January 16, 2014

Investment Risk in a MEPP

We all understand investment risk, right? Equities may go up and they may go down, because markets are volatile and there are other economic issues. But, do we understand what investment risk means for a multi-employer pension plan (MEPP)?

Sometimes we take on risk in the hope of creating an investment surplus that can be used to grant additional benefits – clearly a good aim. But, what are the chances of that risk leading to benefit cuts as opposed to enhancements? In a MEPP, risk is not symmetric.

One dollar of total past and future service deficit requires action, be that benefit cuts or additional contributions, But, one dollar of surplus is largely useless. Indeed, in most MEPPS, even $1 million of surplus would not be spent on benefit improvements. That is because we know about volatility, and that means we keep a portion of surplus in reserve before we augment benefits.

For example, if your asset allocation has a 50% chance of leading to benefit cuts and a 5% chance of leading to enhancements, would you see that as a reasonable risk? I suspect not. Compare to buying a lottery ticket – a $30 million upside and $2 downside. Here the risk is much lower – partially because of the numbers involved and partially because what we do with pocket money is (or should be) so different from what we do as a fiduciary. It is interesting that many people choose not to buy a lottery ticket. They just don’t want to gamble, even with $2, proving that risk tolerance is at least to some degree a personal matter.

Have you given thought to what that surplus figure would be in your plan before it is large enough to convert to benefit improvements? Trustees need to be aware of the extent to which they are taking unrewarded risk. (I really mean “not likely to be rewarded” risks, but that phrase doesn’t sound as good.) Perhaps Trustees should rethink their investment and funding strategy accordingly. Maybe a lower risk investment strategy and lower benefit structure would work better for the members. Or at least it should be considered? Like most things in the pension world, it comes down to understanding the risks and managing plan members expectation.

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