Pension schemes need to consider the significant risks they could face from the impact of their sponsor becoming insolvent or unable to contribute to hep match liabilities, J.P. Morgan Asset Management said today.
In The Missing Link - economic exposure and pension scheme risk, the investment company said that while schemes were aware of the risks posed by volatility in their assets and liabilities, potential problems associated with their sponsor's economic exposure were 'often overlooked'.
Paul Sweeting, European head of the strategy group at J.P. Morgan Asset Management, said: 'If a sponsoring company is heavily reliant on the price of oil, for example, it is essential that the company's defined benefit pension mitigates the effects of fluctuating oil prices in their investment portfolio.
'If not taken into consideration, a significant change in oil prices could have a substantial impact on the sponsor's balance sheet as well as increasing the potential shortfall in pension scheme assets.'
In the paper, J.P. Morgan outlines an approach to both measuring the risk and ways in which it can be managed. It outlines a framework that can be used to develop a portfolio designed to protect against extreme adverse events for the sponsor while maintaining a particular target rate of return.
The approach is focused on the measure used to describe the financial health of the sponsor. J.P. Morgan's framework discounts using the sponsor's share price because historically it could reflect 'idiosyncratic' events it has experienced.
'As an alternative, we therefore propose using some economic variable that can serve as a proxy for the risks faced by the firm,' it said in the paper.
'This means that we essentially think in terms of the economic exposure of the sponsor. The nature of this exposure varies from firm to firm - for example, an aircraft manufacturer might be exposed to extreme increases in the price of aluminium, while a firm that mines aluminium ore will have the opposite exposure; similarly, a transport firm might be exposed to the risk that oil prices rise sharply, while an oil producer will be concerned about large falls in the oil price.'
Mr Sweeting added: 'Trustees are increasingly aware of the range of risks present in defined benefit pension schemes and many sponsors are aware that the call for additional contributions from a pension scheme often comes at the wrong time.
'The Missing Link brings these views together to highlight the links between the two groups and the need to consider all types of risks, particularly in challenging economic conditions.'