The pension fund industry is at an inflection point in its view of risk. The fear of underfunding in the face of falling returns and unfavorable demographics is leading to a greater investment in more exotic instruments. However, this is changing the risk profile to a point beyond what is normally captured through the core metrics and models employed by pension funds, creating a challenge to the traditional risk management approach.
Pension funds at risk: The new approach for long‑term investment
The macro demographic challenge facing the pension industry is well known — an aging population means pension fund participants are drawing from rather than adding to that fund, and therefore increasing its liabilities. The same underfunding pressures that have affected state pension plans are being experienced by private pension plans.
The difficulty in funding the plan and providing capital protection through the current contributions is exacerbated by the fact that, following the financial crisis of 2008, the global economic environment is one of low growth and low inflation. And there are also capital market pressures. A series of market shocks over the past decade have severely affected fund valuations and the ability to create future cash flows based on the capital value.
The dilemma of trying to get higher yields from a lower base while maintaining growth in the fund is forcing pension funds to pursue more creative and arguably more aggressive investment strategies in order to meet their funding challenge. There is no shortage of options. Indeed there is an almost bewildering array of investment opportunities available to pension fund managers: derivatives overlays; increased exposure to alternative assets such as real estate and infrastructure; and the use of swaps as hedging tools. However, the pursuit of these strategies will have a fundamental impact on the risk management of the fund.
When pursuing a more complex investment strategy and its promise of greater investment opportunities, it can become much harder to strike the right balance between risk and return. This is a challenge unique to pension fund managers. Whereas the managers of a mutual fund may be steered by the market, the same is not true of pension funds. For example, a mutual fund manager might be able to look at current investment trends (passive vs. active, exchange-traded funds and so on) and decide whether these can be used as part of a tactical asset allocation approach. For pension funds, a more long term and strategic asset allocation is required. And while a mutual fund manager typically has the choice of either increasing yield or meeting a benchmark, a pension fund must primarily be managed so as to meet a liability stream, which means the choice of a static benchmark cannot capture all the investment challenge that pension fund managers face.
Therefore, if a fundamental change is made in terms of asset allocation — such as the use of derivatives — it may well lead to a situation where the benchmark itself is no longer appropriate. While the use of derivatives might solve the underfunding problem, it creates another challenge in terms of risk modeling and management, because the more traditional models that have used capital pricing models to track and display the risk position relative to the benchmark are not designed to work with derivatives.
The traditional risk report starts from the liabilities and creates a liability benchmark and a projected cash flow that must be supported by the fund. Tracking risk can then be defined relative to the allocations of the liability benchmark. However, most attention will be paid to the risk of a “funding gap” between the liabilities and the current value of the pension fund. A low-risk strategy, based on bonds and other safe assets, might not be suitable when the pension fund is underfunded, as is the situation many now face. This then leads pension plans to pursue higher-risk strategies in an effort to bridge the funding gap. This is where the risk dilemma emerges. For an equities-based strategy, any change in allocation to increase yield, from one stock to another, is against the benchmark and this can be easily reflected in risk models in terms of volatility and correlations. But if there is a purchase of a non-linear instrument such as an option, especially if this derivative is traded with a counterparty rather than on an exchange, there is a profound difference to the risk profile.
The fund has to reassess its benchmark and factor in a higher capacity for loss. What, in purely monetary terms, is the capacity for loss over the stated period? These are typically sell-side measures. If the pension fund's portfolio, which holds different types of instruments, is then held to the same scenarios, the capacity of loss will most likely be greater but the question is whether that capacity of loss is commensurate with the increase in risk as a result of the investment in derivatives. The benchmark now has an expression of loss and the portfolio has an expression of loss.
The final step is to create a third portfolio where everything in the benchmark is scaled up and preceded by a negative figure, meaning that if the fund owns everything in that benchmark, the risk would be zero. Anything that is not bought from the benchmark or is being added in the form of derivatives, forms the absolute budgeted loss and is the number that trustees and stakeholders have to understand is the additional loss or budgeted risk that is being taken in order to catch up the liability funding and capital growth.
In order to solve this risk dilemma, pension funds' risk managers are moving toward techniques and methods more associated with sell-side risk, such as value-at-risk-based absolute risk management, risk budgeting and active risk management, counterparty credit risk analysis and tail risk analysis. Of course the benchmarks are still at the heart of the management of the fund, but the relative measures are less around simple allocation and more skewed toward active risk and risk budgeting where the VaR itself is the basis of the relative calculation and the excess risk represented by that active number is allocated across assets and fund subdivisions.
