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Pension Management

Pension Hacks in a Low-Rate Environment

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November 22, 2016

Low yields and tight spreads can put pressure on pension funds; here are a few ideas to meet this challenge.

financial system softwareWhat are the impacts of low/negative interest rates on pension plans and how are liquid alternatives being used as risk-management tools? This was one topic of discussion at NeuGroup’s recent meeting of the Treasurers’ Group of Thirty Large-Cap Edition. The discussion centered around increasing transparency, the ability to have a holistic view of risk when combining traditional assets and liquid alternative investments – using a risk factor approach, and the ability to isolate one risk factor to hedge a portfolio or to enhance the return of the portfolio.

One question that came up during the session concerned the appropriate time to contribute to one's pension fund. Low yields and tight credit spreads put pressure on pension funds, and deficits end up increasing, requiring significant corporate contributions to make up for volatile liabilities and unrealistic return assumptions. One might be forgiven for thinking that fully funding pension liabilities is a mistake when the yield on the investments is so low, even if you also borrow at low rates. Bankers at the meeting warned that many pension schemes are at a “dangerous funding level,” and if one looks at the distributions of cash, they can get a good idea of when the scheme will run out of money. “If it’s in five years or less, you’re running out of time.”

Also up for discussion was whether companies should hedge some of the pension risk. The answer is it depends on the company’s rating. At the time of the meeting, members wondered whether interest rates were too low to hedge risk. But by hedging, you reduce the volatility of the pension deficit, which in turns reduces the volatility of the corporate leverage ratio. In addition, corporate valuations are depressed when pension deficits are high. One meeting participant noted that pension liabilities are viewed as debt-like for ratings purposes and because of their unpredictability, they may have an impact on a ratings opinion.

In the current low-yield scenario, it was also suggested that an options strategy would reduce risk while keeping the cost of hedging reasonable and preserve the potential for upside. It also makes for more predictability on collateral management for cleared derivatives (the new market paradigm).

One way to meet the current challenges of pension risk is to use a risk-factor approach. The risk with traditional asset allocation is that it is often faced with high asset correlation when markets are under stress. To counteract this, bankers at the meeting suggested the risk-factor approach to achieve diversification and additional yield. This involves a four-step process of (1) identifying a diverse set of risk factors that can be “invested on” via select indices; (2) using multi-model analysis to determine for example how influential each risk factor is on the portfolio or which index brings the most diversification; (3) selecting the indices that meet the objectives of the portfolio; and (4) weighting the final allocations using an equal-risk contribution methodology.

One final pension management suggestion for the group was to not manage it at all; just sell it instead. One of the members noted that she took advantage of the opportunity to sell her company’s 94-percent funded plan to a major pension provider, primarily because it ended up being more economical to not have to deal with the administration.

One final view offered by bankers at the meeting was that pensions will always win the waiting game. That’s because pension funds enjoy “the value of time;” corporates do not. They need to reduce the volatility of deficits to minimize uncertainty to the ratios that matter for ratings and valuations, while letting the pension funds concentrate on building long-term returns at acceptable levels of long-term risk and illiquidity.

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