What is the risky decision?

We often evaluate decision-making risk relative to status quo as opposed to overall risk and I find this problematic. We assume that the status quo is our risk benchmark and that may be incorrect. And defined benefit plans are the perfect example.

Pension fund managers and trustees think of Liability-Driven Investing (LDI) as a risky decision: rates are low and equity markets are still 30% off their highs (at least in the US), and converting some equity holdings to fixed income would be a foolish decision, they claim. Although I personally think rates are lower than they should be, the context of the decision is where I have an issue. Those making the claim assume that the risky decision is to engage is risk mitigation, since historic wisdom suggested that a 60/40 equity to fixed ioncome ratio is appropriate. What they should be aware of, however, is that the current asset mix is an active bet that equities will outperform fixed income. And there is risk in maintaining that mix.

Risk-based Premia

After a few spectacular failures (Nortel, GM) the pension world is not the wonderland it used to be. Both employees and regulators should consider the safety of their pensions when valuing their personal balance sheet.

As an employee:
Consider the future of your company and the likelihood of its survival. It may encourage you to save more lest you end up getting 60-something cents on the dollar like the Nortel pensioners. Your biggest decision will be when you leave the company - do you take a commuted value and truncate your risk to the pension fund's potential demise or do you retain the pension inside the fund?

As a regulator:
Consider the survival of a company. Use default swaps as a guide. Examine the solvency ratio of the company's pension fund. Consider its asset mix relative to the exposure of its liabilities. What is its net risk exposure? Should a company with matched assets and liabilities and a 105% solvency ratio pay the same PBGF/PBGC (pension benefit guarantee fund/corp) premium as one with a significant mismatch and a 75% solvency ratio? Now that is an easier question to answer than the same one with the second fund also having a 105% solvency ratio....after all the greater mismatch has a wider array of potential solvency ratios one year hence.

Call it risk based charges on the regulator side and employees better managing their credit risk.

Pension Fund Leverage

Is it only me who cringes when pension funds issue debt or create "special purpose vehicles" (I know I date myself on that last one).
With respect to SPV's, the sense is that pension funds have tremendous internal investment expertise which they can share with the rest of the world. There are 2 issues:

1. Taking your eye away from your fiduciary duty to pensioners
2. The obligation to hold the equity piece

Yes, SPV's are a thing of the past, but pension funds issuing debt? And using derivatives to leverage their hedges? The bottom line is that leverage introduces risk and if one cannot justify leverage ex-ante or especially ex-post (after something blows up) then it may not be the right approach for a pension fund.

SEI Survey

A recent survey by SEI points to over 50% of pension funds moving to some form of Liability Driven Investing (LDI) mandate. Of course, defining that term is an imprecise science with plenty of debate. The range includes the hard-liners like Towers Perrin who advocate a 100% allocation to Fixed Income as part of its definition of LDI to softer versions with some allocation to equities.

To me, it is not about the actual asset allocation, but about education. It is about recognizing that risk emanates from the liability side of the balance sheet, not just the assets of a pension plan. It is about understanding that as a pension fund manager you are de facto short fixed income and likely inflation. These are not easy markets to navigate and the outlook is fairly bifurcated between doomsday prophets and cheerleaders of economic growth. And with respect to fixed income and inflation the picture is as murky as ever.

It is therefore imperative to understand, measure and interpret your risk based on an entire entity not single parts of that entity.

Bill Gross

Well, how do you like that - Bill Gross singing my tune

Time to take chips off the table

The panic of early 2009 has receded. Equities have rallied by 50% from the lows. Pension funding ratios are marginally better (corporate bond yields have decreased which means liability values have increased).

Markets feel a bit sluggish here. Some negative technicals have been cropping up.

Time to reduce equity exposure.

Liability driven investing (LDI) is being discussed, but it is not an all or nothing proposition. It is possible to transition to lower equity weights and now is the time to consider doing so.

Pension Risk

Interesting article on public pensions:

http://www.washingtonpost.com/wp-dyn/content/article/2009/10/10/AR2009101002360.html

I am not sure that ramping up risk is the right solution but it would be in line with the attitude of banks this past decade...if you need to keep up with peers (or in pension case, liabilities) just keep increasing leverage (risk) and if worst comes to worst (it did and likely will again in the case of pensions) government will be there to help out. Certainly with respect to public plans government backing is explicit; it was less so for the banking industry but that did not seem to stop them.