More companies are seeking to derisk their pension plans. But what does derisking involve? Is it even appropriate? In this article, we examine the rationales for derisking and propose a pragmatic alternative.
Derisking describes the process used to remove as many risks as possible from a pension plan, either with a view to securing the liabilities with an insurance company or running the assets and liabilities as a closed fund.
The most common approach to derisking is to use a portfolio of fixed-income securities and derivatives to mitigate the nominal and real interest rate risk present in pension plans. The extent to which this risk is managed varies according to how exact the matching strategy is, but using key rate duration matching — where assets and liabilities are matched by duration “buckets” — can remove the vast majority of risks.
One of the more robust arguments for derisking centers around the tax arbitrage argument set out by Fischer Black. The argument is based on the idea that a company's leverage is a function not only of the equity and debt that it has issued, but also of the pension plan assets and liabilities. This is because the company is ultimately responsible for the payments of pension liabilities, and because these liabilities represent promises to make fixed payments in the future, they can be regarded as the equivalent of debt issued by the firm. Thus pension liabilities effectively increase leverage. To the extent that the pension plan is invested in bonds that match these liabilities, the leverage is reduced. On the other hand, equity investment — which can be regarded as holding assets that ultimately fund payments to shareholders — essentially adds to leverage.
Viewed holistically in this way, the mix of corporate equity and debt can be altered at the same time as the asset allocation of the pension plan to leave the overall leverage unchanged. There is no tax advantage to having a particular asset allocation within the pension plan, but there is a big tax advantage to a firm being funded more by debt than equity — debt interest payments are tax deductible while distributions to shareholders are not. This suggests pension plans should be fully invested in fixed-income investments, so that all of the leverage comes from debt issued by the company.
However, the tax arbitrage depends on the credit spread being narrow enough that the cost of borrowing does not wipe out the tax saving, since the arbitrage essentially involves issuing debt at the corporate bond rate and investing the proceeds in Treasuries. That means the worst time to try to benefit from the arbitrage is when Treasury yields are low and credit spreads are high — in other words, at a time like today, when even the highest quality borrowers would struggle to benefit, as shown in the accompanying graphic.