Around the world, reductions in pension fund performance, rising forecasts of longevity and changes to pension accounting rules are leading pension fund managers to re-evaluate their investment strategies as they seek to link their asset strategy more closely to their liability requirements.

Liability-driven investing is one part of the solution, but comprehensive pension risk management requires an integrated look at plan design as well as funding, financial and investment policies. How should each of those shape your fund's investment strategy?

THE CHALLENGE: A CONSTANTLY SHIFTING EQUITIES MARKET

Despite knowing that pension liabilities match bonds more closely than stocks, in the past many plan sponsors invested disproportionately in stocks to increase returns and reduce expected pension cost. Unfortunately, this leads to higher asset volatility, with the potential for increased pension contributions and hits to the balance sheet and earnings.

For almost 20 years prior to 2001, above-average returns from both equities and fixed income investments significantly improved the funded levels of virtually all pension plans.

This reduced the level of pension contributions required, but also made fund sponsors complacent about the potential downside risks. The true risk was masked by accounting standard that smoothed the gains and losses in both investment and discount rates used in assessing the contributions required and the plan's effect on the corporate balance sheet. In addition, certain unfunded liabilities were amortized over very long periods.

From 1992 through 2006, liabilities were generally increasing, but equity returns were typically high enough to largely offset or outpace the liability increases, except for the unfavorable capital market period that occurred from 2000 to 2002. As stock prices and interest rates both fell in those years, funds saw asset values fall and liabilities increase, revealing the true risk of those aggressive asset strategies.

This led to new legislation in a number of countries. For example, the United States introduced its Pension Protection Act in 2006, and full balance-sheet accounting for pension plans under Statement of Financial Accounting Standards 158.

In common with other countries, these changes reduce smoothing, and require that the net market value of assets and liabilities be recognized directly on the balance sheet. Further changes being discussed in the U.S. may mean that investment and discount rate gains and losses will directly affect the sponsor's net income.

With reduced smoothing of the short-term volatility of pension assets in relation to liabilities, and the loss of long-term amortization of some unfunded liabilities, most plan sponsors will have to take a more measured approach toward asset and liability volatility risk. However, the need to control cost and improve the funded level of the plan will remain a major priority and a consideration in any risk-management approach.

A PRACTICAL SOLUTION IN AS FEW AS FOUR STEPS

As pension fund sponsors plan for the future, we believe an integrated and proactive approach toward pension risk management is necessary. There are four approaches to managing pension risks, and effective risk management normally involves more than one of them.

1. Plan design: Amending the coverage, benefit provisions and basic structure of the plan.

2. Funding policy: Funding the plan to a level where the surplus position is sufficient to absorb economic shocks, smoothing annual contributions.

3. Financial policy: Changing the capital structure, revising debt covenants or modifying managerial financial benchmarks in anticipation of the increased pension volatility caused by regulatory changes.

4. Investment policy: Addressing interest rate and equity market risk as the two primary sources of asset and liability volatility. Controlling them involves a combination of reductions in equity market exposure, equity portfolio volatility (through diversification) and interest rate risk (by matching the interest rate sensitivity of the portfolio and the liabilities).