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creation of an efficient portfolio. This
allows pension plans to quantify their level
of risk more effectively, and to identify
and hedge unrewarded risks, reallocating
the risk budget to asset classes where the
best rewards are expected. This has meant
that trustees' focus has shifted towards
employing investment strategies that
specifically target their liabilities as the
benchmark to manage their asset portfolio.
A risk-budgeted approach normally
consists of the following:
n Liabilities as the benchmark -- taking
risks where you expect to be rewarded and
hedging unrewarded risks
n Optimisation of the return-seeking
portfolio -- introducing diversified sources
of return to minimise specific asset class risk
n Portfolio protection -- adopting cost-
efficient downside protection strategies on
the return-seeking portfolio to protect the
funding level.
Liabilities as the benchmark
The investment strategy should be designed to
reduce the mismatch risk between the assets
and the liabilities. Some of the principal risks
faced by a pension plan are interest rate and
inflation risks, which are largely unrewarded
in the long term. In order to remove these
two risks, trustees can adopt a hedging
strategy through the implementation of
interest rate and inflation swaps. The hedging
structure should be designed to match the
plan's liability cash flows, incorporating
the existing bond portfolio to optimise the
design. The risk reduction effect of this hedge
is demonstrated by a shift to the left of the
efficient frontier, for example, to achieve a
given expected future funding level, the plan
can do so by taking less risk.
Hedging interest rate and inflation risk is
becoming a fairly common phenomenon
for pension plans. However, this still leaves
one largely unrewarded risk that can now be
hedged -- longevity risk. Over the past few
years, longevity risk has received an increasing
amount of attention, with academic and
industry research consistently indicating
that people are living longer and that this
trend is expected to continue. Trustees are
now increasingly focusing on measuring and
managing longevity risk effectively.
There are two options to hedge longevity
risk in a capital markets format, namely
a customised hedge and a standardised
index hedge, with the end-investors taking
on the longevity risk. Each has different
advantages and disadvantages but the
decision ultimately comes down to a trade-
off between hedge effectiveness and cost.
A customised hedge can provide a
complete hedge against longevity risk and
it is tailored to reflect the actual longevity
Stronger, fitter, faster
Lukas Steyn takes a closer look at the optimisation of pension plan investment
strategies to ensure efficient portfolio management
Pensions Investment strategies
34 October 2008
T
he turbulence experienced over the
past year in the global financial
markets has again firmly focused
the attention of both sponsors
and trustees on the level of risk they are
running in their pension plans. The focus
has increasingly shifted to the adoption of
more efficient investment strategies taking
into account the circumstances of both
the pension plan and the sponsor, with
innovative financial tools being used to
manage the risks more effectively.
Corporate sponsors and trustees can
sometimes have opposing views when it
comes to pension plan funding. Trustees'
focus is generally directed towards
maximising the probability of meeting
member benefits and protecting members'
interests. The corporate's objectives
can be different, for example, to reduce
the volatility in their future pension
contributions -- thereby ensuring that
the probability of paying in excess of their
committed schedule is kept
to a minimum, and to ensure the profit and
loss and balance sheet volatility is reduced
to an acceptable level. However, an open
dialogue between the sponsor and trustees
regarding funding and investment strategy
would enhance the optimisation of the
plan's strategy as it takes into account both
of their objectives.
The buyout approach
An area of growth has been the insurance
buyout market -- the ultimate method
for sponsors and trustees to remove their
pension risks by transferring them to the
insurance environment. However, very
few sponsors are currently in a position
to be able to pay the buyout premium,
especially in current market conditions.
As a result, they have started putting plans
in place to target a buyout funding level
in the future and to implement a buyout
at that point, if pricing is attractive. Until
the externalisation occurs, sponsors and
trustees face the challenge of managing the
investment and liability risks internally.
A risk-budgeted approach
A widely recognised approach is the use
of a risk-budgeted framework for the
Figure 1: Improving portfolio efficiency
Finishing point
Hedged out longevity
risk and increased return-
seeking assets
Introduction of
longevity hedging
Introduction of
alternative asset classes
Introduction of risk
management derivatives
Reallocate risk
budget saved by
hedging unrewarded
risks into return-
seeking assets
Starting point
Current
investment
strategy
Asset-liability risk
ExcessreturnoverLIBOR

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