Risk management methods now in vogue among corporate defined benefit plan executives don't deliver what they promise, new research shows.
Long-duration fixed-income allocation, synthetic duration extension and dynamic asset allocation — three of the most popular risk-management approaches used by many corporate plans — simply don't provide enough protection in controlling downside pension contribution and expense risks when used separately, according to a new report from J.P. Morgan Asset Management, New York.
However, a “3-in-1” approach to managing tail risk in pension liability streams that combines the strategies in a multidimensional risk management framework will be effective in managing corporate pension fund liability risk, according to the analysis.
The results are presented in a paper, “The Blind Side: Managing downside risk in corporate defined benefit plans,” provided exclusively to Pensions & Investments.
J.P. Morgan officials say the firm's latest white paper stems from interest expressed by a large number of corporate defined benefit plan executives in the concept of non-normality, which was analyzed in a 2009 paper, “Non-Normality of Market Returns: A framework for asset allocation decision making” (P&I, May 4, 2009).
“The response to our first paper was unexpectedly overwhelming,” Abdullah Z. Sheikh, director of research in JPMAM's strategic investment advisory group, said in an interview.
The result was a huge demand for analysis of how extreme negative market events — known as tail-risk events — such as the credit crisis of 2008, affect corporate pension fund liabilities.
“The three key issues that corporate defined benefit plan sponsors say they are most interested in are downside contribution risk, median contribution risk and pension expense. They want to better understand how to manage their liability risks,” Mr. Sheikh said.
“Extreme negative events and downside risk do not just apply to asset returns. When a crisis hits, liabilities can suffer consequences just as harsh, and be just as dangerous, for the investor — in this case, the defined benefit plan sponsor,” according to the paper, which was written by Mr. Sheikh and Jianxiong Sun, a JPMAM analyst.
The two most recent extremely negative events — from 2000 to 2002, and 2008 — devastated the funding levels of many corporate pension plans, resulting in the need for unexpectedly higher contributions to bring plans back to full funding.
By the end of 2008, the average funding ratio for U.S. corporatedefined benefit plans was75%. It rose to 82% at the end of 2009, but fell again to 70% as of June 30, Mr. Sheikh said in the interview.
Mr. Sheikh said the last six months show that downside pension contribution risk can arise even in market environments less catastrophic than 2008, the “worst tail-risk event in history.”
“The last six months, characterized as it was by falling interest rates and the underperformance of equities, just proved that derisking and dynamic asset allocation methods used by a number of pension plans just didn't work. Factoring in non-normality is integral. If you understand it, then you're closer to being able to manage pension contribution risk much more effectively,” Mr. Sheikh said.