When the Risk Standards Working Group issued 20 new standards in 1996 to address risk for pension executives and money managers, nobody had thought about "Spitzer risk."
The risk of running afoul of a tougher regulatory environment — symbolized by New York Attorney General Eliot Spitzer's pursuit of illegal trading practices of mutual funds and bid-rigging by insurance brokers — is now high on the list of potential pitfalls for financial executives.
But that's not the only risk missing from the risk group's early list. Among other current hot buttons:
• The growth of hedge funds is affecting market behavior in unforeseen ways, including their heavy use of leverage and complex investment strategies.
• Increased use of derivatives, such as interest rate swaps and futures, is raising concerns that many pension funds don't fully understand the risks and costs involved with these instruments.
• Accounting issues, such as how to fairly price securities, have surfaced.
• Reputation risk is leading many pension executives to articulate carefully defined investment policies and documents.
• Broad market risk is making investors wary of a massive market correction, like what happened when the technology-stock bubble burst in 2000.
When the Risk Standards Working Group, an ad hoc group comprising pension executives, money managers and risk experts, issued their 1996 report titled "Risk Standards for Institutional Investment Managers and Institutional Investors," they had more basic issues to address. The group was created in response to the 1994 mortgage-securities blowup involving the disastrous arbitrage bet on interest rates by Askin Capital Management and Orange County, Calif., that resulted in a $1.5 billion loss.
The Risk Standards Working Group identified 20 basic risk standards in three broad areas they believed plan sponsors and money managers needed to focus on: management, measurement and oversight.
The management area included acknowledging fiduciary responsibility; implementingapproved written policies; and ensuring independent risk oversight and adequate checks and balances. Performance measurement standards addressed issues such as valuation reconciliation and risk measurement. Oversight included comparing money manager strategies with compensation and actual investments, and an independent review of methodologies, models and systems.
Since then, some of the biggest money managers and pension funds have created risk management positions focused on portfolio management and operational risk. Some of the pension plans that have increased their risk management capabilities include the Illinois State Board of Investments, Chicago; the New York City Employees Retirement System; the defined benefit plan of International Paper, Inc., Stamford, Conn.; and the Ohio Police & Fire Pension Fund, Columbus.
Robert Hunkeler, vice president of investments at International Paper, said the company is hiring a director of alternative investments, a new position, to oversee its hedge fund and derivatives portfolio, with a specific focus on portfolio risk management. "The bottom line is, we at the plan sponsor level don't know as much as we should know," he said.