The U.S. Pension Protection Act of 2006 mandates that plan sponsors become fully funded within a seven-year window. As that deadline draws nearer, short-term funding status volatility and the uncertainty around unanticipated contributions have become increasing concerns for U.S. plan sponsors. However, the need to generate superior returns over liabilities to meet longer-term pension obligations (especially as most plans are still underfunded) remains. This tension between long- and short-term horizons, which has been exacerbated by lower interest rates on fixed-income investments and greater stock market volatility, makes adoption of risk-budgeting techniques especially relevant.

The key factors that ultimately determine the risk tolerance (or budget) for each plan and the strategy employed will be unique. In addition to the specific funded status and the liability profile of the plan, the size and expense of the pension fund relative to the size and earnings/cash flow of the sponsoring entity must be considered.

As the impact of pension plans on overall corporate risk becomes more transparent, the inclusion of the pension plan’s funded status on the balance sheet will affect the risk profile of the firm, its credit ratings and its cost of capital. There is now a need to adopt a more holistic view of the pension risk framework, by developing asset allocations consistent with a prudent, disciplined risk-budgeting approach.

Decomposing Risk

Risk budgeting is an approach to investment and portfolio management that aligns risk allocation more explicitly with the asset allocation process. The traditional practice has been to allocate money instead of quantities of risk to asset classes, managers, etc. Risk budgeting injects discipline into the investment process by forcing a plan sponsor to think about rewarded and unrewarded risks and balancing risk and return on each investment choice, with the goal of eliminating unintended risks and unpleasant surprises.

The risk budgeting process explicitly allocates a measure of potential downside to different stages of the investment process, and then monitors risk levels to ensure tolerance levels have not been exceeded. Benchmarks of expected returns and risk thresholds (risk budgets) are chosen based on return/risk appetites.

One prerequisite for risk budgeting is the ability to break down risk into its components. This could be done both in absolute terms as well as relative to a benchmark (i.e., the S&P 500 or a pension liability). Risk decomposition allows a plan sponsor to quantify, for example, how much of the overall portfolio risk is attributable to the equity allocation, and further detail risk allocation to Equity Manager A, Equity Manager B, etc. The plan sponsor could then decide to take on more risk or dial back either active asset management risk or asset class risk. Optimization can bring greater accuracy to the process, but the intuitive rationale is appealing on its own. It’s important to emphasize the qualitative and judgmental aspects that come into play in such an exercise by tempering the mathematical results obtained with a large dose of common sense.

The benefits of applying a disciplined risk-budgeting approach can be seen within a liability driven investing (LDI) framework, as it allows for a top-down and bottom-up approach to risk allocations. Asset/liability risk should be the focus because it is a true measure of pension fund risk, namely the risk that a shortfall in assets will leave the plan unable to pay benefits.

A Case Study in Risk Budgeting

Figure 1 shows a breakdown of the risks for plan assets, liabilities and surplus for a hypothetical $1 billion pension fund with a 70/30 equity/bond allocation. There is significant tracking risk between the assets and liabilities, leading to large potential swings in the surplus/deficit. The risk is almost evenly attributable to the large equity exposure and the dollar duration mismatch between the bond assets and the liabilities.

The surplus risk arises because of the different sensitivities the assets and liabilities have to changes in interest rates. This comes about in two ways:

• The significant mismatch in dollar duration between a pension plan’s bond assets, typically intermediate bonds, and liabilities, which have longer durations. By effectively being short an asset class (long-duration bonds), plan sponsors should expect negative returns relative to liabilities for this portion of the portfolio in the long term. This risk versus plan liabilities does not provide a risk premium and is unrewarded over time.
• The valuation of equities is dependent on discounting future earnings streams, which implies a relationship between equity levels and interest rates — the equity duration. This correlation, however, has been unstable and equities have exhibited both positive and negative durations during various time periods in history. As a result, equity investments provide little direct protection against interest rate moves but offer up the chance of reward by capitalizing on the equity risk premium.

Using a risk-budgeting framework enables a plan sponsor to replace the unrewarded risks with rewarded ones that could help reduce plan costs through higher expected returns. The plan sponsor then decides whether it is capable of, and willing to, assume the risk of large deficits in the pursuit of future rewards — a pension surplus or the elimination of required contributions.

