Focusing on individual asset classes could increase shortfalls

Trustees are in danger of widening funding gaps by focusing too much on the risks and returns of individual asset classes, State Street Global Advisors argue.

The asset manager has published a paper Managing Pension Risk: Confront Your Risk/Reward Dilemma urging underfunded schemes to consider risk budget across their entire portfolio.

The report says the increasing transparency demanded by accounting rules, the emphasis on liability matching in pensions legislation and rising capital market risk made it increasingly difficult for trustees to manage risk.

SSgA senior managing director Dan Farley said: "The environment that we've been in recently has presented increased challenges for pension managers and as a result, we believe there has to be an even greater emphasis on understanding risks across the portfolio and then managing those risks dynamically over time."

The paper makes the case for agreeing a flight path to adjust the plan's strategic asset allocation as funded status improves, and de-risking by reducing asset classes that contribute to funding ratio volatility and shortfall risk.

It also argues schemes should shift from basing allocation decisions on return captures to managing specific risk factors, and should consider instruments and asset classes as addressing pertinent ‘needs' rather than confining them to traditional categories.

This means asset classes could fall into more than one ‘need-based buckets' depending on the outcome required from them.

For example, rather than place high yield in the traditional fixed-income bucket because of its duration and correlation to liabilities, the firm suggested it could be allocated to a growth or hedge needs-based bucket because of its equity-like growth characteristics.

Farley said this kind of approach could help schemes reduce equity volatility, develop strategies for non-correlated returns, optimise income, and manage liability exposure.

"Employing a needs-based framework to portfolio construction, our approach is designed to optimize growth portfolio assets, actively manage portfolio risk and manage the plan's funding ratio volatility," he said.