Rethinking Risk: Pension Plans Should Adjust to Global Realities

• ​Many governments are carrying higher levels of debt, which can increase both economic and asset volatility as well as default risk.
• The resulting incremental increase in default risk suggests pension portfolios may have less duration than implied by traditional measures.
• Pension plans with high levels of equity exposure should consider increasing durations and credit exposure.
• Investment guidelines may need to be adjusted so they don’t measure credit risk simply by the World Bank’s definition of emerging markets.

Article Main Body

​External influences are constantly reshaping American businesses, which either adapt to the changing environment around them or risk extinction. The gasoline shortage and oil crisis of the 1970s, for example, combined with technological advances in the manufacturing of jet airplane engines, led to the elimination of some overbearing regulations in the airline industry, which increased competition and ultimately lowered transportation costs for consumers.

In our view, high government debt levels, greater volatility and low return expectations will force pension plans to make adjustments similar to the forces that encouraged change in the airline industry. For example, while most plans have guidelines that strictly limit the amount of exposure the plan might have to emerging markets, changing global growth dynamics are encouraging a fresh, new look at allocations to this asset class.

The rules and investment policies that currently guide investment decisions are likely to be challenged by the conditions mentioned above, in particular:

• Many investment portfolios could actually have a shorter duration than investors realize.
• Credit investments carry higher levels of equity beta (higher sensitivity to equity returns) than investors may recognize.
• Emerging markets do not carry the same risk levels as they did when investment guidelines were written.

These issues are all related to the higher debt levels in many developed countries and better initial conditions for select emerging market countries.

Accounting for willingness and ability to pay

As most pension plan administrators know, duration is a linear approximation of the sensitivity of a bond to changes in interest rates. For example, the price of a bond with an effective duration of two years will rise two percent for every one percent decrease in its yield. Pension plans rely heavily on such linear estimates to assess the sensitivity of both their assets (investments) and their liabilities (retirement claims). However, on the asset side of the plan’s investments, investors need to be aware that their durations may be “overstated” due to an assumption used by most index providers – namely, that coupons and principal are actually paid in accordance with the security details. Markets are challenging this assumption with certain European sovereigns, which used to be viewed as being essentially void of default risk.

One of the attributes used to account for the likelihood that coupons and principal are paid on time is debt relative to the income a country or company can generate to pay those claims. John Maynard Keynes, the acclaimed British economist, captured this attribute well in the early 1900s when he said, “Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.” In other words, when the debt stock becomes relatively high, it becomes increasingly questionable as to whether the issuer will be willing, or in some cases able, to pay creditors. Given the amount of debt in the government sector in several advanced economies, what used to be considered pure interest rate duration is taking on characteristics of credit risk. This means that investors need to incorporate more of the issuer’s willingness and ability to pay into their risk assessments.