The trade-off between a given level of risk and its appropriateness should be carefully considered. It is at this point that decisions around risk tolerance levels are made. The risk-budgeting process determines the portfolio’s overall risk thresholds and the target outperformance, while taking into account the competing — and sometimes conflicting — priorities of all stakeholders.

Modeling techniques that combine projections on asset and liability growth provide a sense of future funding levels and contribution rates. The plan sponsor then decides on the appropriate level of tracking error tolerance between the existing asset portfolio and the liability. This is the point at which risk measurement becomes risk management.

Building a Risk Budget

The risk-budgeting process does not occur in a vacuum or as an academic exercise. The process starts with considerations that involve the plan sponsor and the size of the pension fund relative to the corporate balance sheet, shareholder equity and cash flow size and volatility. Those considerations will affect the risk budget that addresses the tolerance for pension surplus/deficit volatility.

Within a risk-budgeting context, there needs to be clarity and understanding of two common investment terms — alpha and beta. The total return (and risk) of the asset portfolio can be decomposed into three parts: 1) a risk-free return; 2) systematic market-driven returns (beta) captured by exploiting risk premiums from various asset classes; and 3) active returns (alpha) from skillful active management within an asset class.

There are other reasonable assumptions that plan sponsors usually make: a) they can diversify both alpha and beta by using multiple asset classes; b) there are many sources of active strategies that produce excess returns (alpha) that are uncorrelated; and c) alpha sources can be funded strategies such as market neutral strategies, or unfunded ones using derivative overlays. This would make the alpha and beta both separable and transportable. The critical difference between beta and alpha is that although any investor can earn beta by being exposed to the market risk premium, alpha is a zero sum game and some investors benefit at the expense of others. Alpha, being skill-based, also is more expensive than beta.

Figure 2 shows one potential risk-budgeting framework for the $1 billion plan portrayed in Figure 1. The box labeled “Surplus/Funded Ratio Risk Budget” shows the plan sponsor can tolerate a surplus/funded ratio volatility of 8% (a one standard deviation annualized move as a percentage of assets) or $80 million, not the 13% shown in Figure 1. To reduce the surplus risk to the budget target, the plan sponsor uses liability hedging vehicles (interest rate swaps and long-duration bonds) and gains additional credit exposure using credit default swaps to match the corporate spread exposure profile of the liability. Credit default swaps offer exposure to only the credit risk premium and no exposure to interest rates, unlike a traditional corporate bond. By taking the other side of the trade and selling protection for a premium, a plan sponsor can essentially create exposure to pure corporate spread, which, in conjunction with pure interest rate exposure, effectively eliminates the unrewarded risks in the current asset/liability mismatch.

Once the plan sponsor is comfortable with the overall risk level, a cascading risk budget can be put in place so plan assets can be deployed appropriately. This determines what the individual risk budgets are at the alpha and beta levels.

In Figure 2, the “Total Pension Assets” box, which shows two potential risk budgets, represents the absolute volatility of the return-generating assets combined with the liability hedging vehicles. One approach, for example, might involve the inclusion of derivative overlays to free up capital for other alpha and beta opportunities. This strategy would result in overall volatility at the total pension asset level of 15%. Not using derivatives and having a larger allocation to long-duration bonds results in a lower total pension asset risk of 10%, but increases the surplus risk to more than the budgeted 8%. Moving down the alpha-beta framework, the plan sponsor determines how the 8% surplus volatility budget affects the return-generating assets.

The alpha risk budget (5%) comprises skill-based strategies. It can be difficult to isolate a manager’s skill, and there is an element of beta embedded to varying degrees in all skill-based strategies. For the purposes of this discussion, the embedded beta is removed and the alpha remains. The beta budget (15%) is a collection of asset classes constructed to increase the diversification among systematic risk sources. The combined alpha and beta risk budgets produce a risk budget of 12% for the overall return-generating assets portion of the portfolio.

