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Pension Plan Risk Management

Pension Plan Risk Management. Phil Kivarkis, FSA, EA, CFA, Director of Investment Policy Services Hewitt EnnisKnupp. Pension Funded Status – A Wild Ride. US Debt Rating Downgrade. 2008 Credit Crisis.

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Pension Plan Risk Management

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  1. Pension Plan Risk Management Phil Kivarkis, FSA, EA, CFA, Director of Investment Policy Services Hewitt EnnisKnupp

  2. Pension Funded Status – A Wild Ride US Debt Rating Downgrade 2008 Credit Crisis S&P 500 aggregate pension funded status shows considerable volatility, and two extreme events in three years

  3. Our Survey Shows Broad Risk Management Focus 0% 2% 3% 10% 13% 38% 65% 78% 68% 84% 69% 58% 31% 21% 21% 20% 14% 4% What changes have you made to your target investment strategy? Source – Aon Hewitt Pension Risk Survey

  4. Integrated Risk Management Toolkit Risk Management Assumptions and Methods Plan Design Investment Policy Funding Strategy • Glide Path • Hedge path • Credit path • Return-seeking portfolio • Hedging portfolio • Synthetics/Collars • Pre-funding • Borrow to fund • Fund equity • Stabilizer • Close • Freeze • Cash Balance/ Career Average • Lump Sums • Asset smoothing • Rate averaging • Conservatism • Aggressiveness 3

  5. Current Interest Rate Environment is Challenging Yields are below historic levels… Maturity Source: Citigroup Pension Discount Curve

  6. Some Opportunities Exist Very steep yield curve… CMT = Constant Maturity Treasury Favorable credit spreads… Source: Barclays Capital

  7. Pension Plans Have Already Begun to De-RiskAs Seen in Actual Allocations Note: S&P 500, US plans only. Source: Goldman Sachs Global Markets Institute; Capital IQ; company reports.

  8. Dynamic Investment Policy Components

  9. Improving Your Odds Source: Hewitt EnnisKnupp capital markets expectations

  10. Why Customize? Improved Performance and More Effective Risk Management. Structural Surplus Risk More Effective Hedge Custom MandateLong Credit – 80% STRIPS 20+ yrs – 20% Source: Hewitt EnnisKnupp Illustrative Example

  11. Alternative to Immediate Extension: Two-Dimensional Glide Paths Two-Dimensional Glide Paths offer a way to manage a pension plan out of the current low interest rate environment. First Dimension Funded Ratio Return-SeekingAllocation ReturnNeeds Second Dimension DesiredDuration InterestRate Level Hedge Ratio

  12. Liability Hedging Path Design The glide path implies a certain liability hedging path… Glide Path Hedge Ratio

  13. Liability Hedging Path Design: Hedge Path Corridor …but liabilities and interest rate views also imply certain liability hedging possibilities. Max Hedge Ratio Using Physical Bonds Max Rewarded Upside from Rising Rates

  14. Integration of Hedge Path and the Glide Path - Illustrative • Key Characteristics • Tailored to Plan glide path and funded ratio goals • Incorporates Client’s interest rate views (and ours) • Provides guidance while leaving flexibility to execute • Market opportunities (medium term views) • Available instruments

  15. Hedge Path Development Steps • Design Glide Path (if one doesn’t exist already) • Review Risk Budget and Investment Horizon • Develop a Hedge Path to Complement Glide Path • Develop an Execution Strategy • Update Investment Policy Statement • Consider Outsourcing Execution • Update Reporting to Include Hedge Path • Transition the Portfolio to Target Hedge Ratio on Hedge Path • Credit vs Government • Yield Curve Positioning • Use of Physicals and Synthetics

  16. Key Takeaways Current Environment • Steep curve, spreads favorable • Asset return risk meaningful • De-risking and defeasance trends persist Duration Extension • Two-dimensional paths provide framework for change • Ultimately, risk management drives hedge ratio Customized Portfolios • Customization can improve hedging characteristics • Relative importance increases with hedge ratio • Diversification improves odds of success

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