Pensions, Risk, and Reality

Implications: The process of managing pension plans (defined benefit plans) is too often simplified and neglected due to its long-term nature.  Like Dr. Mangiero, I also agree that the degree of sophistication needs to be raised.  However to do so, all risks within the process must be recognized and managed in an integrated framework. 

Analysis: Defined benefit pension plans are dinosaurs that are imbedded in the past.  However, although they grow more extinct, they still roam our economic world.  What is troublesome is the way we manage such giants has not significantly changed over time.  They are perceived as ever growing, very long-term liabilities that permit investment managers great freedom in choosing an appropriate strategy.  Too often this strategy is focused on maximizing return, and thus reducing the sponsor's costs.  Too little attention has been paid to the risk dimension of investing pension funds.

In reality, proper risk modeling begins with risk recognition and measurement.  Pension plans are financial intermediaries.  The assets ultimately support the liabilities.  To fully grasp this dynamic process, one must first recognize the risks/uncertainty in the liability (i.e., pension promise).  Next, the risks in the assets (i.e., pension investments) must be recognized.  Last how the risks in the liabilities and assets interact must be recognized.  Risk is everywhere in this process. 

The pension promise (i.e., liability) is full of uncertainty with mortality rates, inflation, payment revision from contract renegotiation, etc.  As Jack Treynor noted in the 1970's, there are numerous dynamics with this liability that must be understood (e.g., pension put option, PBGC insurance, etc.)   Pension assets have more than default risk.  Pension assets have market risk due to time and changing economic conditions.  Last, how pension liabilities and assets interface are critical.  This asset/liability issue is about timing of expected cash inflows and outflows (e.g., duration and immunization).

Today, financial analysts, sponsoring corporations, and pension fund managers must realize that past tools are no longer adequate.  A pension fund exists to deliver the promises of corporate management for lifelong earnings to workers.  As such, the first and foremost objective must be risk.  Workers cannot shoulder the uncertainty created by poor management of pension funds.  Risk management, and the derived valuation, must dominate the perspective of all.   No longer can everyone assume that pension investment strategy should focus on return, and that risk will be okay given the long-term nature of pension liabilities.