Building a solid roadmap for risk management
Cone of uncertainty
The risk modeling should illustrate the full range of possible outcomes over a period of time, Pellerin said. Assuming aggressive asset allocation, an extremely positive scenario could drop a plan’s funding ratio from 80% to 105% over five years. But if the markets go bad, the capitalization ratio could drop from 80% to 50%. Such a high risk, high return strategy means that in five years the cap ratio could be between 50% and 105%. This wide range, when illustrated graphically, shows a broad cone shape – which Pellerin called the “cone of uncertainty”.
“If this wide range creates too much uncertainty for the plan sponsor, we can tighten the cone by diversifying the portfolio, eliminating interest rate risk, adding higher quality fixed income securities and putting implement a descent path. This will allow the sponsor to contain the downside risk, maintain some upside potential and, therefore, reduce the uncertainty of contributions. “
Broaden the set of opportunities
“Diversification is the only free lunch, and generally we divide assets into two categories: yield seeking and hedging, but other asset classes can be added to serve a dual purpose,” Pellerin said. Examples of the latter include high yield bonds, such as BB rated bonds which are on the cusp of investment grade and could help increase returns, as well as tactical bonds which have a certain duration. Additionally, a global low-volatility equity strategy can have defensive attributes while playing a yield-seeking role and can be effective when capitalization ratios decline, he said. Inflation-protected commodities and Treasury securities may also be added, especially for plans subject to cost-of-living adjustments. “These can all help move portfolios closer to the cap ratio efficient frontier. “
Plan sponsors should also take a holistic approach to the scenarios in which they may need to make contributions. “We are all hoping the stock markets continue their phenomenal run and rates rise, but hope is not a strategy,” Pellerin said. “For many plans, achieving the end goal will require not only a combination of returns on equity and higher rates, but also funding. Once sponsors accept contributions as a key risk management lever, a much richer risk management strategy can be developed and a much more robust framework can be implemented.
A governance perspective
A successful and robust risk reduction program often requires more rigor around the descent path – the set of target asset allocations that adjust as the funding state of the plan changes. “The transition trajectories have gone from a general roadmap to a fully documented process that is part of the plan sponsor’s corporate governance program,” said Pellerin.
The more strategic use of the descent path allows the plan sponsor to take action more quickly when thresholds are reached. “We have seen some sponsors maintain tighter cap ratio thresholds – say, less than 5%,” he said. “It allows you to manage the process more dynamically. “
In addition, not all descent paths need to be implemented in the same way. Some sponsors prefer a formal, regulated guide that is part of the investment policy. Others prefer to keep a more general guide as a way to discuss next steps when thresholds are reached. “Both approaches work as long as they take risk tolerance into account. We design hedging portfolios that meet the specific attributes of each sponsor, ”he said. “It is important that sponsors adopt a roadmap that reflects their unique situation.