WPF Risk Summit

Hybrids: best of both worlds

The funding levels of US public pension funds, falling from 100 per cent in 2001 to 77 per cent now, is the result of bad governance, according to David Villa, chief investment officer of the $91 billion State of Wisconsin Investment Board (SWIB).

He says irrational governance and imprudent management has resulted in the funding crisis in the US.

He gives examples of bad governance including contribution holidays, unfunded benefit increases, unrealistic investment return targets (with a huge bias to be optimistic), uneconomic investment decisions, higher than normal expense ratios and under-compensated investment professionals.

Villa and Sorina Zahan, partner and chief investment officer of Core Capital Management, have been working together on a paper that looks at governance, market risk and system design. They presented the findings at the World Pension Forum Risk Summit, jointly convened by Conexus Financial, the publisher of

The study aims to develop a palatable mathematical framework to compare different structures to find their vulnerabilities. The modeling is based on option modeling.

Zahan says the study looked at market risk and the impact on different pension structures – defined contribution, defined benefit and a hybrid model – and how they behave when there is not an equilibrium return.

“We looked at the robustness of the structure and the variability of returns, and the net payoff to the employee and the sponsor.”

Not surprisingly the study found that defined contribution plans are very sensitive to market risk, but defined benefit funds were not.

“Convexity, or sensitivity to market risk, is a critical source of return that is often ignored,” she says.

The study found that the defined benefit structure is the most beneficial to the plan sponsor because it keeps the upside. However, that can only be realised when there is prudent investment and management.

“The impact of poor governance is greater on less robust, or more convex, structures. The trick is not to squander the cushion,” she says. “Nothing is wrong with the defined benefit structure, but with the way it is managed.”

The study argues that hybrid plans, which SWIB offers, can allocate both the upside and downside risks between the employee and the sponsor to achieve better alignment of interest.

Villa argues that the hybrid model means better governance because when the trustees come to the table, they’re more interested in getting it right.