How do pension funds clear their deficits and reduce risk at the same time? Over the past few years, consultants and asset managers have come up with a good Plan A, but as we all know, sometimes things don't turn out as we hope. We all need to start thinking about Plan B.
Plan A usually goes by the name “dynamic derisking”. The concept is simple: you reduce investment risk in a steady way over time. This way you give your assets a chance to perform before selling them. When equities rise, accelerate your selling. When bond yields rise, accelerate your liability hedging. Market volatility becomes your friend. Just a few careful trading rules are all that’s between you and the sweet spot – derisked and deficit cleared.
What’s Plan B? This is the question one dare not ask. But here’s a reality check for those contemplating the dynamic derisking route. How would it perform if the next 10 years look like the last 10? They almost certainly will not, but it’s a sobering analysis to request from your advisers. Many dynamic derisking plans would not have worked over the past decade. In fact, the timing of starting the strategy was absolutely crucial. How can you be sure they will work starting from now? So what is Plan B?
The vast majority of pension funds take two huge risks: a “long” view on equities, that stock markets will tend to rise, and a “short” view on real yields, that is, that inflation-linked bond prices will tend to fall (as bond yields rise). This is concentrated risk in two very volatile areas. Even if these views make sense over the long term, they can be very painful from one pension plan valuation to the next, and you may need to be more patient than you can afford.
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