Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Consultants
    • Coronavirus
    • Courts
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Opinion
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Russia-Ukraine War
    • SECURE 2.0
    • Special Reports
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • Climate Change: The Inescapable Opportunity
    • Impact Investing
    • 2022 ESG Investing Conference
    • ESG Rated ETFs
  • Defined Contribution
    • Latest DC News
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • Trends in DC: Focus on Retirement Income
    • 2022 Defined Contribution East Conference
    • 2022 DC Investment Lineup Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Performance Data
    • P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
    • Future of Investments Research Series
    • Charts & Infographics
    • Polls
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
    • 2023 Defined Contribution East
    • 2023 ESG Investing
Breadcrumb
  1. Home
  2. Print
May 28, 2007 01:00 AM

Trading off exposures

Top management, better analytics will play a new key role as pensions are consolidated with corporate business units

William McHugh
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print

    CIOs face a call to action summoned by a new paradigm of pension fund management brought about by the most significant changes to pension plans since the enactment of ERISA, the adoption of FAS 158 and the Pension Protection Act.

    Chief investment officers have to understand the implications of this paradigm and rethink their approaches to risk and asset allocation. Doing so effectively can strengthen the financial well-being of both the corporation and the pension plan. It will require embracing new tools for defining, measuring and managing risk and implementing customized asset allocations.

    Under the Financial Accounting Standard 158 environment requiring a pension plan’s underfunding or overfunding to be on the corporate balance sheet, short-term swings in the financial markets will have a direct effect on the corporation’s risk exposure. Pension plans will be transformed from off-balance sheet operations with results smoothed over many years to large consolidated corporate business units with high potential short-term volatility. This transformation brings the plan to center stage for senior management and places it in direct competition with the sponsor’s core businesses for risk and resource allocations.

    As a result, CIOs, in addressing pension plan asset allocation issues, must first assess the plan’s upstream effects on the sponsor and then align the plan’s risk profile with the corporation’s ability to absorb risk in the short and long term.

    Traditional assessments of pension risk such as volatility of returns and surplus do not provide chief financial officers, treasurers and CIOs with actionable information. For example, it is difficult to assess whether an expected return of 7% and a standard deviation of 10% is appropriate for either the plan or its sponsor. Similarly, surplus volatility provides some insight as to the potential impact of the pension portfolio’s allocation on the plan, but does not explain its upstream impact on the corporation. CIOs must translate the pension lexicon into a language relevant for corporate decision-making. Three corporate finance-based metrics we developed go a long way toward accomplishing this goal.

    Shareholder equity at risk: This measure defines risk in terms of FAS 158. For every asset allocation, it is possible to calculate the potential impact on shareholders’ equity. Shareholder equity at risk represents the difference between the impact of the expected and the worst-case scenarios. If senior management expected that given the plan’s asset allocation, the corporation would experience a $100 million increase in shareholder equity during the year, and in the worst-case scenario, a $600 million decrease, the risk would be $700 million. Unlike standard deviation of returns or surplus volatility, shareholder equity at risk is a meaningful risk measure that enables the CIO and CFO to assess whether the plan’s risk level is appropriate (in light of the corporation’s overall risk profile) or whether it needs to be adjusted.

    Cash flow at risk: This defines risk in terms of contribution requirements under the Pension Protection Act. Cash flow at risk represents the difference between the expected level of contributions and a worst-case scenario for a given portfolio allocation.

    Earnings at risk: The third measure defines risk in terms of the potential impact of the pension plan on corporate earnings. Earnings at risk represents the difference between the corporation’s expected level of pension expense and a worst case, measured for the same portfolio allocation.

    The use of these risk measures facilitates the identification of an asset allocation that delivers the desired level of returns on plan assets within acceptable levels of corporate risk.

    The greater transparency of pension risk under the Pension Protection Act and FAS 158 will cause many CFOs and CIOs to extend risk management techniques — such as those used in hedging interest rate exposure — to the pension plan from the corporation. While these concepts might be new to many pension plans, corporate treasury teams have been successfully hedging interest rate and other corporate balance sheet risk exposures for more than 20 years.

    With the needs of the plan and the corporation so closely aligned, the plan’s asset allocation must be based on a customized solution that reflects both corporate factors (e.g. industry, financial strength, tax strategy and plan size relative to the balance sheet) as well as plan-based factors (e.g., the nature and growth rate of its liabilities and funded status). Consideration of both sets of factors facilitates the assessment of important trade-offs between risk control, investment results and the financial impact of the plan on the corporation, and ensures that the total risk of the plan’s investment policy is aligned with the corporation’s capacity for absorbing risk in terms of shareholder equity, earnings and cash flow. The result is a customized, rather than a one-size-fits-all 70/30, asset allocation.

    The heavy concentration of equities within most pension plans represents a large risk exposure to both the plan and shareholders. Reducing a plan’s long-only equity stake, and funding a wide range of beta and alpha sources that can generate returns with low correlation to equities and each other, is the winning approach to reducing the volatility of the plan’s surplus. Within the next five years, we believe the typical final-pay pension plan will have from 25% to 35% of its assets invested in non-traditional asset classes, vs. about 8% today.

    Never have the skills and experience of the CIO been more critical than they are now in implementing this approach, maintaining the viability of the DB plan and managing the plan to meet the dual objectives of enhancing shareholder value and ensuring participant benefit security.

    William McHugh is group head of the strategic investment advisory group of JPMorgan Asset Management, New York.

    Recommended for You
    Read the print edition of P&I
    Read the print edition of P&I
    Citadel's Ken Griffin gives $125 million to Chicago museum; name will change
    Citadel's Ken Griffin gives $125 million to Chicago museum; name will change
    Gender diversity is improving on FTSE 350 boards
    Gender diversity is improving on FTSE 350 boards
    The Institutional Investor's Guide to ESG Investing
    Sponsored Content: The Institutional Investor's Guide to ESG Investing

    Reader Poll

    January 25, 2023
    SEE MORE POLLS >
    Sponsored
    White Papers
    The Future of Infrastructure: Building a Better Tomorrow
    Fulcrum Issues: Equity Returns and Inflation — Choose Your Own Adventure
    What Matters Most in Considering a Private Debt Strategy
    Why pursue direct lending in the core middle market?
    Research for Institutional Money Management
    Are Factors a Thing of the Past?
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    December 12, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Consultants
      • Coronavirus
      • Courts
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Opinion
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Russia-Ukraine War
      • SECURE 2.0
      • Special Reports
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • Climate Change: The Inescapable Opportunity
      • Impact Investing
      • 2022 ESG Investing Conference
      • ESG Rated ETFs
    • Defined Contribution
      • Latest DC News
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • Trends in DC: Focus on Retirement Income
      • 2022 Defined Contribution East Conference
      • 2022 DC Investment Lineup Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Performance Data
      • P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
      • Future of Investments Research Series
      • Charts & Infographics
      • Polls
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
      • 2023 Defined Contribution East
      • 2023 ESG Investing