Pension Peace of Mind

459747_red_life_saverIf the history of pension plan management has taught us one thing, it’s that many of the preferred investment strategies of the past 15 years have yielded extreme volatility in funded status. As a result, many sponsors have recently embarked a liability-driven investing (LDI) journey, where the fixed income component of a pension portfolio is systematically increased as the plan’s funded ratio improves.

The case for customization

Because every plan sponsor’s situation is different, there is no “one size fits all” risk-management framework. For example, a firm that sponsors a frozen plan representing 50% or more of the company’s market capitalization may have a much lower tolerance for volatility than a firm with an open, relatively small plan. Such a low tolerance for risk likely means that a greater relative allocation to liability-hedging assets (such as long-duration bonds) is more appropriate.

However, a robust pension-hedging program should both protect the plan’s funded ratio against unfavorable rate fluctuations (a duration-matching objective) while allowing for the use of active management to outperform its benchmark (an asset-performance objective). The balance between these two objectives will depend on the sponsor’s specific goals and constraints.

Different ways to manage pension risk

Strategies such as plan freezes, LDI and glide-path implementations are now relatively common. However, some recent alternate de-risking techniques have piqued the interest of many plan sponsors. For example, two blockbuster annuity purchases took place in the United States in 2012, both involving “annuity-in-kind” transfers in which money was transferred in the form of specific physical securities (mostly bonds) rather than cash. This process may not only reduce the cost of an annuity purchase but may also manage some of the risks associated with such transactions. At the same time, many U.S. sponsors have used the low rate environment to fund pension plans by issuing debt. Under certain circumstances, this strategy may be a very effective way to improve a plan’s funded status.

Increasingly, corporate sponsors are looking to reduce their pension risk exposures, actively pursuing “pension peace of mind” from a corporate finance standpoint.  Many clever risk-management strategies exist, and it may serve sponsors to search for a properly customized approach.

François Pellerin, FSA, EA, CFA, CERA, is LDI strategist, Pyramis Global Advisors