Pension plans gauge risk amid quest for gains

When Connecticut Treasurer Shawn Wooden took office in January, he knew he was confronting a public pension plan funding gap of at least $35 billion. He also had a hole to fill in his organization.

Mr. Wooden needed someone focused on the investment risks embedded in the state employees' and teachers' pension plans that own thousands of holdings in companies, government bonds, real estate and infrastructure worldwide. He turned to Kevin Cullinan, a former senior risk officer at General Electric Co.'s pension plan who oversaw the company's $27 billion of externally managed investments from 2013 to 2016 and was the risk manager for alternative assets including private equity from 2005 through 2012.

"Mission No. 1 is seeing the risk," Mr. Wooden said in an interview. "Having a chief risk officer that is not a portfolio manager creates some distance and some independence. I think that's better governance, better monitoring and better accountability."

Connecticut is joining a growing number of major public pension funds that have appointed chief risk officers since last decade's financial crisis to evaluate volatility, liquidity, leverage, the impact of rock-bottom interest rates and new risks like global warming. Though the $380.7 billion California Public Employees' Retirement System, Sacramento, the largest U.S. pension plan, appointed a CRO in 2010, the $216.2 billion New York State Common Retirement Fund, the third-largest pension plan in the U.S., didn't do so until 2017. Some of the biggest U.S. public pension plans, including the $82.3 billion Virginia Retirement System, Richmond, the $75.6 billion Georgia Teachers Retirement System, Atlanta, and the $74.5 billion Michigan Retirement Systems, East Lansing, don't have a chief risk officer.

The appointment of such officials by public pensions is a natural progression, said Richard Bookstaber, the chief risk officer for the University of California's investment division and a former head of risk management at Morgan Stanley, Salomon Brothers and hedge funds including Moore Capital Management.

Banks adopted chief risk officers in the 1990s to monitor and coordinate the positions of trading desks that moved in and out of securities and derivatives over periods of days. Hedge funds, which held investments for weeks or months, added the position in the 2000s, with institutional asset managers following, Mr. Bookstaber said.

"The risk manager role is moving to consider risks that occur over longer and longer time frames," he said. "Pension funds and sovereign wealth funds have positions that move very, very slowly."

They may move slowly, but their holdings are often complex. Squeezed by unfunded liabilities of at least $1.6 trillion and median return assumptions of 7.3% annually, pensions have increased allocations to more opaque and illiquid "alternative" investments like private equity and debt, real estate and infrastructure which are harder to assess.

"Understanding the type of risks that you have in these illiquid portfolios is very difficult," Mr. Bookstaber said.

Essential to the job of chief risk officer is being able to drill down into the pension's holdings to see exposure to sector, country, and strategy, Mr. Cullinan said.

Asset managers like BlackRock Inc. and Bank of New York Mellon Corp. have developed software that can model how investments, including private equity, perform under different scenarios. Bloomberg LP, the parent of Bloomberg News, competes in offering portfolio analytics.

BNY Mellon's Risk View allows clients like pensions and endowments to see how their current portfolio would have performed during periods like the Asian "flu" in 1997, the Russian debt crisis in 1998, the bursting of the dot-com bubble in the early 2000s and the 2008 financial crisis.

While the software can help officials identify risks in broad strokes, pension funds should understand their limitations, said Steve Foresti, chief investment officer at Wilshire Consulting.

"You will never have full visibility into what all the risks are," he said. "They are incredibly valuable insights into potential risks but they're still just a flashlight in the dark."

Connecticut is among U.S. pensions that are lowering their assumed rate of investment return to better reflect a long-term decline in interest rates. Connecticut lowered the rate on the teachers' pension to 6.9% from 8% while extending the amortization period for its unfunded liabilities to 30 years.

At the same time, the state reduced its allocation to stocks, which carry more risk, to 40% of the portfolio from 48%, while increasing its allocation to fixed income to 32% from 20%. The state employee pension also has a 6.9% assumed rate of return.

"What we're in the process of doing is 'derisking' the portfolio," Mr. Wooden said. "We've had a great nine- or 10-year run. I don't think most observers believe the next 10-year run will look like that."