Improving Risk Management in DC and Hybrid Pension Plans

François Cocquemas: This short paper highlights the key conclusions of Amenc et al. (2012) regarding the best practices for managing risks in defined-contribution (DC) and hybrid plans.

Author(s):

Francois Cocquemas

PhD in Finance candidate and research assistant at EDHEC-Risk Institute.

Pension funds can be described, according to Sender (2012), based on their degree of hybridity between the pure definedcontribution (DC) and pure defined-benefit (DB) systems. In a DC scheme, each member owns a certain number of units in a fund; for a given member, the market value of his or her pension is the number of units times the net asset value per unit. At retirement, members can usually claim their pension rights as a lump sum, purchase an annuity (at a cost), or a mix of the two. Similarly, hybrid plans have a DC component with a given proportion of risk sharing (see Figure 1), which essentially makes them function very closely to pure DC funds. In current schemes, the member can choose between several funds. Most of these funds, in their current forms, are plagued with issues: inadequate strategies (lack of diversification, rare or antiquated life-cycle approaches); little to no risk management; high costs; limited or costly options for pay-out; lack of transparency and vulnerability to non-financial risks. Here, we focus on the investment strategies and the closely linked risk management decisions they entail. Most current DC funds and the DC part of hybrid plans share the same need for better asset-liability management (ALM) strategies, which rely on simple principles and an extensively- tested literature. Proper ALM strategies require three components: liability-driven investing (LDI), to account for consumption objectives at retirement; life-cycle investing (LCI), to account for the time to retirement; and risk-controlled investing (RCI), to account for short-term risk budgets. Beyond investment risk, though, the risks in pension plans can only be thoroughly managed through a generalised move towards hybrid plans and an integrated approach to risk management, that respect both the institutional and financial specificities of pensions, and especially the role of the sponsor company when there is one.

Type: EDHEC Publication
Date: le 27/11/2012
Research Cluster : Finance

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