J.P. Morgan Proposes Strategy for Managing DB Sponsor Risk

March 5, 2012 (PLANSPONSOR.com) - The funding position of a defined benefit pension plan is often linked quite closely to the performance of the sponsoring company’s business, J.P. Morgan Asset Management notes in a new paper.

J.P. Morgan provides the example of a pension plan sponsor whose financial health is dependent on high oil prices and may struggle during periods of oil price weakness. If the assets of the pension plan also performed badly at this time, the ability of the sponsor to address any funding requirement would be restricted precisely when the need for such a requirement would be heightened.  

Mitigating this risk is difficult, but J.P. Morgan’s research, presented in a paper entitled “The Missing Link: Economic Exposure and Pension Plan Risk,” explores structural linkages between pension plan funding position and the performance of the sponsoring company’s underlying business, in the process outlining a precise approach for measuring that risk variable and then mitigating it with an asset allocation framework that can be used to hedge sponsor risk.      

Key to this approach is the identification of an economic variable that can serve as a proxy for the risks faced by the sponsoring firm (such as the oil price in the example above). Once the variable is identified, J.P. Morgan has developed an asset allocation framework that investors can use to hedge sponsor risk.

Measuring the Risk Variable  

When considering portfolio risk, J.P. Morgan’s preferred measure is the conditional value at risk, or CVaR. According to the research paper, this is calculated as the average of the worst results at some level of confidence, usually 95%, giving the CVaR95.  

To quantify the joint plan and sponsor risk to extreme movements in a key variable within the non-normality framework, J.P. Morgan can calculate the cross-return CVaR95, or CRCVaR95, of a portfolio. The CRCVaR95 extends the CVaR concept of portfolio risk to consider the return on the portfolio relative to a give factor, such as an asset or other economic variable.  

As such, the CRCVaR95 is calculated as the average portfolio return during the lowest 5% of returns for the given factor. The returns of both the factor and the portfolio need to be simulated to identify the worst 5% of factor returns. Then the average portfolio return in the simulations that correspond to the worst 5% of factor performances is calculated. This provides a link between the performance of the factor and its implication on the performance of the portfolio as a whole.  

Paul Sweeting, European head of the strategy group at J.P. Morgan Asset Management, said: “Investment committees are increasingly concerned about the range of corporate pensions risks and many plan sponsors are aware that the call for additional contributions from a pension plan often comes at the wrong time. Our research highlights the links between the two groups and the need to consider all types of risks, particularly in challenging economic conditions.”  

More information is available at http://www.jpmorganinstitutional.com.

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