Meet pension obligations

During the “perfect storm” earlier in
the decade, equity markets and
interest rates fell, and pension plan deficits soared. As a result, companies
had to report higher pension expense
and balance sheet liabilities and divert
additional cash to fund up the plan.

This storm highlighted the risk pension
plans can pose to an organization, but it
also taught us the prudence of implementing risk management techniques
that would have dampened the effect of
the tough economic conditions and
thereby its effects on company finances.
Many companies have not implemented
effective risk management techniques
and as equity markets have dipped again
recently, sponsors again find themselves
in the difficult position of choosing
between funding capital projects or the
pension plan. With the introduction of
changes to accounting rules and new
pension funding requirements, which
require fully funding a pension plan
within seven years, the inherent volatility of pension plans is further highlighted
and so is the need to effectively manage
their risk.

“One of the single most effective means
of financially managing these plans often
given inadequate attention by employers
is the investment allocation of the plan’s
assets,” says Anthony Scattone, Senior
Retirement Consultant for Watson Wyatt
Worldwide. “Failure to match a plan’s
asset allocation to the company’s financial goals results in risk and reward disparity and will impact the amount of cash
that will need to be infused into the plan
over the next 10 years.”

Smart Business spoke with Scattone
about liability-driven investing and how
the multi-faceted investment strategy
enables plan sponsors to create value
and manage risk.

What are the most effective means of managing pension risk?

The three primary risk management
techniques that sponsors can employ
include making adjustments to the plan’s
benefit design, the sponsor’s long-term
funding policy and the plan’s asset allocation. The last technique has generally
received the least attention and offers
the most opportunity for sponsors to
improve their risk management and
financial performance. It begins with
recognizing that assets and liabilities are
out of sync, and that one size doesn’t fit
all. Calibrating your plan’s asset allocation model to comport with liabilities
through liability-driven investing (LDI)
is a solution that is overlooked by
employers.

What is liability-driven investing?

LDI is a commonly used term that
describes the strategy of managing the
plan’s assets in light of the plan’s liabilities. Traditionally, most sponsors have
invested the plan’s assets like they
would any other asset portfolio, generally allocating 65 percent of the assets in
equities and 35 percent in fixed income,
without consideration of the liabilities
they are intended to meet. Ultimately it
is the relationship between a plan’s
assets and liabilities that drive plan
costs. Rather than managing only one
side of the equation that drives plan costs, LDI seeks to manage both assets
and liabilities.

What does an LDI portfolio look like?

LDI does not mean that sponsors
should invest all or most of the plan’s
assets in fixed income, although this is a
common misperception. LDI will mean
different things to different sponsors. A
sponsor’s financial goals with respect to
cash flow and expense, its time horizon,
and its plan’s funded status will drive the
right LDI strategy.

How do you determine the right LDI?

To find the ‘right LDI,’ sponsors should
undertake an asset-liability matching
study, or ALM. In an ALM, the plan’s
assets and liabilities are modeled under
thousands of potential economic scenarios, and expectations for the cash flow,
pension expense and the associated
volatility are quantified. This modeling
process examines these expectations
and the associated risk under multiple
asset allocations, generally considering
the split between equities and fixed
income, and the use of long duration
fixed income or even derivatives.

Rather than thinking in terms of asset
returns, this type of analysis helps sponsors make asset allocation decisions
based on the bottom line — the cost
(contributions, expense, etc.) and risks
of the plan. This step is critically important since studies show that more than
90 percent of asset returns are driven by
the strategic asset allocation and less
than 10 percent are driven by the choice
of particular investment managers.
While many spend significant time and
energy on the latter decision, not enough
time is spent on the more strategic decision of how assets are allocated to the
broad categories of asset classes.
Sponsors undertaking an ALM must be
careful to engage advisers who have the
specialized expertise in both pension
assets and liabilities.

ANTHONY SCATTONE is a Senior Retirement Consultant for Watson Wyatt Worldwide. Reach him at (713) 507-1737 or
[email protected].

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