The Need to Balance Return and Risk: Wake Up Call for Pension Funds

Implications: Too often the managers of pension funds use an objective of maximizing return.  However in doing so, they neglect risk.  In the volatile markets of today, the focus on returns, while neglecting risk, is causing problems.  It's time to stake a step back and rethink the management of pension funds. 

Analysis: The management of a pension fund has a single objective.  That objective is not to maximize returns in order to minimize the cost of funding by the corporate sponsor.  The objective is to provide the deferred compensation that the pensioned employee has earned, at the agreed upon future date.  In other words, safety and soundness is at the heart of investing pension funds.  The phrase "safety and soundness" (taken from the banking industry) is another way of saying prudent risk management.

There are three types of risk within a pension fund.  First, there is the risk of determining the amount and timing of the pension liability/ payment.  (Clearly defined contribution plans have a lower level of this risk than defined benefit plans.)  Second, there is the default risk in the pension fund's assets/investments.  Third, there is the risk of matching the maturities, or duration, of the pension liability and the pension assets (e.g., asset-liability issues).

Clearly too many pension fund managers have accepted too much risk (e.g., investing in hedge funds.)  Pension funds must invest strategically.  Pension funds must have a risk management program that recognizes, measures, and manages the total risk profile of the fund.  That means recognizing all three risk elements, and how these elements interact.

In summary, simply chasing returns will not suffice in the long term.  The trick of managing pension funds is balancing risk and return.