We have seen major volatility in world stock markets in recent weeks. Karen Heaven highlights the key questions schemes need to ask.
- Schemes should avoid knee-jerk reactions to increased volatility
- Investment strategy should be monitored on an ongoing basis to see if it continues to meet the scheme’s requirements
- Interest rate risk is the most significant risk many schemes run
1. What should schemes do?
It's important to avoid a knee-jerk reaction to increased market volatility. Schemes don't necessarily have to do anything. Ideally, schemes should engage in a process of monitoring and reviewing investment strategy at all times, and have clearly articulated goals, objectives and constraints which can provide the context to evaluate any proposed actions.
2. Do we need re-examine the scheme's investment strategy?
Investment strategy should be monitored on an ongoing basis. If a scheme goes off-track against its own objectives, a clear 'call to action' can help trustees consider whether to take action to put the scheme back on course. Two key levers to consider are investment risk and required (versus expected) returns in the context of achieving the scheme's funding objectives.
It's important that the degree of investment risk a scheme runs is appropriate to its wider circumstances, such as the strength of its sponsoring employer. Also, the strategy should offer sufficient expected returns to meet the scheme's funding objectives. Continuous monitoring helps avoid the pressure to react to market events and allows schemes to remain on-track to meet their aims.
3. What does this mean for a scheme that has already de-risked?
Pension schemes that have largely eliminated investment risks by hedging interest rate and inflation risk and are not running return-seeking risks will obviously experience substantially lower funding level volatility than schemes that are still running material investment risks.
However, because the majority of pension schemes still require investment returns to help fill their deficits, there are relatively few schemes in this position. Schemes that are fully funded and largely de-risked should retain this low-risk strategy. There is often a temptation to ‘take profit’” on earlier decisions; however, the risk is usually asymmetric i.e. the pain of increasing risk and getting it wrong is greater than the gain from increasing risk and getting it right.
4. Can the scheme manage equity downside risk better?
Pension schemes that hold equities usually do so in the expectation of generating out-performance to help reduce their deficit. Before thinking about reducing equity downside risk, the first question should be what is an appropriate level of equity risk?
Frequently, we see pension schemes with an over-reliance on equity returns. Better diversifying sources of expected returns can be used to substantially reduce equity risk, although it is worth remembering that in very volatile markets, correlations between asset classes can increase, meaning that the benefit from diversification in these scenarios will be reduced.
Using an equity volatility control strategy, which keeps equity volatility roughly constant by adjusting equity market exposure over time, should reduce equity volatility while delivering comparable expected returns. It also allows for affordable downside protection to be purchased, further reducing downside equity risk.
5. How can we integrate market views into our investment strategy and how can this be done?
We believe that it is extremely difficult to "call" any markets, and for that reason, we aim to build investment strategies for our clients that will perform robustly under all market scenarios, rather than needing to constantly predict which markets will perform well.
Even if markets could be successfully and consistently predicted, most pension schemes do not have the appropriate governance in place to implement market views in a timely manner. Where a scheme does want to incorporate market views into its investment strategy, we prefer to recommend strategies where our clients allocate to asset managers that have the ability to implement market views, such as a multi-class credit manager or certain types of diversified growth fund.
6. What does this mean for our interest rate hedging?
For many pension schemes, interest rate risk is the largest investment risk, and so decisions around hedging interest rates (and inflation) are some of the most crucial investment decisions that a scheme can take. In line with our philosophy on investment risks, we do not believe that schemes necessarily need to eliminate risks where they believe that there will be upside, for example, a belief that interest rates will rise faster than the market predicts.
However, it is important to "right-size" these risks. Is the potential pay-off from getting this right commensurate with the size of risk you are taking and most crucially, can your scheme afford it if your views on rates are wrong?
For a scheme with low levels of interest rate hedging today, increasing the hedge in a timed-diversified manner is often a simple way to increase the hedge, while reducing the regret risk of locking in to what many people view as current low levels of interest rates. We would not advise knee-jerk changes in the direction of hedging strategy for any pension scheme in the face of increased market volatility.
Karen Heaven is director and investment consultant at Redington
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