Pension players round Europe have been reconsidering their long-term pension policies and strategies. A few of the many factors behind this move are the fast spreading perceptions of a lower equity risk premium in coming decades and higher pension fund risks.
Given the dependence on lower long-term equity premium, more attention has been focused on alternative investment classes, such as private equity, hedge funds and commodities. Many pension funds expect these investment classes to create greater diversification or generate a higher risk premium, leading to acceptable contribution rates for employers and employees in the long run. On the other hand, the lower funding level and perception of higher risk has nurtured a kind of risk awareness, which sometimes spurs on a significant reduction in risky assets within the asset mix.
So while lower expected risk premium calls for more promising, but often also riskier assets, greater risk awareness has cast doubts on the amounts allocated towards risky assets. How can one best cope with these issues?
One answer stems from behavioural finance in combination with the use of non-linear products (options). Let us first consider the behavioural finance approach. People and organisations generally shy away from risks if they can avoid them at little cost. But there is a difference between extreme and unacceptable risks, on the one hand, and average, acceptable risks, on the other. Risk management is therefore not simply the ratio between risk and return, but a balance between extreme – avoidable – risks, acceptable risks and expected long term returns. A pension fund with a funding level of 130 might deem the 3% probability of a funding level below 90 (with all the dire consequences for employees and the parent company) unacceptable, where on the other hand a 20% chance of funding level falling below the 110 might be completely acceptable to it.
The problem with the conventional asset classes such as bonds and equity is that if one wants to reduce the extreme risks (very low funding levels, extremely high contribution rates, etc), one must also reduce the average risks and subsequently increase the average contribution rate to levels that are deemed untenable. However, by combining these conventional, linear asset classes with option strategies, one could very well reduce the extreme risks while still assuming many of the acceptable risks. This leads to acceptable contribution rates. The bottom line is that risk management is all about avoiding extreme risks, assuming moderate risks and arriving at desirable returns. And this can be achieved in a flexible manner by adopting option strategies on top of conventional asset allocation.
This principle can best be illustrated with a business case. Let us consider, an average, Dutch pension fund based on a defined benefit scheme with conditional indexation. The contribution rate depends quite heavily on the funding level: the higher the funding level, the lower the annual contribution required. If the funding level exceeds 1.6, the parent company will receive (partial) restitution. If, on the other hand, the solvency drops below 100%, the contribution rates will rise in order to try to cushion the fall in solvency. For expository reasons, the asset allocation is simplified to equities worldwide and bonds.
Using economic data from 1970 to 2001 into a vector auto regression model, this process can generate economic scenarios for Dutch price inflation, Dutch loan inflation, worldwide interest curves and equity returns. The average values for these economic variables can be adjusted to the current view on these parameters.
Given the scenarios generated and the pension fund’s indexation and contribution rate policies, the effects on the various probabilities of future developments are calculated for different asset allocations. Added to the allocations without options are allocations in combination with an option strategy. This option strategy is based on the pension fund’s aversion to risk; it shields against very poor equity returns. The options are priced using the estimated spread between observed historical and implied volatilities (ie, the implicit volatility as derived from quoted market prices of the various options), which takes into account all aspects of the options simulated. All costs and returns concerning the options have been incorporated into the model and, therefore, into the results.
Figure 1 shows the results of different asset allocations on a 35-year horizon in a risk-return context. This illustrates the impact of the allocation on the average contribution rate versus the probability of under funding. The upper line shows that the risk of under funding increases for asset allocations with more equities. This increase is due to the more volatile fund returns for allocations with more equity. The extra equity also results in a higher expected return, which results in a lower contribution rate (see figure 1) and a higher average funding ratio (not shown in figure 1). The choice of the best asset allocation depends on the pension fund’s appetite for risk. The larger the risk it dares to take, the higher the returns and the better the expected funding ratio and contribution rate will be.
The lower line in Figure 1 shows the same risk-return measures but now with the option strategy included in the asset allocation. One can conclude from this figure that, given the original asset allocation of eg, 50% equities (and 50% bonds), the probability of under funding can be reduced by 50% (from 5.5% to 2.7%), under equal average contribution rates and average funding level (not shown in figure 1). This is possible by implementing the option strategy and shifting the asset allocation to 62% equities, as illustrated by the blue arrow.
Instead of reducing its risk, the pension fund can also opt for an asset allocation with the same risk and higher returns (lower long term contribution rates) by implementing the option strategy and shifting to an asset allocation of 83% equities. This is illustrated by the green arrow, and implies a contribution rate cut of over 30% (from 17.6% to 12.2%).
Because of the protective nature of option strategies, the more extreme risks, such as the probability of funding levels falling below 90% or contribution rates above eg, 50% of salaries, can be reduced even more, often 50% to 80% reduction for low probability events (see table 1). What has changed on the other hand, is a reduction in probability of ‘abundant’ outcomes, such as extremely high funding levels and exploding parent company restitution above funding levels of 160. This is a fair trade-off: a reduction of downside risk in exchange for a reduction of extreme upward potential. This can only be achieved in a cost neutral way by means of option strategies which still allow for allocations in high return-high risk equities, with only extreme risks and extreme opportunities excluded.
Simply stated, the alternative asset plus option strategy generates on average the same amount of return in the long run as the strategy without options, but a bad economic environment during several years has a much less severe impact on the asset returns (and funding level) and good economies create good but slightly less exploding asset returns, funding levels and resulting restitutions. This will help the parent company to be less vulnerable for adverse economic circumstances, and at the same time increase the probability of future retirees to receive their expected pensions in full.
A summary of the most relevant risk and return measures for the above-mentioned asset allocations are shown in Table 1.
In order to obtain a clearer view of these strategies, this firm has designed bespoke software in co-operation with ORTEC Consultants, leading ALM adviser and software provider.
By choosing an efficient but transparent option strategy on top of the investment mix, the implementation burden can be kept to a minimum. If the right collateral agreements are applied, credit risk on the product providers can be reduced to near zero.
In summary, one can conclude from studies at various pension funds that long-term option strategies create tailor-made efficient solutions. Extreme risks are reduced to very low levels, but less extreme risks are accepted, leading to a better return than simply reducing the equity allocation in order to achieve the desired risk levels at the tail-end of the distribution. This does not only stabilise the pension fund’s performance, but also cushions the parent company contribution to the pension fund under adverse market circumstances. A wider selection of tools, especially the strategic use of derivatives, provides a better fit with the pension fund and parent company’s needs.
Theo Kocken is managing director of Cardano Risk Management in Rotterdam, The Netherlands. Info: www.cardano-riskmanagement.com