Pension De-Risking Is 'An Impossible Dream,' JP Morgan Claims, Yet Sources Highlight Inconsistencies

(November 15, 2011) — A new research report by JP Morgan Asset Management asserts that in seeking to de-risk pension plans entirely, plan sponsors are “dreaming an impossible dream.” However, some industry sources claim that the firm’s assertions demonstrate narrow thinking, as they fail to manage risks effectively when markets are dynamic.

According to JP Morgan’s white paper, strategies such as tax arbitrage are not feasible in a low yield, low liquidity environment. At the same time, arguments in favor of de-risking, such as agency costs and “creative accounting,” can actually end by increasing overall risks, the paper says. “By blending broadly diversified return-producing and liability-matching assets, however, sponsors can ‘right risk’ their plans while providing for growth and moderating unrewarded interest rate risks, notes report author Paul Sweeting, European head of Institutional Strategy Group.

‘Right risking’ entails the following considerations, JP Morgan asserts: 

1) A plan’s funded status and the most efficient means of sustaining or enhancing it; 

2) The plan sponsor’s capital structure, taking into account plan assets and liabilities; 

3) The risk appetite of the sponsor and the plan; and 

4) The extent to which the long duration plan liabilities can be used to access sources of return unavailable to conventional investors. 

However, a recent paper by Timothy B. Barrett, the chief investment officer at Eastman Kodak, Donald Pierce and James Perry of the San Bernardino County Employees Retirement Association (SBCERA), and Arun Muralidhar of AlphaEngine Global Investment Solutions claim that JP Morgan’s assertions are only partially correct, with blaring inconsistencies. “JP Morgan makes the same mistake all the other folks in this business make – namely, they are focused on static approaches to managing risk when markets are dynamic,” Muralidhar told aiCIO, summarizing his report. “…An intelligent investor will create a dynamic beta strategy that is positively correlated with liabilities and negatively correlated with assets, and adding this strategy to the portfolio helps pension funds get paid to de-risk. And this is true whether your measure of risk is the volatility of the funded status, drawdown of the funded status, volatility of the asset portfolio or drawdown of the asset portfolio.”

According to Muralidhar, all other strategies, whether buying put options on equity, buying tail risk hedges, or selling equity to buy long duration fixed income, are unwise strategies as you pay hefty fees to de-risk. “You pay the manager/broker who provides this product and you pay with guaranteed higher contributions in the future,” he said. 

“If one accepts the conclusions of the paper, titled ‘Dynamic Beta Management: Getting Paid to Manage Risks,’ then smart investors will target an absolute return of 10% with such a special correlation profile,” Muralidhar notes. He adds that the target return must be above the traditional 8% target return as most funds have assets that are less than 90% of their liabilities, and thus, have a need to grow much more than liabilities to make up the gap. “Doing less worse than the S&P500 is insufficient, and even fund of funds will have to achieve this target return and correlation profile to make it worthwhile for pension funds to invest in them,” he says.