By Tony Baily
One in six defined benefit pension schemes are at serious risk of default according to a report from the Pensions Institute. As a result, potentially millions of individuals would not receive their full pension benefits.
Can a scheme’s investment strategy help it to escape this danger zone? And just as importantly, can the other 5,000 defined benefit pension schemes avoid falling into the danger zone in the first instance?
High returns with no risk – a dream?
Ideally, any pension scheme should want its investment portfolio to deliver a high return with no risk, but this is simply not possible. However, for many pension schemes it is possible to deliver a higher investment return with significantly less risk, especially in the form of exposure to extreme risks. Many investment professionals believe that they can help schemes to achieve these desired results. Quite often their tool of choice is an asset-liability model. This helps to show the uncertainty around the expected outcome. It is then used to help construct a portfolio that can achieve the expected outcome with less risk.
“This is great!” trustees think. “Where do we sign up?” A word of warning, this approach is not without problems.
Asset-liability muddle
These models are highly dependent on the underlying assumptions: expected return on assets, volatility of those returns and the correlations between asset classes. In the run up to the 2008 crash, there was “the calm before the storm” with market risk (VIX) perceived as being low. This gave schemes a false sense of security about the level of risk they were exposed to.
This is especially true for extreme risks. Quite often schemes will be shown the impact of a “1-in-20” bad outcome, so they can decide whether this could be tolerated. Isn’t it enough to be right more than 95% of the time? The answer should be a definitive no.
The small percentage of the time the models are wrong, the moves are extremely violent with a much greater impact on schemes’ funding than the frequency of ‘just a small percentage of the time’ would lead us to believe. An example might help to show just how significant this can be.
BIG benefits from avoiding extreme outcomes
If we remove the 15 biggest one-day moves from 7,000 trading days of the S&P 500 equity index – representing the biggest surges and plunges – that adds more than 60% to the S&P for the 1986-2016 period.
That means 0.2% of the moves are responsible for more than 60% of the result. A dizzying disproportionality. Also the knock-on effects are often more dramatic than the initial, often major market shock. A short period of market crisis can lead to a decade or longer of deleveraging with serious economic consequences. That small percentage of the time when we misjudge crises has disproportionate consequences for a significant period of a pension scheme’s life.
Said another way, if schemes can avoid these extreme risks, their performance can be greatly improved and with more predictability.
How to be robust and resilient
So how can pension schemes make themselves more resilient to such extreme risks?
These models lead to many pension schemes relying heavily on a favourable economic environment in order to do well. However, no comfort is provided in stressful economic conditions, such as a recession or a period of high inflation. Indeed such environments are viewed as ‘unlikely over the long-term’. In contrast, it is possible to build portfolios which consciously include assets that do well during adverse environments, such as recession and high inflation. These provide true diversity (rather than mathematical diversification) and help to make the portfolio robust to different economic conditions.
Schemes should aim to build a portfolio that can withstand severe market shocks, either by giving up some of the potential upside received during very strong markets or by paying for insurance. The benefits of this are shown in the example above.
Predictable results in an uncertain world
Pension schemes experience with asset-liability models shows that no one can predict the future. But if we build truly diverse portfolios that are robust to a range of market conditions, we can achieve more predictable outcomes for our pension schemes. This avoids the extreme events that could place the scheme in the danger zone. By avoiding these extremes, it is possible to also significantly increase returns. This will help ensure members receive their full benefits and let trustees and sponsors sleep more easily; dreaming of high return with no extreme risks.
Tony Baily is a client director at Cardano
