Change investment practices to mitigate risk

This article is brought to you by our sponsor Hewitt.

Kevin Wesbroom, principal consultant at Hewitt Associates, says the future for those offering defined benefit pensions looks set to be dominated by risk, so best practice firms will get a head start

For those employers fortunate enough to sponsor a defined benefit (DB) pension plan, their future looks set to be dominated by risk – how to measure it, which risks to take, how to reduce or remove risks, and how to balance risk and reward.

This emphasis on risk is an inevitable consequence of the chain of events that started with the closure of DB plans to new entrants to stop the problem getting any worse. Since then, we have seen action to reduce the (increasing) cost to employers (in terms of higher member contributions and reduced future benefits), approaches to de-risk investment portfolios, and plenty of extra contributions.

Yet pensions continue to be a major distraction for many employers. As more of them decide to close schemes to existing members, we move increasingly to an end game, and the burden of dealing with pensions is moving from HR to finance teams. Finance directors already have the risk management tools and techniques they need to deal with legacy financial obligations, which is how pensions will often be viewed.

So we can expect to see the starting point for investment policies to change. No longer will it be the unfettered search for long-term return. Rather we will start with items such as value at risk, and risk budgets and ask ‘how much bad news can we afford to take?’

This will lead to more emphasis on liability-driven investment (LDI) approaches as the starting point, with interest rate and inflation exposures swapped away via derivative instruments for cash requirements. Return-seeking portfolios will now have some very specific and finite targets, for example, if they need to attain the London Interbank Offered Rate (Libor), which is the main setter of interest in the London wholesale money market, plus 150 basis points over the next 10 years in order to to get to buyout stage.

These finite targets will have well diversified sources of return from multiple asset categories such as hedge funds, infrastructure, private equity, currency, commodities and even volatility itself. The task of being a gifted amateur trustee will look increasingly onerous and many will want to hand the job over to the “professionals”.

Assets will only be one part of the overall strategy. Enhanced transfer value (ETV) exercises to reduce deferred liabilities, partial pensioner buyouts to reduce longevity risk, credit insurance against corporate defaults will all have their role to play in an ever more complex environment. The result will either be a total removal of pension scheme risk, or a scaling back to a more viable-sized fund relating to active members only. Risk awareness will be in the ascendancy, as corporates regain control of their pension obligations.

The views and opinions in this article are those of our sponsor, Hewitt, and do not necessarily reflect those of

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