Demystifying De-risking

Transcription

1 SEI Perspectives Demystifying De-risking With Canadian bond yields reaching record lows and interest rates remaining at rock bottom, DB plan sponsors who delayed de-risking their plans in anticipation of an imminent rise in yields must be wishing they had started the process early to protect their funding levels. But how many have a mechanism in place to identify and quickly exploit such opportunities? Funding volatility is high and chances to capitalize on upside and mitigate downside scenarios are missed at DB plans peril. Against this backdrop, de-risking has become a much- discussed investment strategy in the pension world.

2 In this context of continued high volatility where plan liabilities are growing and the assets are shrinking (see Figure 1 below), the need to de-risk has never been more pressing, even if, according to many, the environment is shifting. Ratio of Assets to Liabilities 130% 120% 110% 100% 90% 80% 70% 60% 50% Mercer Pension Health Index* *The Mercer Pension Health Index shows the ratio of assets to liabilities for a model pension plan. The ratio has been arbitrarily set to 100 per cent at the beginning of the period. The Index assumes contributions equal to current service cost and no plan improvements. Assets: Passive portfolio with asset mix shown below. Liabilities: 50 per cent active members, 50 per cent retired members; Canadian Institute of Actuaries transfer values (April 2009 standard, including changes effective February 1, 2011, for transfer values after February 1, 2011) without the one-month lag for active members and annuity purchase proxy values for retired members. Results will vary by pension plan. Asset mix: 42.5 per cent DEX Universe Bond Total Return Index; 25 per cent S&P/TSX Composite; 15 per cent S&P 500 (CAD); 15 per cent MSCI EAFE (CAD); 2.5 per cent DEX 91 day T-Bills.

3 What is de-risking? Most DB pension plans have needed to take on a degree of investment risk on their paths (or glide path ) to attaining fully funded status. As illustrated in the diagram below, de-risking aspires to proactively lower this risk as the funding level improves. The latter part of this sentence is critical, as most plan sponsors are under the impression that they lost the opportunity because the rates are poised to change direction. The truth is, de-risking isn t a step to take at one point in time during a pension plan s lifecycle, but rather a framework for managing the plan throughout its lifecycle. The Plan s Glide Path The Concept De-risking aspires to proactively lower investment risk as the funding level improves. Insure some benefits? Take even less risk preservation > 120% Funded Funding Level Take less risk bank what was gained 100% to 120% Funded Take investment risk vs. liabilities grow the funding level 90% to 100% Funded For illustrative purposes only. Funding basis agreed in advance with plan sponsors. Time Funding deficits can narrow for a variety of reasons, namely: Unexpected changes in market conditions Significant contributions by the Company Change in the membership profile, perhaps as a result of a bulk-transfer exercise

4 The process of de-risking begins with performing a detailed analysis of a plan s liabilities. Once a clear picture has been established, an investment and de-risking strategy can be designed that aligns directly to the plan sponsors needs and goals. Pre-determined trigger points and corresponding courses of action can be mutually agreed in advance to ensure that suitable changes to the plan s asset allocation and portfolio strategy are made as and when the funding level improves or market conditions provide an opportunity to de-risk. For example, when funding levels reach a certain point, a strategic reduction in equity exposure could be implemented by physically moving assets out of equities and into long-dated bonds. Regular monitoring of a plan s funding levels and the ability to act speedily to capture opportunities are key to the effectiveness of any de-risking strategy. The diagram below illustrates how locking in funding-level outperformance could lead to a lower required portfolio return (de-risking). 110% For illustrative purposes only. 20% Funding Level Surprise Required return on portfolio (right hand side) 100% 15% Funding level experience (left hand side) Expected funding level path (left hand side) Required return after funding level surprise (right hand side) Funding Level 90% 80% De-risking as the funding level improves 10% Required Return 70% 60% 05% % Source: SEI Pension Solution. Based on SEI s Capital Market Assumptions. Asset class assumptions use a combination of empirical and forward-looking analysis and are designed to be long-term in nature. Assumptions include estimates of annual return, volatility and correlations by asset class, as well as prospective ranges for these values over various time horizons. Changes in assumptions may have a material impact on the simulated return presented. All projected returns are presented gross of fees and charges. Forecasts shown are not necessarily indicative of any future performance.

