More returns without increasing risk?
Amid greater longevity and falling stock markets risk management has become a much more important issue for pension funds than ever before. However, different pension funds are tackling the problem or having the problem tackled for them in very different ways.
Whilst a number of well resourced companies remain firmly committed to defined benefit pension arrangements, many other companies have chosen to close their final salary pension scheme. But are such companies deluding themselves if they believe that this will reduce their financial risk? According to leading actuary Ronald Bowie, the chairman of the UK’s Institute of Actuaries Pensions Board: “Any employer who has, for example, closed their final salary scheme to new entrants and who thinks that they have made any material difference to their financial risk for the next 20 years or so has got their head in the sand.”
Reducing company risk actually requires more than merely scheme closure to new entrants. Schemes would also have to terminate future accrual and then secure benefits, either through insurance or by government bonds or arrange a transfer of liabilities out from the defined benefit (DB) arrangement into an alternative defined contribution (DC) scheme. The problem with this solution is that risk is not really eliminated it is just transferred to the scheme member.
Luckily for the majority of DB scheme members, most companies are not as radical as this. However, companies and trustees still have to review their pension arrangements and they do have to decide what to do in the present situation. Many funds are assessing the risks they run, whether they can be managed and, if so, how they can be managed.
Each pension scheme can probably identify hundreds of risks but the trick must be to ensure that it is the most significant risks that are recognised.
According to Kurt Winkelmann, co-head of global investment strategies at Goldman Sachs Asset Management, after three years of negative global equity returns, pension surpluses have declined, but changes in target returns have not kept pace. Many people including those at Goldmans have revised down their long and short term equity premium assumptions. As a result, Winkelmann now recommends that pension funds change their investment policy to increase exposure to total active risk; implement a more diversified active risk budget and re-evaluate the relevance of any institutional constraints.
Most pension schemes have experienced a significant decline in their funding status as a result of the recent capital market falls. As a consequence and just as pension schemes become more risk adverse their target return requirement increases and asset class return assumptions become more crucial. As funding status deteriorates, schemes have to earn more just to stand still and if they want to get back to a fully funded status they will need to increase their target return considerably. For example, a scheme now only 80% funded would need to increase its target annual return by about three percentage points if it wants to reach fully funded status in 10 years.
The big question for most pension schemes is whether this is possible without a huge increase in their risk budget. The main problem is, of course, that expectations of a lower equity premium mean that investors will need to either increase equity risk or look for other uncorrelated sources of risk. As a result the concept of portable Alpha is really being explored in some detail.
The question for pension fund managers is whether they can really just look to traditional long equities and government bonds to get them out of their solvency crisis. Winkelmann’s argument is that active risk can substantially improve the portfolio Sharpe Ratio because it is uncorrelated with market returns. It adds to portfolio returns linearly but has only a small impact on total portfolio risk. The key is a properly structured exposure to active risk. The result that funds want is an increase in portfolio returns without a significant effect on portfolio risk.
As a result funds are now being advised to go into hedge funds and various overlay strategies. At the moment this appeals to the brave and the desperate but will the average fund be able to ignore these ideas for ever.
One overlay strategy that does seem to gaining wider acceptance at the moment is currency overlay with key players such as Record Currency Management, Pareto Partners and Gartmore Investment Management all appearing to gain good business. With a number of market participants in currency trading such as central banks, corporates and traditional asset managers not “profit-maximisers”, currency does seem to be one of those rare markets that empirical evidence apparently shows that even the average currency overlay manager has added value. In addition, there appears to be strong evidence that currency hedging actually reduces risk.
There is no such thing as a free lunch but there do appear to be a few games in town that can potentially increase return without any significant increase in risk. Isn’t it time that more pension funds explored the options?