Risk Management: Foundations for a Changing Financial World

CHAPTER 52

DEVELOPING AND IMPLEMENTING A RISK-BUDGETING SYSTEM^az

Leo J. de Bever

Sponsors need a better understanding of funding risk because their behavior can completely undo asset/liability management. Safe pension funding strategies are inherently expensive, and actuarial valuation surpluses are not money in the bank. Unless interest rates move up sharply and market indexes beat their mediocre outlook, return to full funding will be some years away. Managers can help by better allocating risk and return across all active and passive strategies.

The Ontario Teachers’ Pension Plan (OTPP) is structured as a partnership between the 250,000 Ontario teachers covered by the plan and the Ontario Government. Each partner is legally responsible for 50 percent of any funding deficiency. Plan benefits are indexed to consumer price index (CPI) inflation. OTPP has roughly a 50/50 stock/bond split, and 60 percent of its assets are invested in Canada. Very early in its history, OTPP started using derivatives extensively to modify the asset mix. Like many pension funds, OTPP suffered in the boom/bust cycle of the 1990s, for reasons unrelated to investment policy. The issue was something pension managers rarely worry about: sponsor policy around benefits and contributions. I will begin this presentation by focusing on sponsor behavior because I think it is the biggest risk in any pension fund.

ROLE OF THE SPONSOR

Sponsors generally lack a good understanding of the volatility of financial ...