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Risk exists the moment future benefits are promised. The question then becomes how best to financially manage those risks. Modern portfolio theory defines risk as the deviation of an investment's returns from a benchmark. For the fund as a whole, then, liabilities represent the benchmark. To decide where to spend risk, managers must identify a plan's liabilities. By projecting best-case, worst-case and most-likely scenarios for the growth of liabilities, you can identify investment opportunities and begin to construct a portfolio.

Portfolio Construction

Constructing a solid portfolio involves several interrelated steps:

• Allocating assets strategically, to bonds, equities and other investments
• Designing benchmarks for each allocation
• Making decisions about indexed, core, active, satellite and absolute returns
• Selecting a manager

Each of these steps can be isolated and evaluated for its risk–return contribution to the plan's risk budget.

The key is simultaneous asset allocation and implementation. This integrated approach offers powerful advantages. It provides a better way to manage the delegation of risk to investment managers and, with appropriate benchmarks for the fund, avoid unwanted or unrewarded risks.

Integrated Solution

Taking risks offers the potential for returns. Because you can control where risk is spent and who is making decisions, risk is more manageable than performance. By selecting the right policies and making the right choices for managing investments with liability-based benchmarks in mind, you can control the cost of offering retirement benefits to employees — and ultimately yield the best return for your plan.

Howard Crane is practice director, Americas, for Watson Wyatt's investment consulting practice.

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