What are the differences between rewarded and unrewarded risks for pension funds? Martin Steward explains.

"You must hedge your unrewarded risks!" pension funds are told. But what are unrewarded risks? "Interest rate, inflation and longevity risk, for starters." Sure, but why do we call them ‘unrewarded risks'?

Imagine yourself at the races. You have to pay €20 just to get in. This is unrewarded risk. But once you get in you can put another €20 on Live Long And Prosper to win at 3-to-1. You risk being €40 down for the potential to be €40 up. That is rewarded risk.

Promising a pension is an unrewarded risk: pay it and you make no gain, fail to pay and you're in big trouble. Promise someone two-thirds of their final salary at retirement today and you take inflation risk. You take regulatory risk: pension rules can change - like the move to mark-to-market accounting that introduced interest rate risk. And the longer people live, the longer you spend paying their pension.

But these are all unrewarded risks only as subsidiaries of the original risk of promising a pension. They are not unrewarded risks per se. Just because something is an unrewarded risk in your liabilities, that doesn't mean it can't also be a rewarded risk in your assets: buy a bond and you are rewarded for taking interest rate risk. Promising the pension is like your €20 entrance fee to the races; investments to meet that promise are the bets you make while you are there. Furthermore, we can leverage rewarded risks in our assets relative to the same risks in our liabilities: Live Long And Prosper at 3-to-1 will more than repay your entrance fee; and if we think interest rates are going down, we can increase the duration of our bonds relative to our liabilities.

There are certainly cash flow investments linked to longevity - notably all the life business written by insurance companies. But can we take geared exposure to this risk in the same way we can with duration? Of course. Life insurance will do that, because people who buy life insurance are generally wealthier than people in pension schemes. But for real gearing, we should also consider exposure via equities.

If you think the gold price is on the up it makes more sense to own a goldmine than gold itself. You can borrow, leveraging a fixed cost (digging) to maximise rising revenues.When it comes to longevity risk a pension fund does not have fixed costs: as longevity increases, costs increase. That is why life insurance can only ever be a match to your liabilities (and generally not a perfect one, at that). But why not buy equity in companies that can leverage fixed costs to take the risk that people don't live longer - by selling stuff to wealthy elderly customers who would become more populous and spend more over longer periods if they do? Or, indeed, companies whose variable costs decrease as people live longer and demographics get older?

These are all gambles, to be sure. Live Long And Prosper might have an off day. But if you believe that life expectancy improvements will continue to be under-estimated, you must also believe that the odds offered on this horse today are weighed decisively in your favour.