When thinking about how to effectively manage risk in an investment program, governance plays a critical role.
Your reporting package should not be set it and forget it - it should evolve as your pension plan does.
Don't discount how important pension plans are to providing retirement income security for your employees.
A few months ago, we published a paper called Institutional investor best practice by 2025. In this paper, we addressed how investors will need to fundamentally change how they approach capturing opportunities, mitigating risks and managing costs within their investment portfolios to set themselves up for success in 2025 and beyond.
These changes are driven by a few key things happening in the pension industry, including the erosion of funding relief and increasing PBGC (Pension Benefit Guaranty Corporation) premiums. As these and other external forces exert greater impact on pension plans, many sponsors are reassessing best practices.
To kick off 2020, here are 10 things we believe help position pension systems for success in the coming decade.
- Establish and document your investment beliefs.
Investment beliefs are a series of high-level principals, unique to each committee, that guide decision-making and supersede the personal views of individuals. For these investment beliefs to help committees make effective decisions, they need to be discussed, agreed to and documented. Establishing beliefs will save time and allow committees to explore how those beliefs, in conjunction with their desired endgame and time horizon, drive the selection of optimal implementation decisions. This approach reinforces plan objectives so they are actionable, measurable and impactful, and is fundamental to improved governance.
- Ensure your fiduciaries are focused on the right governance decisions.
When thinking about how to effectively manage risk in an investment program, governance plays a critical role. You can think of governance as a core component of your risk budget that, when spent wisely, allows you to focus on key decisions such as how benefit policy and funding policy can drive effective investment policy decisions. Key components of a well-codified governance process include investment program objectives, investment beliefs and clearly identified roles and responsibilities-which indicate at what level decisions are made (i.e., delegation of decision-making authority). All this should be captured by reporting metrics necessary to monitor progress toward the desired endgame. Governance is what you fall back on when questions arise about decisions and actions.
- Speaking of reporting, make sure yours is custom to the outcomes you seek.
Your reporting package should not be set it and forget it - it should evolve as your pension plan does. As return-seeking allocations shift to hedging assets, attribution detail will also shift focus on the largest sources of change to funded status, like nominal and credit risk. As the time horizon shortens, there will be new focus on liquidity metrics and forward-looking downside risk estimates.
- If your plan is mature, surplus risk management will be critical.
This will require a renewed focus on liability hedging portfolio construction blind spots, including the split between credit and Treasury bonds, the impact (or lack thereof) of key rate duration mismatch and, increasingly, the impact of the hedging portfolio on the return-seeking portfolio structure, and vice versa.
- Ensure you are still adequately diversified - even as your plan matures.
As your hedging allocations grow, it is still key to remain diversified - especially if you treat hedging and return-seeking as uncorrelated sources of risk. There are a variety of ways that plan sponsors can access diversifying assets in today's market outside of just passive and concentrated equity. Plan sponsors should also consider cheap beta and, even better, factor exposures to help round out the composites within their investment portfolios.
- Keep your hedging composites simple, if you can.
Our analysis consistently reassures us that because there is no immunizing asset for the spread component of corporate pension liabilities, the false precision and complexity of some hedging strategies is unnecessary until a plan is very far along a de-risking glidepath. While some level of key rate duration matching across the curve is appropriate and can materially improve the effectiveness of the hedge, don't prioritize complexity outright. Taking a simpler approach can still provide optimal surplus risk mitigation and portfolio effectiveness, while helping alleviate unnecessary fees.
- Be ready for new late state glidepath considerations.
For closed, frozen and/or hibernating pension plans, as you get closer to your endgame, you may encounter unfamiliar risks to manage and/or harness, including liquidity, downside protection (e.g., contributions, low vol equity, options) and risk transfer. Ensure that you seek out advice and support from your provider(s) to help you model the impacts these risks can have on your ability to downsize your plan.
- As your pension plan matures, time horizon is increasingly important.
Within the return-seeking portfolio, a shorter time horizon limits the opportunity to use less liquid investment vehicles and strategies, but it may also impact the factors you consider using to enhance returns. Conversely, the use of liability hedging strategies in conjunction with a glidepath can mitigate the challenges of a shorter investment time horizon by linking your asset portfolio with daily changes in interest rates that impact liabilities.
- Fees continue to matter.
Make sure you don't miss any fees. In addition to sub advised manager fees, understand the value, cost and price of other delegated (and not delegated) activities, including transition management, currency transaction and other administrative and legal functions. Not all providers quote or bill these in the same fashion and it can be difficult to get a full view of the costs you're being charged.
- Don't discount how important pension plans are to providing retirement income security for your employees.
Retirement income security, especially late in life, is of significant concern for both individuals and society in general. Until it is better addressed by defined contribution (DC) plans, defined benefit (DB) plans are incredibly effective tools for attracting new associates, retention and lifetime income provision. The important fiduciary work you do is critical to helping ensure a secure and enjoyable retirement for your employees.
All 10 of these things are important; if you're struggling with where to start, we suggest prioritizing points 2, 4 and 6.
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