Did you know that managing pension risk is a thing?
The investment landscape has grown and will continue to grow tremendously over time. With new investment vehicles being created and strategies designed, it is very important to pay even greater attention and oversight to how pension investments are carried out.
When ineffectively managed, there is the threat of low or lack of cash flow, access to capital, liquidity among others. The ultimate outcome of pension relies on strategy choices made by those in charge of managing the pension plan and their strategies for managing risk.
The main consequence of pension risk is underfunding which results in low or no money to pay out to retirees. Sponsors of underfunded plans are faced with two simultaneous decisions:
- Manage the pension risk
- Grow existing assets.
Investing is a risky process that requires expertise, knowledge, and time to produce the best results. In this article, we look at 5 ways pension risk can be managed.
5 Ways of Managing Pension Risk
- Asset Returns
This is the preferred way of improving funded status – by reducing the number of future contributions. However, current market conditions may project that future returns for traditional portfolios will be lower than the previous average.
In this case, organizations can consider changing the type of risk they incur by adding exposure to alternative investments.
- Liability Hedging
Pension plans are extremely sensitive to interest rates. Although management of pension schemes cannot control or predict the direction of rates, they can calibrate their plan’s sensitivity to change in the interest rates.
There are creative and capital-efficient ways to lower the opportunity cost of placing liability hedges without sacrificing returns. This is also possible in low-interest environments.
- Contribution Policy
The funded status of a pension is improved with certainty through regular contributions. Pension contributions should be thought of as a proactive decision.
A contribution budget can be developed which aligns with other organizational priorities.
- LDI Strategies
This involves hedging a fund’s exposure to interest-rate risk and inflation risk using bonds, swaps, and other means. The aim is to stabilize and overtime shrink underfunded ratios by matching liabilities with assets
Low-interest environment however, makes it difficult for some sponsors to embrace LDI investing
- Alternative Strategies
A means of diversifying risk that involves sponsors allocating a significant portion of their portfolios to alternative asset classes where returns do not typically correlate with equity returns.
The most common method is real estate investing with infrastructure and venture capital as other examples.
Similar article: Choosing a Pension Plan Investment Strategy
Summary
Investing in pension fund contributions is as risky as any other investment. The consequence of the inability to manage pension risk is underfunded pension plans which means that retired employees will not receive their monthly payments or lump sum. Pension administrators must be highly knowledgeable and careful when managing the pension risk they face.
