Tail-risk events — which are loosely defined as the probability of rare events taking place that could impact a portfolio of investments — are happening more frequently these days and need to be addressed by investors and their advisors to protect their investments.
When describing tail risk, quant investors usually refer to black swans, fat tails and negative skew. For defined benefit plan managers, the ultimate tail risk is a “perfect storm” — periods such as the tech bubble crisis period from 2000-'02 and the 2008 financial crisis when return-generating assets crashed and investors' “flight to quality” pushed down yields on government bonds to historical lows.
This lethal combination of declining asset prices and increasing present values of liabilities pushed the funded ratios of DB plans from well funded to underfunded. According to a Milliman pension study, the average funded ratio for the 100 largest U.S. corporate plans declined from 123% in 2000 to 82% in 2002, and then after recovering to 105% in 2007, fell to 80% in 2008.
Against this background, there is a compelling case for a hedge that would provide some protection against possible future tail-risk events. However, there are some important questions that need to be addressed by a fund manager contemplating a tail-risk hedge:
- Due to the cost of tail-risk hedges, should DB plans be a buyer or seller?
- How will tail-risk hedges fit with my plan's current strategic/glide path strategy?
- Which tail-risk hedge vehicle is appropriate for my DB plan, if any?