The challenge with conventional de-risking

November 13, 2018

The majority of schemes we come across are worried about market falls. This is truer now than ever with markets at, or near, all-time highs but with worrying events on the horizon.

Funding levels are better than they were a few years ago, and governance standards are higher meaning that trustees know that no decision is still a decision.

As a result, trustees are considering taking some money out of equities to “de-risk”.

I am going to pose a couple of questions: Is this really de-risking? If so, is the de-risking consistent with the worry that drives it?

Is this really de-risking?

Let’s take an example where a scheme decides to take 10% out of equities and put it in cash.

In this situation, the scheme is simultaneously 10% less exposed to market falls but is also 10% less exposed to market rises. If we think about de-risking in terms of reducing exposure to losses from equity market falls, then this is clearly de-risking. But what happens if the market goes up? In that situation the scheme is 10% less well funded than it would have been and, therefore, needs an even bigger market rally to achieve its objective.

Is the de-risking consistent with the worry?

A 10% de-risk to me still shows an incredible amount of confidence in market rises. After all, 90% of the assets in this example remain in equities. I would interpret the scheme’s positioning as follows:

- The scheme wants to remain in equities as they generally believe in them

- There is a concern that growth could be muted; or

- Markets could fall and, if they do, they want to be protected

However, a 10% de-risk doesn’t meet the above for two reasons:

- It is still exposed to the full upside of equities

- It is still exposed to the majority of the market falls – if the market falls 20%, the scheme will still be down 18%

A 10% de-risk is a one-dimensional solution to a multi-dimensional objective.

Structured Equity using equity options is a way of creating a solution that is better tailored to these needs. For example:

- Having capital protection from market falls of up to 20% - i.e. if the market falls 20% over 3 years, the scheme will not lose what?

- Being exposed fully to equities up to a cap of 25% - the upside is still retained up to and well above the investment objective

This is just one example – the parameters can be tweaked to suit the needs and concerns of each scheme.

So whilst disinvesting from equities into cash may feel like de-risking, it may not be the ideal solution for your needs.

Mark Davies

Mark has been involved in the derivatives market since it started for pension schemes in 2004. A qualified actuary, Mark specialises in developing derivative solutions that address the bespoke technical requirements of pension schemes. Mark is also heavily involved in derivatives education for clients and has spoken at conferences where he has made derivatives understandable for pension schemes.

Mark joined River and Mercantile Derivatives in 2004 from HSBC and is a qualified Actuary. Mark has a MA and MEng Engineering from Cambridge University.

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