“The COVID pandemic itself didn’t fundamentally change how risk management for pension plans should be addressed, but it did confirm why it’s important to have a sound risk management framework,” said Francois Pellerin, multi asset-class strategist at Fidelity Investments. “Plan sponsors who adopted the risk management best practices we’ve been preaching were able to adapt to market changes faster and emerge from the crisis in better shape than those who didn’t adopt those practices,” he said, speaking at Pensions & Investments’ Canadian Pension Risk Strategies virtual conference.

Those best practices included a long-term risk management strategy that dynamically reacts to evolving market environments. For example, a glide path supplemented by funded ratio projections under different market conditions, along with a thoughtful contribution policy, has helped sponsors cope with the recent crisis, Pellerin shared, at the session ‘What New Concerns Have Arisen for Plan Sponsors Because of the Pandemic?’ In addition, the plan sponsors who fared well had maintained a policy to spend their risk budgets where they were compensated, and they didn’t try to time the market. “The pandemic crisis validated that these best practices in risk management work.”

Understand the risk types

The types of risks that plan sponsors face in managing their pension fund are unchanged, whether pre-or post-pandemic, Pellerin noted. A key uncompensated risk is discount rate risk, or not knowing where rates driving pension liabilities will be. “Before COVID, many sponsors assumed rates had to go up and, with that expectation, they didn’t hedge their liabilities, thinking that higher rates would solve the problem,” he said. Pension liabilities have an inverse relationship to rates, similar to bonds. “But the hope of rising rates introduces uncompensated risk through duration mismatch to the plan’s liabilities.”

Another risk that pension plans face is potential equity market drawdown. “That’s the black swan event or the recession that can set everyone back. But the idea that you can see it coming or time the market has proven to be unsuccessful once again,” he said.

Read also Experts say the 4% rule, a popular retirement income strategy, is outdated

That’s not to say that equity risk is not compensated, Pellerin noted. “It’s not necessarily a risk to avoid over the long-term.” Sponsors with a long-term investment horizon and an equity allocation commensurate with their risk tolerance — for example, 60% allocated to return-seeking assets and 40% in hedging assets — didn’t necessarily need to react when the pandemic crisis hit, he said. “Those sponsors with a proper balance between the undertaking of compensated risk and the safety net provided by hedging assets were able to the stay the course on their long-term objective and are now generally better off than if they had tried to time equity markets or hope that interest rates would rise.”

Integrate asset-liability modelin

A key approach for pension funds to manage through varied market environments is to take a top-down approach to integrate asset-liability modeling into their strategic risk management framework. “During and after the crisis, we saw the importance of having a documented road map that the pension committee understands, so when quick action is needed, there are no surprises since all stakeholders are on board,” Pellerin said.

The risk management framework should also integrate scenario planning. “At Fidelity, we resist the urge to look at the immediate impact of higher rates,” he said. “We suggest projections over three or five years, because they can provide more realistic scenarios. This results in a better grasp of the impact of changing the discount rate or having different levels of equity returns on the return-seeking side.”

Pellerin urged pension plan stakeholders to assess not only what goes well in scenario planning, but also to assess the consequences of adverse outcomes. “If the numbers on the downside are too big, it probably means you need to work with your advisors and asset managers to reduce some of the risk,” he said.

Cone of Uncertainty

Risk modeling should illustrate the full range of possible outcomes over a period of time, Pellerin said. Assuming an aggressive asset allocation, an extremely positive scenario could result in a plan’s funded ratio rising from 80% to 105 % over five years. But if markets go awry, the funded ratio could drop from 80% to 50%. Such a high-risk-high-reward strategy means that in five years, the funded ratio could be between 50% and 105%. That wide range, when illustrated graphically, shows a broad cone shape — which Pellerin referred to as the ‘cone of uncertainty.’

Read also Impact investing: A brief guide to responsible investing

“If that wide range creates too much uncertainty for the plan sponsor, we can tighten the cone by diversifying the portfolio, carving out interest rate risk, adding to higher-quality fixed income, and implementing a glide path. That will allow the sponsor to ring fence downside risk, retain some upside potential and, therefore, reduce contributions uncertainty.”

Widen the opportunity set

“Diversification is the only free lunch and, typically, we bucket assets into two classes: return-seeking and hedging, but other asset classes can be added that serve a dual purpose,” Pellerin said. Examples of the latter include high-yield bonds, like BB-rated bonds that are on the cusp of investment grade and could help to boost returns, as could tactical bonds that have some duration. In addition, a global low-volatility equity strategy can have defensive attributes while playing a return-seeking role and can be effective when funded ratios dip downward, he said. Commodities and Treasury Inflation-Protected Securities can be added as well, especially for plans subject to cost of living adjustments. “These can all help to bring portfolios closer to the funded-ratio efficient frontier.”

Plan sponsors also need to take a holistic approach to scenarios where they may need to make contributions. “We all hope that equity markets will continue their phenomenal run and that rates will go up, but hope is not a strategy,” Pellerin said. “For many plans, reaching the end goal will not only require a combination of returns from equity and higher rates, but also funding. Once sponsors accept contributions as a key risk management lever, a much richer risk management strategy can be developed and a much more robust framework can be implemented.”

A governance perspective

A successful and robust de-risking program often needs more rigor around the glide path — the set of target asset allocations that adjust as the plan’s funding status changes. “Glide paths have evolved from serving as a general roadmap to a fully-documented process that’s part of the plan sponsor’s corporate governance program,” Pellerin said.

Using the glide path more strategically allows the plan sponsor to take actions more quickly when thresholds are reached. “We have seen some sponsors maintain tighter funded ratio thresholds — for example, less than 5%,” he said. “This allows you to manage the process more dynamically.”

Read also Nigeria. Pension Funds downsize investments in states by 36%

In addition, not all glide paths have to be implemented in the same way. Some sponsors prefer a formal, regimented guide that’s part of the investment policy. Others prefer to maintain a more general guide as a means to discuss next steps when thresholds are reached. “Both approaches work as long as they account for risk tolerance. We design hedging portfolios that address the specific attributes of each sponsor,” he said. “It’s important for sponsors to adopt a road map that reflects their unique situation.”

Read More @PIOLINE