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Not just sitting ducks

In election season, politicians ask: Are you better off than you were four years ago?

But pension funds should ask: Are they better prepared to deal with the risk and return challenges that lie ahead than they were when the financial market crisis struck?

Two major developments over the coming weeks could set the course of the economy and financial markets for the next few years at least. One is the outcome of the presidential election. The other is how a new or continuing administration and Congress address the so-called fiscal cliff that is set to trigger Jan. 1 with automatic, massive tax increases and federal spending cuts.

On top of these looming uncertainties, the economy remains weak, unemployment remains high, the federal deficit and federal debt remain at record levels, and the European debt crisis remains unresolved. Further, continuing low interest rates encouraged by Federal Reserve monetary policy and the potential for another downgrading of U.S. government debt because of unresolved fiscal issues all put further stress on both on the asset and liability sides of pension plans.

President Barack Obama and Mitt Romney in their campaigns haven't addressed specifically how they will deal with these concerns and their potentially significant impacts on pension funding.

Financial upheaval has a way of revealing weaknesses in pension fund investment policy and risk management, as it did during the financial market crisis.

Defined contribution plan officials face similar issues that they should address. For them, the financial crisis revealed apparent flaws in target-date fund allocation strategies that resulted in unexpected losses in the crisis. Many funds failed to live up to their promise of a safer way to allocate assets in stocks and fixed income as participants approach retirement. That led to an unprecedented joint Securities and Exchange Commission/Department of Labor hearing June 18, 2009, on target-date funds.

With uncertainty from the election, it is an appropriate time for pension fund executives and other institutional investors to evaluate their investment policies and risk management practices on how well they have learned the lessons of the financial crisis.

Even with the systemic risk protections enacted in the Dodd-Frank Wall Street Reform and Consumer Protection Act, the current extreme fiscal and monetary policies leave policymakers with much less financial maneuverability to shore up the financial system in the event of another crisis.

But pension plans are not just sitting ducks. A fiscal cliff — or other economic problem — doesn't have to translate into a pension debacle.

Pension funds can't avoid risk, but they can manage it. They can do more to improve funding levels. They can do a better job of investment management in an environment currently generally inhospitable to their objectives. For better outcomes generally, they need to keep a long-term view and a diversified asset allocation, realizing many macroeconomic events turn out to be just blips on the long-term horizon.

In many instances, the financial market crisis revealed investment processes that underplayed risks and risk management that wasn't robust enough to capture all risks.

For example, investment and risk processes often failed to keep up with more complex and rapidly evolving financial markets and instruments. Losses often went beyond maximums expected in stress-test analysis.

The challenge isn't just to strengthen the risk management side of investment management, but also to strengthen the return side.

Pension funds have tried to be resilient, but generally have not recovered from the financial market crisis.

The asset cushion many had is now gone. In the event of another major downturn, most would enter with a big funding deficit.

In 2007, the average funding level of the Milliman 100 list of the largest U.S. corporate defined benefit plans was 105.2%. It fell to 72.4% as of last August as aggregate assets declined, while aggregate liabilities rose.

Over the last five years especially, pensions funds have been challenged in trying to meet their expected investment rate of return, which on average for the Milliman 100 has declined to 7.8% in 2011 from 8.3% in 2007.

Some pension plan executives are stepping up to the challenges by embracing derisking strategies. Other plans should do so, as well as better optimize risk-and-return management.

The Indiana Public Retirement System, Indianapolis, for example, has adopted the lowest investment return assumption of any major public plan — 6.75%, — while the state bolstered its pension contribution.

Ford Motor Co. plans to reduce the risk of its pension plan by reallocating assets to 80% fixed income and 20% return-seeking assets.

General Motors Co. plans to offload $26 billion in pension liabilities and $29 billion in pension assets to Prudential Financial Inc. Although that would not improve its overall funding ratio, it would allow GM to concentrate resources on its more problematic pension assets and liabilities.

The State of Wisconsin Investment Board is implementing risk parity, a strategy that leverages its asset allocation to better manage risk rather than magnify return.

Even in securities lending, programs have dampened ambitions, limiting income to only intrinsic value after many ran into trouble trying to drive income by investing collateral in higher returning, riskier assets.

Fees have come under pressure as well. In defined contributions plans, for example, the Department of Labor has adopted fee disclosures that aid 401(k) sponsors.

In hedge funds, the 2-and-20 fee model is breaking down in the face of modest performance since 2010, and especially this year in competition with traditional long-only management, as U.S. stock indexes returns have soared into the midteens.

Pension funds should be better at reducing unsystematic risk — especially in alternative investments as their allocations rise — by demanding more transparency, liquidity, control and customization, qualities generally lacking before the financial market crisis. This change could strengthen investment returns, due diligence and risk management.

While pension officials can do much more to strengthen their plans, the long-term sustainability of the plans ultimately depends on stable and favorable markets. Continuing low interest rates, for example, have daunted some efforts to use liability-driven investing to stabilize funding levels in recent years, although some funds have employed it with success.

But reducing risk alone, no matter how successful, isn't enough for underfunded plans. They need to invest in growth-seeking investments to bolster assets to improve funding.

Policymakers, whether led by a new Romney or a re-elected Obama administration, must put forward policies that improve the nation's fiscal condition and encourage economic and employment growth. Such policies would promote favorable interest rates and investment markets, and better secure and grow retirement income.

Failing that, they will face weaker retirement systems, both defined benefit and defined contribution, resulting in more dependency on the federal government, which isn't capable of managing a sustainable pension system. n

This article originally appeared in the October 29, 2012 print issue as, "Not just sitting ducks".