Do de-risking strategies actually lead to greater risk?
Steven Berkovi questions whether the much-adopted traditional 'de-risking strategies' of selling equities to buy bonds are in fact increasing risk in pensions schemes.
Risk management strategies are a part of everyday life, even if we are not consciously aware that we are doing it. Most are common sense – look both ways before you cross the road, always wear your seat belt, don't eat too many sweets.
These are all very sensible risk management strategies but something seems to have got lost when it comes to pension fund investment, as the majority of pension funds are still taking too much risk – probably more than they can afford.
Traditional de-risking – hoping for the best, preparing for the best
The majority of de-risking strategies involve selling growth assets (often equities) and buying matching assets (mostly bonds) when the time is right, often when a funding ratio trigger is hit.
Implicitly, this means that trustees have to continue to take too much risk at the outset of the strategy in the hope that equities continue to rise whilst interest rates (mainly real interest rates) rise faster than is already expected – or at least stay on their predicted path.
If this ideal scenario plays out then the funding ratio will rise, the triggers kick in and de-risking starts.
When things don't go to plan
But what happens if equities don't go up? Or interest rates fall?
The overall picture just gets worse. Because you are taking too much risk already, the deficit starts spiralling out of control.
It's also worth bearing in mind that these same de-risking strategies also lead to de-returning. This might not be a phrase you will find in the dictionary, but it should be there – at least in the pension fund dictionary. So what is de-returning? As you sell your growth assets and buy matching assets, you start to reduce the ability of the overall growth assets to help remove the deficit i.e. you reduce the expected return on the portfolio.
This means that trustees put more pressure on the sponsor, often at times when they need it least.
De-risking where you might not lose everything
No one starts their de-risking journey thinking that you can lose it all. Ok, so you might not lose it all, but you could lose more than you bargained for.
In order to help avoid this from happening a change to the plan is required. Not just a change in trigger points or time frames but something a bit more fundamental - a change in philosophy.
So rather than just investing for the good times, consider the impact of the good, the bad and the different. What happens if growth slows down, or we head into another recession? Different combinations of investments can be used to deliver positive returns across a range of economic conditions, which in turn helps to add balance to your portfolio.
By adding some real diversification – strategies that don't all move together in the same way and at the same time, is just one way to help a pension scheme withstand shocks, and not just rely on the good times to deliver.
This will help to reduce the risk in your pension scheme, and if done in the right way means that you don't need to reduce the return on your portfolio either. This is de-risking without de-returning, which is good for trustees and sponsors.
Written by Steven Berkovi, senior client manager, Cardano, www.cardano.com
