Investment - Articles - To De-Risk, Re-Risk or Right Risk? That is the question.

 By Rupert Brindley, Managing Director, Global Multi-Asset Group, JP Morgan Asset Management
 However, the recurrent question has been whether to respond with additional sponsor funding, or whether some sort of change in asset allocation can contribute to the heavy lifting?

  

 Who’s asking the question?
 In order to address the benefits and dynamics of funding and de-risking, we need to consider each of the stakeholders in the discussion.

  

 The trustees will be primarily interested in securing the accrued benefits as quickly and prudently as is reasonable, although they may hold specific views on market conditions. By contrast, the sponsor will be highly focussed on the cashflow costs of achieving funding recovery, with a secondary focus on the associated balance sheet risks. Finally, shareholders and market analysts typically deduct the net pension debt from enterprise value, and only focus on asset / liability matching risks when pension obligations are large in relation to shareholders’ funds.

  

 From this brief characterisation, we would expect trustees and the sponsor to negotiate a cashflow-friendly glidepath towards fuller funding under a recovery plan. Asset / liability mismatching positions will therefore be optimised to reflect the duration and spread dynamics of the funding basis. This progressive solution will be accelerated only if shareholders support a major opportunistic funding or buyout transaction.

  

 Shareholders are typically relaxed about asset allocation
 The net accounting deficit of the pension plan is shown on the balance sheet as senior debt. However, the flexibility in timing deficit payments in the light of other compelling needs, gives this debt some hybrid features. This improves the capital structure of the sponsor, and allows it to absorb some market-related volatility. Hence shareholders rarely push for senior debt issuance to enable a “Boots-like” bond de-risking, although they may discourage a cyclical business from amplifying its risks via the pension scheme. This pressure for full funding has further declined in the light of the reduced tax advantage between net funding costs and gross roll-up within the fund.

  

 So if finance theory is not decisive in setting the policy, what does the accounting and funding perspective suggest?

  

 The corporate bond standard
 A focus on the accounting position of the pension scheme under IAS will lead towards quality corporate bonds as the minimum risk solution. If the trustees require a more prudent funding basis, rather than paying additional monies into a scheme that already enjoys an accounting surplus, it is natural that the corporate bond investment program should be credit-enhanced by a small additional escrow account.

  

 Benefit of long-term investment horizon
 The insurance sector values the benefit of originating an illiquid liability in the light of a suitable matching portfolio that may be held to maturity. The capitalised value of its loss-adjusted expected spread amounts to a subsidy compared to the Gilt-based alternative.

  

 Pension funds enjoy a less restrictive regulatory framework, and hence may adopt a similar principle in support of defensive infrastructure and real estate assets. Finally, a maturity “ladder” of shorter-dated high-yield bonds should earn a coupon rate that averages out yields over the cycle. This smoothes out fluctuations and captures a purer long-term risk premium.

  

 Misleading signals from the Gilt market?
 Gilt yields hit an all-time low level at the end of January 2015. Therefore, many trustees are now querying whether a market that has been explicitly targeted by quantitative easing should be regarded as a credible yardstick for assessing funding. This line of thinking further motivates the quest for broader alternatives to Gilts, and reinforces the argument for corporate bonds to become the new de facto standard.

  

 Timing the hedge?
 Behavioural finance recognises that it is easier to change course by taking profits, rather than by admitting an earlier mistake. The collective reluctance of the industry to cover painful rate exposures has led to a steady trend of stop-loss transactions, as a progressive funding level “water torture” has taken its toll. We believe that this behavioural weakness should be rectified by increasing corporate allocations, thereby reducing the risk of future coercion in an adverse bond supply / demand environment.

  

 So what’s the answer?
 Right-risking can be enshrined in a glide path that progressively targets a high-quality corporate bond endgame. Real assets and higher-yielding bonds will find a significant role earlier in this journey, as additional return sources are exploited.

  

 The benefits of targeting this more affordable objective will be visible in