The research, which was compiled by Paul Sweeting, European head of Institutional Strategy Group, finds that plan sponsors that seek de-risking pension plans entirely are “dreaming an impossible dream.” Strategies such as tax arbitrage are not feasible in a low yield, low liquidity environment. Similarly, arguments in favor of de-risking, such as agency costs and “creative accounting,” can actually end by increasing overall risks.
According to the white paper, de-risking has become a key feature of the pension landscape. As a result of escalating costs and increasing regulation, de-risking is seen as the ultimate aim for defined benefit pension plans, according to a recent survey from Aon Hewitt. The survey found that 78% of U.S. respondents thought it was prudent to reduce risk as funded status improved, in the U.K. 69% of respondents stated that their longer term objective was to take less or no risk in their schemes. In continental Europe, 53% of respondents stated that their long-term plan was to de-risk their pension plans and run them off, while a further 10% were targeting a buyout.
Sweeting goes on to explain the rationales behind de-risking. The tax arbitrage rationale states that it makes sense for companies to issue debt and use the proceeds to eradicate pension deficits, since the coupons in issued debt were tax deductible and the assets in the pension plan accumulated free of tax. The member security rationale is simple, in that the other reason for de-risking is to make the pension plan safer for members. If there is no risk in the plan, then members are guaranteed to receive their pensions.
The author continues with why de-risking is essentially impossible. Sweeting writes, “unless annuities are bought to secure members’ benefits, complete de-risking is either impossible, impractical or both. This is because pensions are affected by a number of difficult-to-hedge facts.” The most obvious of these facts is longevity, as it is difficult to determine the current underlying rates of mortality for the members of the plan.
Sweeting concludes, that rather than de-risking, firms should seek to “right risk” their plans. This process involves hedging interest rate and inflation risks to the extent that it is cost-effective to do so, but maintaining exposure to risks that hold the prospect of commensurate rewards.
Right risking entails the following considerations:
• A plan’s funded status and the most efficient means of sustaining or enhancing it;
• The plan sponsor’s capital structure, taking into account plan assets and liabilities;
• The risk appetite of the sponsor and the plan; and
• The extent to which the long duration plan liabilities can be used to access sources of return unavailable to conventional investors.