Allocating Beta, Alpha Risks

The next step is to parcel out the beta and alpha risk to individual strategies. This will require risk modeling of the individual strategies and their combinations relative to the liability. In addition, optimization with expected return assumptions for the managers/strategies should be used to ensure that the information ratios produced are consistent and account for the 8% surplus risk at the plan level. The sum of the individual risk budgets might be greater than the risk budget at the next higher level, but this simply accounts for the fact that correlations and diversifications create offsets that reduce risk.

Beta risks should be taken in those areas where there is a well-justified risk premium to be had. Ideally, the beta sources should be well-diversified with low correlations with each other as well as to the plan sponsor’s business. Asset classes such as private equity and private real estate, with their illiquidity premiums, can be good sources of alpha. Alpha returns typically have low correlations with other alpha sources as well as beta sources of returns.

If alpha and beta sources can be unbundled and transported, greater diversification may be achieved by appropriately allocating the risk budget between the two depending on the level of conviction in the alpha source for active returns. The use of derivatives can facilitate alpha transfers. Practical implementation, however, is harder with constraints around the availability of effective, cheap and reliable derivative (and cash-based) vehicles. Figure 3 shows the relative sources of alpha and beta for various asset classes. For some asset classes — such as large-cap equity and investment-grade bonds — alpha and beta can be easily separated.

The risk-budgeting process described in Figure 2 ensures that there is a series of cascading targets from the surplus risk budget to each individual manager and that it all comes together, qualitatively, quantitatively and intuitively. The whole process is dynamic because risk budgets are either fully utilized and sometimes exceeded or underutilized as the volatility and correlations in the market change between managers and strategies. By contrast, traditional risk-budgeting practice only has involved monitoring tracking error at the individual portfolio level, which rarely is aggregated and taken to the highest level — the risk of underperforming the liability.

After the risk-budgeting process is implemented, the overall pension plan’s sources of risk might resemble those shown in Figure 4. The exercise reduced the surplus risk to the target budget of 8% by removing the unrewarded interest rate and credit mismatch risks relative to the liability.

Employing Derivative Strategies

Risk budgeting also has applications within an LDI framework. Most LDI strategies envision a reduction in return for lower levels of funded ratio and contribution volatility. As a pension plan moves away from equities and invests in longer-duration bonds, there is reduction in liability-relative return (lower expected return on bonds replaces higher expected return on equities) along with decreased liability-relative risk. If a plan sponsor wants to maintain a significant allocation to equities to take advantage of the equity risk premium, then diversified beta sources, including derivatives, can help reduce surplus volatility. Investing in swaps with longer durations is considered an efficient way to address the interest rate risk mismatch with the liabilities.

Swaps are more flexible and provide a more accurate hedge than longer-duration bonds because they can be structured to more closely fit the cash flow profile of the liability. The use of leveraged swaps, in either a separate account or pooled vehicle, frees up capital that can be invested in alpha- and beta-generating vehicles. Indeed, the overall asset allocation can remain largely untouched, when swaps are overlaid to hedge away the interest rate risk in the liability. Although the equity and other non-bond sources of beta remain, surplus volatility can be substantially reduced — in many cases by about 50% — generally without adverse impact on expected return.

The solution that provides the most risk-adjusted return involves leveraged swaps and market-neutral alpha sources — the approach used in the case study. This approach can be used with or without some combination of highly diversified beta sources. The market-neutral approach with diversified sources of uncorrelated alpha provides significant risk-reduction benefits with associated return-enhancing potential. As the alpha/beta mix changes to reflect higher beta (even diversified and exotic beta), so too does the risk-reducing benefits of the allocation.

An Efficient Approach

The primary management consideration for a pension plan fiduciary is how best to manage the risk surrounding the plan’s ability to meet future benefit obligations. Risk budgeting is a key to measuring and managing the pension funding risk and, within an LDI environment, is the framework that binds the process together. This process involves assessing the amount of risk to be employed, as well as how much risk will be applied to each asset class, alpha or beta exposure and individual managers. Every investment decision is evaluated in the context of the overall contribution to risk and return. Risk is then budgeted and “spent” in the most efficient way possible subject to the unique risk and return profile of the sponsoring entity.

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