Welcome to blog one of a three part blog series regarding financial risk management for pension plans at this very unsettling time.
The Coronavirus introduces a health, financial and economic crisis. Financial markets react strongly: Stock prices fall sharply, credit spreads jumped, liquidity is drying up and interest rates are very volatile. This has huge implications for pension plans all over the globe, facing lower funding levels; breach of allocation bandwidths and risk limits, while governments and central banks provide intervention and try to dampen the negative economic impact.
Since the previous crisis, the pension industry has placed much more attention to (strategic) risk management. How will those efforts payout in this crisis? We list the main challenges for financial risk and strategy managers at pension plans, and the possibilities on how best to approach this unique situation.
4 challenges pension risk and strategy managers face during a crisis:
- Breach of risk limits
- Breach of allocation bandwidths: when and how to rebalance?
- Extraordinary economic and financial market conditions
- The role financial risk and strategy managers play
1. Breach of risk limits
Many pension plans face a breach of short and long-term risk budgets or limits after the Coronavirus outbreak. Even though sophisticated ex-ante scenario (risk) models significantly improved after the Global Financial Crisis, and provide deeper insight for understanding the underlying financial market drivers and uncertainty. The role of models are highlighted in the blog of Hens Steehouwer and Paul van ‘t Zelfde.
The March 2020 market movements confirmed the economic empirical laws or stylized facts during a crisis reflected in those models. To name a few:
- Short-term investment returns are much more negative in a crisis than the positive returns in bull markets (skewed and fat-tailed distributions).
- Markets show high uncertainty (increased volatility) and a lack of diversification (high correlations) in times of crisis.
The use of improved scenario models resulted in more realistic portfolio risk assessments, used to set risk limits reflecting the risk attitude. However, even if your pension plan applies these sophisticated scenario models, the risk limits may be breached when the risk in the current markets exceeds the risk appetite. For example, suppose the board sets a threshold of 2.5% worst-case loss as the upper limit (a situation that occurs once every 40 years). The current market developments have created a unique situation, however, that happens only once or twice every 100 years, i.e. much worse.
In that case, plans may need to reconsider their (short-term) risk attitude and limits. This might require going through a lengthy governance process to align all stakeholders. Plans could also opt to keep the risk attitude in place and focus on de-risking their pension schemes. Alternatively, from the perspective of the pension fund as a long-term investor, it might be prudent to evaluate the current setup, and await the situation, before drawing any conclusions.
In all cases, it is important to incorporate the beliefs and governance process of the plan, in combination with volatile market circumstances; local regulators considering temporary crisis-rules; and the possibilities and costs to make changes in the portfolio.