The Intersection of Pensions and Enterprise Risk Management

Abstract

For most of the last forty years, corporate defined benefit pension plan assets have been managed to balance risk versus reward in more or less the same way that a risk averse individual would do with his own portfolio. Recently liability cognizant strategies have been developed, but these also attempt to balance risks and rewards.But pension plans are not individuals; they, much like their widely-held corporate sponsors, are pass-through institutions. The economics of such entities are found in the corporate finance literature rather than in the literature of portfolio choice. The corporate finance (and thus the pension finance) objective is economic value added rather than return for risk.Enterprise risk management is a corporate finance activity too and its goal should also be value added rather than return for risk. The intersection of enterprise risk management and pension finance leads to a value-based discipline with two startling results:• Widely-held corporations can increase shareholder value by hedging away their own systematic risk (e.g., CAPM β).• Very many corporate defined benefit pension plans should define their liabilities and manage their assets to develop a net short equity exposure (negative β).

Longevity Risk Management, Corporate Finance, and Sustainable Pensions

“…Pension risk adds volatility to the sponsor's stock price, increases the equity beta of the firm, and raises the weighted average cost of capital or WACC. Moreover, a pension plan typically decreases the firm's optimal leverage ratio and reduces debt capacity (Frieman et al 2005;Jin et al 2006;Gold 2008;Long et al 2010).…”

“…Pension risk adds to the overall risk profile of the corporation, consuming risk budget and displacing business opportunities that might have otherwise been pursued. If the risk of the pension is too great, then it can impact liquidity and/or financial strength, leading to reduced access to the capital markets and threatening the execution of business plans (Coughlan and Ong 2003;Frieman et al 2005;Gold 2008).…”