When it comes to reducing pension risk, there’s an interesting dynamic between desire and ability. During periods when the desire to de-risk is high, the ability to de-risk is often low because economic conditions are seen as unfavourable.
However, when the ability to de-risk increases, desire often decreases because the financial strain has eased, at least temporarily. To manage pension risk effectively, it’s important for pension plan sponsors to both understand and manage the dynamic between desire and ability.
A lot of desire, but limited ability
Over the past few years, many defined benefit plan sponsors have aspired to reduce the financial risk associated with their pension plans. This should be no surprise, because the funded status of pension plans has been relatively poor.
When a plan’s funded status is poor (typically following a period of poor financial market performance), desire to reduce pension risk is high because plan sponsors are experiencing the negative side of volatility, and they’re feeling the pain of increased funding requirements and hits to their corporate profit and loss (P&L) statements and balance sheets.
There are a number of actions a plan sponsor can take to reduce pension risk, including increasing the allocation of plan assets to liability hedging investments, such as long-term bonds, and transferring risk from the plan through vehicles such as a group annuity.
However, in an environment of low-funded statuses, it may be relatively costly to de-risk for the following reasons:
- In addition to reducing downside risk, de-risking often limits the ability to benefit from strong financial market performance. As a result, de-risking may “lock-in” past losses that are the cause of the pension plan’s poor funded status. For example, past losses may have been caused by decreases in long-term bond yields and/or poor investment returns on the plan’s return seeking investments (such as equities), which de-risking could lock-in, and;
- Certain de-risking actions, such as the purchase of a buy-out group annuity, may lead to a large one-time P&L charge and the requirement to make a special one-time contribution to the pension plan.
Therefore, in an environment of low-funded statuses, there’s often a lot of desire to reduce risk, but for many plan sponsors, there’s also limited ability.
Increased ability, but diminished desire
As a pension plan’s funded status improves, the ability to implement de-risking solutions also improves, but the desire to de-risk often decreases.
There can be logical reasons for the decrease in motivation to de-risk in this type of environment. However, the decrease in desire to de-risk is often influenced as much by emotions as by logic. For instance:
- Good news is the “norm.”
We have a tendency to believe that good news, such as a strong economy, strong equity returns and low financial market volatility constitute the “norm.” On the other hand, we view bad news, such as a weak economy, negative equity returns, historically low long-term bond yields. and high financial market volatility as short term anomalies.
When good news follows bad (i.e., a pension plan’s funded status improves), we may believe that normal conditions have finally returned, continued good news is to be expected going forward and the need to de-risk has therefore diminished.
What the above line of thinking fails to recognize is that financial markets are inherently volatile and we are destined to experience future periods of bad as well as good news.
- We hate missing perceived opportunities.
During a period of improving funded statuses, a plan sponsor may feel that, after weathering periods of financial losses, it finally has the opportunity to reap the benefits from positive financial market performance. By taking de-risking action too soon, it will miss future upside opportunities. Naturally, we all hate to miss opportunities.
However, the plan sponsor should recognize that low cost de-risking opportunities may be short-lived. For example, at the end of 2013, many pension plans were fully funded (or close to fully funded). Early 2014 would have been a good time for many sponsors to reduce pension risk.
In fact, the funded status of plans that were de-risked in early 2014 are significantly higher today than for plans that were not de-risked. In reality, the true missed opportunities often occur when plan sponsors fail to take de-risking action when good opportunities arise.
- Memories can be short.
When the funded status of a pension plan improves, pensions may cease to be a burning business issue. When this occurs, the plan sponsor often turns its attention to other pressing business matters and may quickly forget the financial pain caused by the plan when the funded status was low. Thus, the desire to de-risk decreases.
The plan sponsor should recognize that, even if pensions have ceased to be a burning business issue, in the absence of taking de-risking action, the risk still exists and will likely come back to bite some time in the future.
Also, once a plan is fully funded, there’s often limited value to be derived from any surplus that could develop if the plan sponsor continues to take pension risk.
Managing ability versus desire
So, how should plan sponsors best manage the dynamics between de-risking desire and ability? My suggestions include:
- Clearly articulate your pension risk management objectives, which should reflect the risk tolerance of your organization. Over time, the success of de-risking action (and inaction) should be measured against these objectives.
- Create a clear de-risking plan (i.e., journey plan or glide path) for achieving your risk management objectives. Ideally, the plan should include triggers (i.e., the attainment of specific funded statuses) at which time specific actions will be taken. The inclusion of specific triggers encourages de-risking action when conditions are right, even when the desire may have decreased.
- Be diligent about sticking with your plan, even though the desire to de-risk may diminish as the funded status of your pension plan improves.
- Remind yourself periodically of the financial pain that pension risk can still cause your organization if this risk is not managed.
There is an unmistakable relationship between pension de-risking desire and ability. In order to manage pension risk effectively, it’s important to both understand and manage this interesting dynamic over time.