, such as hedge funds, private equity, commodities, infrastructure and active currency management has opened up new investment opportunities. These can provide higher expected returns, lower volatility, lower correlation with traditional asset classes and absolute return strategies.

More pension plans have incorporated these alternative asset classes to expand their efficient frontier and improve their risk-return characteristics, subject to having the necessary governance structures in place. However, there is still a long way to go for pension plans to reduce their historic reliance on listed equity markets.

Portfolio protection
A large number of pension plans and corporates would like to maintain exposure to equities to generate outperformance above their liabilities, but are looking for ways to provide protection against falling equity markets, while still maintaining equity upside exposure.

Most pension plans, however, do not want to pay the upfront premium that would be associated with a put option protection strategy. Therefore, they have typically looked to finance the downside protection by selling some of the unrequired upside potential. This is referred to as a ‘costless’ collar strategy, and entails buying a put option at the desired level of protection required, while selling a call option at the level that would equate to the cost of the put option in order to provide financing for the protection. Trustees are increasingly using equity derivative protection strategies that are tailored to their specific risk/reward trade-off.

Conclusion
Optimising the allocation of the risk budget is imperative to ensure efficient portfolio management. With trustees and corporate sponsors more comfortable with, and proactive at, using derivatives structures to manage risk, these strategies will be more prominent in the pension solutions set going forward.


Lukas Steyn is a member of the J.P. Morgan European Pension Advisory Group