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Pension funds should right risk, not de-risk
13 November 2011
JPMorgan Asset Management’s Paul Sweeting said this week that using de-risking strategies in pension funds can carry bigger costs and risks
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Pension funds that use de-risking strategies could be putting their scheme under higher costs and risks, according to JPMorgan Asset Management.
The company’s European head of strategy, Paul Sweeting, said this week that despite pension schemes understandably wanting to remove risk from their portfolios, taking some risk could actually carry benefits if it were carried out “rationally”.
At the company’s annual European Media Tour on Tuesday, Sweeting said the answer to this was to adopt a right-risk approach, which involves hedging interest rate and inflation risks so that it is cost-effective while keeping exposure to risks that can produce matching rewards in line with the risk appetite of the plan.
However, Sweeting said it is less about removing risk altogether but more about introducing the right kind of risk or reducing it to an acceptable level. He said that complete de-risking is either impossible or impractical, and pointed out that there will always be some residual risk which means it makes sense to offset it with investment risks.
“As a result, it makes sense for pension funds to hold onto their assets and liabilities – and not to try and match them completely with risk-free assets.”
De-risking has come into greater focus for pension schemes recently, with Aon Hewitt’s Global Pension Risk Survey 2011 showed that de-risking is perceived as the ultimate aim for defined benefit pension plans due to rising costs and more regulation. Nearly three quarters of US respondents said they thought it was sensible to reduce risk as funded status improved, while 69% of UK pensions said their longer-term objective was to reduce or remove risk in their plans.
According to Sweeting, de-risking can actually raise risks for shareholders through higher exposure to the firm’s profitability while losing the benefit of having diversified returns in the pension plan. He said de-risking approaches usually only take market risk out of the equation, as well as a complete disinvestment from return-producing assets.
Tax arbitrage, which is a popular form of de-risking, can involve fully matching liabilities which requires risk-free bonds, but Sweeting pointed out that firms cannot borrow at a risk-free rate. He said the tax arbitrage strategy does not work if it is too costly to borrow, and that it is not feasible in a low-yield, low-liquidity environment.
He also said that if a plan moves to a lower risk strategy - such as going from equities to bonds - but the firm’s capital structure is not changed, then this will tend to be costlier for the firm which could in turn impact the scheme’s members.
If a plan wants to reduce risk to a more acceptable level – in other words re-risking – this could involve changing the balance between matching and return-producing assets, or hedging tail risk through options or other derivatives.
JPMorgan said in its paper, Risky business… don’t de-risk, right-risk, that although exact matching is impossible, it is crucial that the interest rate risk created by pension liabilities is recognised in the nature of the bond portfolio. According to Sweeting, risk can be good for pensions in times of illiquidity, capital flexibility, and market efficiency.