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Pension Investing: What's the Right Level of Risk?

Most plan sponsors should put more emphasis on liability hedging, one adviser claims. Another point of view: Take no risks, period.
David McCann, CFO.com | US
February 2, 2009

Pension funds using liability-driven investment strategies in 2008 strongly outperformed those using a traditional asset-allocation approach, according to Watson Wyatt.

The pension consulting firm constructed hypothetical LDI and traditional investment portfolios at the end of 2007 and tracked their performances throughout last year. The LDI strategy, designed to better match investments with liabilities by investing more in long-term bonds, earned a 0.2 percent return. The traditional strategy, focused on a broad range of corporate stocks and bonds, suffered a 24.6 percent loss.

The poorly performing portfolio consisted mostly of equities (45 percent) and short-term corporate bonds (30 percent), and had no position in long-term bonds. The LDI portfolio was only 26 percent equities and 0 percent short-duration bonds. But it was 40 percent long-duration bonds, which served as a hedge against liabilities.

Based on those results, actual pension plans using a liability-driven approach likely had returns in the range of negative single digits to break-even, depending on the particular asset mix in their portfolios, compared with 20 percent to 30 percent losses for the other approach, according to Watson Wyatt.

The results are certainly not surprising, considering what happened with the markets in 2008. "The point, though, is that many people are still talking about diversification as being the best way to control risk, but we think there is a better way, which is liability hedging," said Mark Ruloff, director of asset allocation consulting for Watson Wyatt, which has a self-interest in the study results because it makes money by helping plan sponsors implement new investment strategies.

Ruloff said, in fact, that Watson Wyatt has been trying to persuade plan sponsors to switch to an LDI approach since new pension-funding rules took effect in 2005. Under the old rules, the amount of funding a sponsor had to make could be based on the expected rate of return on investments. Now, the funding liability is calculated based on corporate bond rates, which in essence means that the sponsor must wait for actual gains on equity investments to materialize before using them to reduce plan contributions.

"Under the old funding rules, there was an equity bias that encouraged you to take risk in equities because of the immediate rewards," Ruloff told CFO.com. "The new funding rules have changed that." Yet most companies are still using traditional allocations or are in the process of slowly phasing in LDI strategies, the consulting firm claims.

Meanwhile, long-duration bonds, though up more than 8 percent in 2008, were outpaced by another type of liability hedge: interest-rate swaps, which in some cases provided returns of greater than 30 percent, according to Watson Wyatt.

But Ruloff noted that Watson Wyatt's hypothetical LDI portfolio was not constructed to completely minimize risk. In addition to the 26 percent position in equities, it included 7 percent allocations to real estate, private equity, and funds of hedge funds — all three of which were more highly represented than in the traditional portfolio.

"We're claiming that LDI in all cases was better," Ruloff said. Looking at the returns from 2008, he continued, it is plain that long bonds performed better than equities, as did swaps, and while real estate and hedge funds went down, they didn't go down as much as equities.

Definitions of LDI vary markedly among pension experts, however, and Watson Wyatt's is quite broad indeed. The only definition that makes sense to Zvi Bodie, a Boston University finance professor and a former consultant to the Pension Benefit Guaranty Corporation, is putting all funds in fixed-income investments. "The pension liability you're trying to hedge is 100 percent fixed income, so I don't see why any risk is merited," Bodie told CFO.com.

That opinion is based on Bodie's contention that companies are not competent to take risks with their pension funds. "The risks you should take are in your business, where you presumably should know how to manage those risks and add value," he said.

And it follows, he added, that placing trust in pension consultants is not a very sound strategy either, because managing their own risk inevitably entails recommending moderate funding strategies that are not the best way to meet their clients' liability-hedging needs.

"As a practical matter, if an adviser did tell you to be 100 percent fixed income and the stock market went up, they're [out on a limb] because they went against the current," Bodie said.




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