5 The governance challenge An inherent challenge faced by many pension plans wishing to implement de-risking strategies is the inability to respond swiftly to changing market conditions. Investment strategies are often reviewed infrequently and plan valuations are undertaken intermittently, in some cases only every three years. Hence, in SEI s experience, the adoption of an investment de-risking approach often requires a shift in a plan s governance structure, with the plan sponsors delegating some investment responsibilities to a strategic partner such as an external manager. The level of delegation will vary according to the comfort levels of the plan sponsors, but may include: Manager selection, monitoring and replacement Dynamic asset allocation within pre-determined ranges Implementation of the de-risking strategy Including new asset classes as available and including esoteric asset classes (e.g. Hedge Fund of Funds) and/or risk management strategies (e.g. Derivatives) Under this arrangement, the benefits to the plan sponsors can be considerable. They can be more nimble in their decision-making and, as much of the burden of day-to-day administrative tasks is removed, have more time to focus on the strategic aspects of running the plans. An inherent challenge faced by many pension plans wishing to implement de-risking strategies is the inability to respond swiftly to changing market conditions.

6 Implementation is key In identifying a de-risking partner, we believe that the importance of proven implementation experience cannot be underestimated. We point to the example of a pension plan who exited from its relationship with an investment consultant, in part due to the inadequate implementation of a de-risking strategy. A judgement by the plan sponsors and the investment consultant had been made to de-risk the plan by selling equities and buying long-dated bonds. Regrettably, by the time the strategy was executed, equity markets had fallen and rates had declined, leaving the funding status behind plan. Good advice is important, but the ability to implement that advice efficiently is critical. Conclusion The volatility of recent market cycles has added weight to the case for robust risk management and the viability of de-risking strategies as a potential tool in this quest. De-risking aims to help plan sponsors take advantage of the markets by forming a view on the opportunities in the market and, where appropriate, acting to quickly take advantage of them. Key benefits: A successful implementation can improve a pension plan s funding levels and reduce volatility A successful implementation can leave the plan sponsors in control of important strategic issues whilst removing the burden of day-to-day administrative tasks There are numerous providers in the Canadian marketplace who have experience in either advising on or implementing a successful de-risking strategy. Few, however, have a tangible heritage in both and we believe that it is those who do that are able to provide the most efficient solutions, and ultimately boast a competitive advantage.

7 SEI As a leading Manager of Managers globally, SEI is well-positioned to assist Canadian pension plans with timely decisions relating to the overall management of their plans. SEI s pension solution focuses on achieving the long-term goals of a pension plan within a defined risk management framework by providing both dayto-day investment management and advisory services. The approach can enhance pension governance and decision-making by freeing the pension plan sponsors from the operational burden of running the pension plan investment strategy but leaving the executive decisions and oversight with the plan sponsors.

8 Important Information This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be relied upon by the reader as research or investment advice regarding thefunds or any stock in particular nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Funds. Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. This material may contain forward-looking information ( FLI ) as such term is defined under applicable Canadian securities laws. FLI is disclosure regarding possible events, conditions or results of operations that is based on assumptions about future economic conditions and courses of action. FLI is subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from expectations as expressed or implied in this material. FLI reflects current expectations with respect to current events and is not a guarantee of future performance. Any FLI that may be included or incorporated by reference in this material is presented solely for the purpose of conveying current anticipated expectations and may not be appropriate for any other purposes. Information contained herein that is based on external sources is believed to be reliable, but is not guaranteed by SEI, may be incomplete or may change without notice. Past performance does not guarantee future results. Refer to the prospectus or offering document. SEI Investments Canada Company is the Manager of the SEI Canada mutual funds and is a wholly owned subsidiary of SEI Investments Company. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or any other government deposit insurer. FOR FINANCIAL INTERMEDIARY USE ONLY. NOT FOR PUBLIC DISTRIBUTION SEI (04/12)