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1 May 2013 CFA Institute Journal Review

Risky Business: Why Right-Risking, Rather than De-Risking, Is Key for Pension Plans (Digest Summary)

  1. Daniel J. Larocco

Recent surveys indicate that a significant number of pension plans in the United States and Europe now consider it prudent to materially reduce the level of investment risk in pension plans as funded status improves. The author argues that “de-risking” may actually raise the sponsoring firm’s and its plan participants’ exposure to risk.

What’s Inside?

The author identifies several reasons why “de-risking” is growing in popularity with pension funds. Although the reasons have considerable intuitive appeal, the author argues that the approaches have their limitations with respect to their ability to match the liabilities of the pension plan. Thus, an appropriate level of investment risk (i.e., “right-risking”) will always be needed to offset the limitations of de-risking strategies.

How Is This Research Useful to Practitioners?

The most useful aspect of the author’s work for practitioners is his description of the limitations associated with the growing trend of de-risking strategies. The author identifies four arguments for de-risking strategies and the limitations of each.

The first argument relates to tax arbitrage. Plan sponsors attempt to engage in tax arbitrage when they increase the leverage of the firm while reducing the risk of the pension plan. In so doing, a firm can deduct the interest expense of the additional leverage against its taxes, use the debt to reduce pension deficits, and have the higher level of plan assets grow tax free. But tax arbitrage suffers from several practical problems. First, issuing corporate bonds as an offset to the risk-free liabilities of the pension plan involves a mismatch. As the spread between the corporate rate and the risk-free rate increases, the benefits of the tax arbitrage disappear. Similarly, increasing firm leverage raises the risk of the firm’s equity and increases the likelihood that the firm’s equity will behave in a manner different from the equities in the pension plan.

The second argument is for member security, which states that less risk in the pension plan (all other things being equal) increases the likelihood that plan beneficiaries will receive their pensions. The author argues that this view is an oversimplification because less risk in the pension plan reduces the growth rate of assets, thereby increasing the pressure on the firm to fund pension deficits.

The third argument concerns agency risk. Agency risk recognizes that individuals often have incentives to act in a manner contrary to the needs of their employer. Applied to the de-risking of pension plans, this approach argues that lower levels of investment risk reduce agency risk; however, less risk will almost certainly lead to lower returns.

Finally, the risk appetite argument suggests that the current environment, with increasing regulation, low interest rates, and increasing longevity, has made pension plans a source of great risk for their sponsors. Although true, these points also increase the need for investment returns.

How Did the Author Conduct This Research?

No empirical analysis was conducted to support this article. The author relies solely on arguments that have previously been made by others regarding the limitations of de-risking in order to support his contention that the “right” level of investment risk in pension funds does exist.

Abstractor’s Viewpoint

Although the argument that the limitations of de-risking result in an appropriate level of investment risk in pension funds is obvious, the author provides the practitioner with little in the way of practical guidance. A more precise definition of de-risking and right-risking, as well as an empirical analysis of how these items interact with funding status, would be useful.

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