In the past, when financial markets were stable, most pension funds had ample possibilities to remove unwanted risks. But not all pension funds derisked when they had the opportunity to do so.
There is an important reason why pension funds have been unwilling to hedge their risks – the ‘derisking dilemma’. When derisking was affordable, it was not perceived as being desirable. In 2008 however, derisking was seen as being desirable but was also perceived (rightly or wrongly) as being unaffordable. If the funding ratio of a pension fund is high, derisking becomes more affordable (see the Figure below).
However, it is very hard to persuade both members and sponsors to derisk at such a time, as equity markets are rising, interest rates are low and hedging seems both expensive and unnecessary. When equity markets fall, the desire to hedge risk increases rapidly, but the ability to fund derisking decreases as it becomes less affordable (see the Figure below).
Although most pension funds cannot yet afford to derisk completely, it is nevertheless the perfect moment to draw up plans and to reach agreement on how and when to derisk. In other words, now that pension funds and their sponsoring companies have the desire to derisk, they should make plans for when it becomes affordable. This can prevent becoming trapped by the affordable/desirable dilemma. In the white-paper “Planning your way out of the financial crisis”, a detailed set of guidelines for CFOs and Pension fund managers is described to build a roadmap toward derisking.
Figure: The Derisking dilemma (source: AEGON Global Pensions)