The transition to a risk budgeting or active risk model from a traditional factor model is not something that can be accomplished overnight. It is a dramatic change of risk reporting styles that is likely to cause internal and external issues if implemented too hastily. There has to be a process where the old reporting model is used and does its best to capture the risk from derivatives use, but then the derivatives usage is gradually brought in. By employing an approach that manages the transition, trustees can see that it is not a new or enhanced factor model in order to take account of the derivatives but is instead a different view of the risk. The two together should start to give the pension fund trustees a three-dimensional picture of the risk in the fund. Depending on the level of underfunding and the level of risk required to bridge that gap, they will then start to gravitate toward one view or the other.
In addition to changing the reporting process, pension fund trustees have to increase their own risk management capabilities through education and to understand that the rules of the game have changed. It is critically important that trustees understand what they are being told in terms of risk management.
The challenge for pension funds and their trustees in understanding these changes in risk management cannot be underestimated. Not only do they have to deal with a demographic challenge and an alarming fall-off in yield, they also have to grapple with risk management concepts that have previously been the domain of the higher echelons of sell-side investment banks. While these measures have become somewhat commoditized within the general sell-side sector, the buy-side is not overly populated with people that specialize in this area.
For pension funds there is an obvious investment required in technology and in data management in order to ensure the reliability of the metrics; however, the importance of individual knowledge and experience is critical. It is unrealistic to expect trustees and senior management to master the intricacies of derivatives risk management alongside conventional asset allocation. It is simply too big a task for many pension fund managers, consequently a lot of the requests from pension funds are, in the first instance, for consultancy and not technology. But this is also a new area for many pension fund consultants. Many have been offering specialists in swaps strategies for some time, but now there are more exotic products being used by pension funds. Ultimately though, pension fund trustees and plan sponsors need to have tools that are going to help them to drive their own thinking and create their own independent models rather than simply consuming what the consultant provides for them.
Technology will have a clear role to play in granting pension fund trustees the independent risk awareness that they need to successfully manage their risk. They will need a system that captures a holistic view of risk that comprises the staple measures such as market and credit alongside the less conventional metrics such as counterparty and liquidity risk that are not readily available in factor models. This is essential in order to get a total portfolio view of risk.
There is a widespread consensus that pension funds need to attain this additional knowledge and skill, but there is not yet a widespread consensus as to how to get there. This should not, however, diminish the importance of addressing the fundamental changes in risk management that are affecting pension funds.
The demographic trends creating the funding challenge are not going to change and while the volatility in today's capital markets might ease, the use of more complex investment strategies is likely to be a permanent change for pension funds. Therefore it is imperative that pension fund trustees and managers move to address these fundamental changes in their risk profile in order to meet the obligations of current and future pension fund members.
The most challenging issue — as always with risk management — is the change in the internal mindset of the various stakeholders, from board members to portfolio managers. Successful enterprise risk management, whether at a pension fund or an investment bank, requires that a risk-based view is taken of strategy and control, and that risk becomes a cultural keystone of the organization. There are various means by which financial institutions can create a companywide risk culture but there are fine margins between success and failure. For example, adopting a top-down approach driven by the board will raise the importance of risk management among staff but may lead to a compliance-led view of risk, whereas a bottom-up approach to risk that does not have the support of senior management will be doomed to failure.
There are some straightforward, initial steps that can be taken, such as ensuring the company has a well-defined risk appetite that is aligned with the company's strategic goals. And there are practical measures that can be implemented, for example, taking risk management out of its natural environment in the back and middle office and into the hands of front line staff.
Such a move, however, requires the portfolio managers in the front office to be given the tools and technology that enable them to see beyond the immediate and instead view risk in a more long-term, systematic and holistic context.
A scenario analysis framework that works in conjunction with conventional risk reporting tools is key. For example, a risk dashboard that includes pre-trade risk information as well as scenario analysis can act as a pre-emptive defense against market shocks or macro events like a eurozone breakup. It can also give front-office managers an insight into actionable risk and help spread a culture of enterprise risk management.
The provision of such tools must also be backed up with timely reporting and accurate data. A risk dashboard that is not regularly updated is of little use and if managers believe the data are not consistently credible, they is less likely to be acted upon. Finally, the inclusion of what-if scenario analysis on the desktop of pension fund managers will enable them to view and to act upon the potential portfolio risks from certain scenarios, to discover how correlations change during crises.
Once more, it can be a fine margin. An overreliance on risk models has often been cited as a primary cause of the financial crises; but the right use of suitable technology in the correct context and by the relevant managers can ensure that a culture of risk exists at the heart of the investment process.
Marcus Cree is vice president, risk solutions, and Laurence Wormald is head of buy-side risk research, at SunGard.