Short-term constraints less costly than lack of risk management strategies

It is not so much the presence of funding ratio constraints that is costly for pension funds as their reluctance to implement optimal risk-management strategies, according to research by Edhec.

The results of a new study by Lionel Martellini, scientific director, and Vincent Milhau, research engineer with the Edhec Risk and Asset Management Research Centre, says that dynamic risk-management strategies can turn irreversible contributions into reversible contributions and short-term constraints into long-term constraints, hence the severe opportunity cost for pension funds that do not follow them.

It says institutional investors, particularly defined-benefit pension funds, are currently facing a profound dilemma. The desire to alleviate the burden of contributions leads them to invest significantly in equity markets and other classes that are poorly correlated with liabilities but offer better long-term performance potential. However, stricter regulations and accounting standards give them significant incentives to invest most of their portfolios in assets that are highly correlated with liabilities.

The study says nnly dynamic allocation strategies that are contingent on the state of markets and therefore on the outperformance or underperformance of the investor’s performance portfolio in comparison with their liabilities allow this dilemma to be resolved.

The idea is to implement genuinely dynamic management of asset-liability risk budgets, as is already the case in asset management with portfolio insurance techniques.

Edhec’s empirical tests at a ten-year horizon show that implementing a risk control strategy while respecting a maximum funding ratio of 130 per cent (a level beyond which the pension fund’s utility is assumed to be nil), in addition to a minimum level of 90 per cent, would allow the conditional mean of the funding ratio to be brought down to 110 per cent. It would also allow for savings of 17.885 per cent in terms of initial contribution under the assumption of irreversible contributions.