Sunday, February 13, 2011

Are Pensions Planning to De-Risk Funds?

Ruth Sullivan of the FT reports, Pensions plan to de-risk funds:
UK pension funds plan to reduce risk-taking on assets and liabilities in the next decade.

Nearly three-quarters of defined benefit pension schemes aim to de-risk their funds, according to a survey of 200 schemes, carried out by Aon Hewitt. Bigger schemes plan to do this by becoming self-sufficient without relying on sponsors for payment of benefits, while smaller ones want to buy out the benefits from an insurance company.

“Nobody wants pension risk any more. Trustees and sponsors do not want pension funds to turn around and bite them, they want out,” said Kevin Wesbroom, at Aon Hewitt’s global risk services.

On the asset side, funds plan to move away from equities, especially UK companies, favouring property, hedge funds, commodities, currency and infrastructure. They will increase their exposure to bonds and use other liability-driven investment strategies.

However, in spite of intentions to de-risk, trustees need to reduce deficits. Although aggregate deficits among FTSE 350 companies fell over 2010 from £80bn ($128bn) at the start of the year to £40bn at year end, further reduction is needed.

“Balancing risk and reward has never been easy. Pension funds face the dilemma of having to continue to run risk in the short term in order to get risk off the table in the long term,” said Mr Wesbroom.

The research shows 43 per cent of pension schemes realise they will have to extend their time-scale to reduce deficits. In the past few years this has increased from five years to eight years and this year is expected to rise to 13 years.

There has also been a steady rise in the number of plans closed to both new and existing members, from 12 per cent in 2008 to 29 per cent last year while over half of respondents expect to close schemes to existing members this year.

The de-risking of mature pension plans is a long-term trend. As pension plans mature and start paying out more in benefits than they receive in contributions, they try to match assets-to-liabilities a lot more closely, meaning they start moving away from risky assets to get into other assets which provide more steady cash flows.

Of course, asset-liability matching isn't an exact science, but mature pensions can't afford to go through another severe drawdown like they did in 2008. As the article states, further reduction in pension deficits are needed. That's a big reason why central banks around the world (led by the Fed) have been targeting asset reflation and mild inflation. If inflation expectations pick up, rates will rise (hopefully) at the same time that assets are rising. This will help reduce pension deficits further.

So far, stock markets around the world keep grinding higher which tells me pensions are in no rush to de-risk their portfolios anytime soon. Skeptics abound waiting for the next major downturn but I continue to believe that there is so much liquidity in the financial system that the risks of a melt-up outweigh those of a meltdown as another stock bubble gets underway. There will be corrections along the way as markets get overextended, but I think Chris Ciovacco of Ciovacco Capital Management is right, bears will be taken to the woodshed during the next correction.

A few more things to keep in mind while reading this article on pensions 'de-risking' their portfolios. First, UK pension plans have the highest exposure to equities in the world. Second, mature pension plans have to reduce their deficits which means they still need to take on equity risk in both public and private markets. Asset-liability matching is easier to implement once pensions are close to fully funded status but most pensions are far from being fully funded. Finally, de-risking or taking on more risk hoping that markets solve the problem are not a long-term solutions for dealing with chronically underfunded pension plans. Without serious reforms, pension deficits will continue plaguing company and government finances, placing more stress on already fragile retirement systems.

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