Corporate plan sponsors can structure their pension portfolios to mitigate the risk from down performance of the sponsoring company's underlying business, according to a new research paper from J.P. Morgan Asset Management.
The paper found that when firms are struggling, pension plan assets are more likely to suffer as well, resulting in a need for larger contributions to help the funding status at the worst time for the business. However, portfolios can be constructed to protect against pension risk without sacrificing returns during worst-case scenarios for the business, said Paul Sweeting, European head of the strategy group at J.P. Morgan Asset Management, co-author of the paper.
The paper, “The Missing Link: Economic Exposure and Pension Plan Risk” used the price of oil as its example in simulating the average loss in a portfolio in the worst 5% of scenarios.
“If a plan sponsor is heavily reliant on the price of oil, it is essential that the company's pension plan mitigates the effects of fluctuating oil prices in their investment portfolio. If not taken into consideration, a significant change in oil prices could have a substantial impact on the sponsor's balance sheet as well as increasing the potential shortfall in pension assets,” Mr. Sweeting said.
“You can take the principle and extend it beyond just commodities,” he added.
In general, a plan sponsor would identify the biggest risk factors and construct a portfolio protecting against the downside of a particular asset. A business whose financial health is positively linked to the returns on a particular asset is likely to slump under periods of low returns for the asset, thus the need for hedging risk on that asset, the report states.
“What you hope for is, if any risk factors identified impact the company badly, the pension surplus is more protected than the regular market provides,” Mr. Sweeting said in a telephone interview. “They can change the benchmarks to reflect different sector weights, which would protect against future extreme events.”
Mr. Sweeting said oil was used because it can work for a number of industries, mainly in production and transportation, but that the principle of protecting against asset downside would work in most scenarios.
The decision to structure a portfolio against asset risk would be strategic, not tactical, Mr. Sweeting said. It would be put in place as a long-term protection against the worst scenarios, while still providing nearly identical returns in normal market conditions. The research paper goes through different changes in asset allocation that illustrate how the expected return from the original portfolio allocation can still be obtained, while improving returns in scenarios where the specific asset has a downturn.
Creating an asset allocation to counteract the risk of a particular asset is a good strategy for pension plans that are underfunded and looking to reduce risk, Mr. Sweeting said. “It is reducing risk without losing returns,” he said. “It's something which we've seen interest in already.”
However, “pension plan underfunding is less of an issue if the company is in a good position,” he said.