JAMES SO: One I would call 'majoring in the minor.' Paying too much attention trying to over-engineer the fixed-income solution. Take care of the big risks first. The big risks are really asset allocation decisions, but if you have an asset allocation that's heavy on return-seeking assets, your proverbial golden ratio — 70% equities, 30% fixed income — the equity, or the return-seeking portion is going to throw off so much risk vs. your liabilities that it doesn't make sense to over-engineer your fixed-income solution. Yet plan sponsors sometimes want to engineer the fixed-income benchmark to squeeze out another 100 or so basis points of tracking error.
The other one is what I could call 'cognitive bias.'
We have clients that want a higher-quality fixed-income portfolio. We can oblige, but we will point out that they're going to miss out on some alpha. The additional risk we might take from being able to go down the credit quality spectrum to the triple-B space or perhaps even cross-over credits could add quite a bit of alpha and not that much tracking error. The tracking error of the portfolio might go from 100 basis points to 150, or 200 basis points — and that concerns them while they're willing to keep a heavy return-seeking allocation that generates 2,000-plus basis points of tracking error vs. their liability.
FRANÇOIS PELLERIN: Some old habits die hard. Many plan sponsors are not hoping that interest rates will go up, they know they will. That's a mistake. We continue to think that even when rates are low, it's a non-compensated source of risk.
For a typical plan, 90% of the risk exposure on rates is beyond the 10-year key duration node, and the Fed doesn't control that. The Fed controls the front end. For both fundamental and technical reasons, we don't see how the long end can go up dramatically and salvage pension plans. I would continue to try to take risk that's compensated.
The other mistake that I see is plan sponsors feeling good about selling their retirees to an insurance company via a partial annuitization. If half of your liability pertains to retirees and you sell all those to an insurance company, you haven't gotten rid of half the risk. You've only gotten rid of a small portion of the risk because you will be mostly left with participants whom many insurance companies don't want to touch with a 10-foot pole.
GARY VEERMAN: I agree with François on the interest rate piece, but I'll say it in a different way. I don't think plans hedge enough interest rate risk. The fact is, if you're not getting paid for it, why are you taking risk? It's as simple as that.
And on the other part of risk, I think in a lot of cases, very well-funded plans, or plans near 100% funded, could be taking too much risk. Obviously, it's hard to generalize the correct amount of risk because every plan is different. But it's hard to argue that increasing funded status beyond a certain point, say 115%, adds any real value to most plans. We refer to it as pension asymmetry, and it can be simply defined as the fact that an increasing funded position has decreasing marginal benefit, while decreases in funded status are increasingly painful.
We think pension asymmetry should factor in a plan's strategic asset allocation decisions.