Risk Management 2.0

(August 27, 2013) — Pension plans must now look to the second stage of de-risking if they are to continue on the path to becoming fully funded, according to a new comment piece from Aon Hewitt.

Having successfully displayed a meaningful shift out of equities into fixed income and alternatives, and having engaged with dynamic investment policies and pension transfer risk programs, the consultancy has now urged pension investors to consider five new areas which need addressing.

Joe McDonald, senior partner in Aon Hewitt’s North American pension risk team, said institutional investors should focus on the true economic liabilities of the fund, settling more pension risk transfers, continuing with asset liability management plans, tackling the longevity issues, and rewarding and sharing best practices.

On the first point, McDonald argued employers are becoming more aware that the reported liabilities often understate the true value of the economic commitment to the pension fund, due to things like administrative and investment management expenses, life expectancy improvements, and the effects of downgrades and defaults on the bond return.

“The true economic liability often exceeds that Generally Accepted Accounting Principles liability by 10% or more,” McDonald said. “It is the economic liability that should be used for assessing a settlement strategy or dictating triggers for funding of de-risking. Plan sponsors will increasingly understand, measure, and link their strategies to the economic liability.”

The decision to settle more – either through lump sum offers to groups, annuity purchase, or full plan termination – is still challenging, but McDonald predicted that two camps would emerge.

In one camp, settling liabilities will be the clear goal and for whom the entire plan will likely be eliminated in 10 years’ time. In the second, a properly risk managed, self-insured program will be seen as better than handing money to an insurer.

In addition, the ongoing longevity problem will also be addressed through greater use of longevity-hedging products, such as annuity buy-ins, longevity swaps, insurance-linked securities, and related structured products, McDonald predicted.

On the investment side, the recent shift to fixed income, even when bonds are at their most expensive, will result in pension funds more resembling insurance products.

McDonald predicted that this will mean the demand for high quality long-dated fixed income will “explode” in the coming years, and “put tremendous upward pressure on prices and downward pressure on yield spreads”.

“Pension funds that build up their long credit bond portfolios and adopt creative strategies to manage interest rate exposure will be glad they did as supply won’t be able to keep up with the demand,” he added.

Finally, McDonald believes those pension plans which successfully manage their liabilities will be ultimately rewarded, as the plan sponsors begin recognising the hard work as a measure of the company’s outperformance.

“As pensions are increasingly material and volatile, the investor community becomes more knowledgeable about pensions, and as management strategies diverge, we expect that how you manage your pension programs and communicate externally those programs will be a source of outperformance for those that do it well,” McDonald said.

“Now is the time to assess the work that has been done, prepare for the next steps in managing risk, and position your organization to reap the rewards from successfully managing your pension programs.”