(March 22, 2013) -- Corporate CIOs don't approach asset allocation as a binary decision—although choosing between pure equities and 60/40 would shorten the workday—so why think of portfolio risk as an either/or choice?
That's the stance of St. Louis-based NISA Investment Advisors, and the thrust behind its recent paper, "Defining the Pension De-Risking Spectrum." Portfolio managers at the firm have found clients increasingly asking about "de-risking," but meaning wholly different things by it. One client might have a 10% allocation to liability-driven investing in mind, while another may be thinking full-blown annuitization.
While clients' notions of de-risking run the full spectrum, few individuals conceive of the strategy as such.
"We have seen a fairly pervasive interest in de-risking," Managing Director David Eichhorn told aiCIO. "But, beauty is in the eye of the beholder: it can mean fairly modest shifts to fixed income, or even whole buyouts. Our conversations with clients on de-risking varied so much that we thought it would be useful to calibrate discussions by providing a more complete risk spectrum."
Eichhorn compared NISA's model to the visible light spectrum. As with colors, some points on the de-risking spectrum are significantly more visible than others. Namely, full pension risk buyouts, such as the multi-billion deals GM and Verizon inked with Prudential last year.
"The headline annuity purchases clearly create a lot of discussion, as they should," Eichhorn said. "A buyout is in the de-risking spectrum: it's effectively the endpoint. But there's an enormous range between 60/40 and a buyout, and that's where lots of plan sponsors will find the solution that best fits their needs. We thought a comparison of status quo vs. buyout was a very incomplete discussion."
NISA's paper defines an additional zone of very low risk called "hibernation" for portfolios no longer primarily focused on seeking returns, but stopping short of annuitization. Annual funded status volatility ranges from roughly 4% to as low as 1% in the hibernation mode. Plans can achieve the top end with portfolios invested nearly entirely in fixed income based on "fairly blunt fixed-income indices," which are likely heavily tilted toward corporate debt, Eichhorn said.
The journey down below 2% volatility takes a finer touch, according to the paper. Firstly, the fixed income portfolio must closely mirror liabilities, which means blending indices to match duration, convexity, and the liability's yield curve. For pension risk to approach buyout level (which isn't zero, as the lawsuit brought against Verizon's annuitization attests to), NISA contends that a plan can dampen volatility by measuring it more accurately. This means swapping the common corporate discounting methods (the US' Pension Protection Act's formula, for example) for an economic-based discount curve (such as a corporate/treasury blend).
A higher quality discount curve more accurately reflects the economics of the liabilities and encourages a lower-risk portfolio that likely contains more treasury bonds. Additionally, it will dovetail with the calculations used in a buyout scenario. The hibernation mode can provide a useful staging area for annuitization, according to the paper, "because its low risk allows time for 1) a sponsor to consider the merits of and make the necessary contributions for an annuity buyout, and/or 2) the fiduciaries to aggressively shop pricing among insurance providers."
NISA's advice naturally follows its own best interests as a portfolio management firm.
But there is plenty of evidence to suggest a gap between plan sponsors' hearty appetites for de-risking, and fluency with their own liabilities and strategies for taming them. A recent global survey by Aon Hewitt, for example, showed a "marked reluctance" by those managing pension funds to "participate in broader liability management exercises aimed at reducing long-term liabilities and accelerating flight plans."
Mercurial pension liabilities can batter a corporate balance sheet, but so will spending billions to make those obligations somebody else's problem. However a CIO decides to deal with pension risk, choosing from a spectrum of options beats out binary decision-making.
