October 14, 2013

Defined benefit (DB) plan sponsors should develop new methods to better manage investment, longevity, and inter-generational risk for future sustainability, according to research.

Risk Budgeting and Longevity Insurance: Strategies for Sustainable Defined Benefit Pension Funds,” by Amy Kessler of Prudential Retirement, outlined a modern approach for DB plans to handle changing demographics and increasing longevity.

The paper suggested a midway approach between the insurance model and the conventional pension model. [EXPAND Read more]

This method incorporated “managing just below fully funded status without any reserves or capital behind the risk, maintaining a low volatility asset strategy that is heavy in fixed income and absolute return with a modest allocation to risky assets to benefit from diversification of asset classes, and hedging the longevity risk of their retirees to ensure sustainability even in the face of longer life.”

Kessler said the right combination of the two models would allow pension funds to improve moderation of risk and reduce potential losses to a manageable scope.

In order to implement such an approach, plan sponsors need to understand the extent of impact longevity risk will have on pension funds, the paper concluded.

“While longer life is a welcome development, it is also a significant financial obligation for pension plan sponsors, particularly where the retirement age has remained the same for decades,” Kessler said. “This raises questions about sustainability and fairness, particularly where pension deficits are acute, the credit quality of the plan sponsor is weak, and life expectancy is underestimated.”

The effects of these risks will be amplified particularly by today’s low interest rates and low growth, the study reported.

To resolve further complications of risk, Kessler said plan sponsors should first re-budget risk by identifying areas in which risks are compounded.

Such risk budgeting would include establishing “a targeted level of potential risk of loss from which the plan and its sponsor could recover over the medium term.”

After proper budgeting, plan sponsors should recognize unrewarded risks, such as interest rate risks, and discover opportunities to take risks that are rewarded, such as credit and exposure to equities and alternatives, Kessler explained.

To create a lower risk and lower volatility portfolio, sponsors would also incorporate liability-driven investing, alternative fixed income, and absolute return strategies, the study found. The result would allow sponsors to allocate to assets that were intended to support liabilities.

DB plan sponsors also need to involve longevity insurance to guarantee their obligations will be met regardless of future liabilities concerning longevity.

Kessler said most US public pension plans are “short duration” plans—with risky assets of no duration and liabilities with long duration. This “mismatch” will also add to the challenges DB plan sponsors face, contributing to the underfunded status of most pension funds.

“It is clear that the current standard practice of leaving longevity risk out of pension risk analysis will lead to an underestimate of total risk,” Kessler said. “This is particularly acute for inflation-liked liabilities and deferred liabilities, where their longer duration makes them significantly more sensitive to adverse outcomes.” [/EXPAND]