Milla Krasnopolsky: There are multiple definitions of risk and they vary based on the key plan objectives. However, regardless of what the risk metric is, risk measurement is only useful to the extent that a plan sponsor has the ability to manage that risk. So there has to be a way to make the risk management process actionable. One way to do that is to create policies that are risk-based as opposed to capital-based. Many rebalancing or de-risking triggers are based on capital allocations relative to target investment policies. However if policies focus on risk targets, such as level of duration or equity beta, in addition to capital allocations, then managing funded status risk may be managed more efficiently as systemic market risk exposures are aggregated across all assets and liabilities.
Regarding performance benchmarking, the overall plan benchmark should be the liability together with a process for measuring and monitoring contributors to funded status change. However, there are various complexities to modeling liabilities. Although most LDI managers mainly focus on a point in time projected cashflow durations in determining the appropriate liability hedging strategy, assuming that a liability would perform just like a zero coupon fixed income instrument is an oversimplification for plans with more complicated liability structures that include variable benefit provisions or varying degrees of optionality. Another factor that affects how liability risk is measured is the type and magnitude of credit risk that is embedded in the discount rate calculation. Taking all these factors into account, it is then not surprising that performance of customized liability benchmarks may vary greatly from one plan to the next and standard peer universe comparisons become challenging and possibly irrelevant.
Funded status performance and risk reporting that reflects an integrated asset and liability investment and risk management process demonstrate the ultimate measures of success for an LDI strategy.
Chris Paolino: The first step to effective risk measurement is to adapt the framework so that it incorporates liabilities and looks at risk based on those parameters. One of the key things for both staff and investment committees to understand is this: If your funded status volatility is something you are specifically trying to minimize, what are the main drivers of that volatility? Is it equity risk? Is it interest rate mismatch? Is it lack of corporate spread duration risk? All of those things are factors that people need to be aware of as they move down the path. There are lot of different ways to model and test for those risk factors, and lots of different risk statistics that you can consider. I think that there are advantages and disadvantages to all of them. The key is to understand your main drivers of risk and your tolerance around that volatility.
We also feel strongly that the higher a plan allocation to fixed income, the more important it is to have a custom benchmark. The liability stream can change a lot, particularly if there are nuances—for example, a high proportion of the liability being in a cash balance plan that has floating rate dynamics, or minimum guarantees. So as you get further down the path toward immunization, the more important it is to measure performance against a nuanced benchmark.
Peter Austin: There is no one answer for how one defines, manages and monitors the risk of a pension plan, because the risk can take different forms. You need a collection of different measures to help develop a rounded view of the risk attributes of a plan so that the fiduciary, together with its advisors, can make informed decisions.
The way we think about pension plan risk is the volatility of funded status, which incorporates asset allocation as well as the funding levels of the plan. Every CFO, particularly CFOs of public companies, is acutely aware of funded status volatility because it impacts balance sheets, and a wide range of other issues, not the least of which is access to liquidity. Metrics like value at risk (VAR) are interesting, and looking at VAR from a probabilistic standpoint can also be helpful. There are no right or wrong answers. It all depends on the environment and the objectives of the sponsor.
What plan sponsors need is a decision framework that is consistent over time, and given the volatility of today's markets, the importance of consistency cannot be overstated. The decision framework gives you an opportunity to consider all of the potential outcomes, which will better prepare the sponsor to accept whatever outcome transpires. Plan sponsors are making decisions everyday with regard to their plans. It is critical that they are not surprised by the outcomes, so they can stick with the de-risking plan they have laid out.