Don’t be afraid to ask questions
Gail Moss finds out the kind of information pension fund trustees should seek from their asset managers since they cannot realistically be expected to understand the many complex products and strategies that are used to manage risk
Over the years, asset managers have devised increasingly sophisticated financial tools to help institutions protect against risk. And, in a world of recession and continuing economic uncertainty, pension fund trustees need to concentrate more and more on risk management.
But how can they hold their financial managers to account if they find it difficult understand the complex products and strategies involved? What sort of questions should they be asking their managers? And how much detail should they expect in the financial reports that they receive?
“There is no limit to the number of questions that trustees can ask, nor is there an ideal level of detail they can receive about risk management strategies,” says James Meenan, founder of JNM Research, a Dublin-based trustee coaching company. “But it is inconceivable that anyone who is not a full-time professional can achieve in-depth knowledge. A pragmatic approach is to create a structured dialogue between trustees, their in-house investment team and external investment advisers and managers that will grow their knowledge over time, if only because of different levels of knowledge and experience.”
There should also be a structure that defines responsibilities. For instance, the London Pensions Fund Authority (LPFA) board delegates investment responsibility to the investment committee, investment sub-committee (made up of the investment committee chairman, the chief executive and the chief investment officer, with an external independent adviser) and the investment team.
Before entering into any complex investment arrangements, these must be understood and agreed by the in-house investment team, the external advisers and the investment sub-committee.
The proposals then go through a due diligence process of over 100 steps. When finally in place, the arrangements are monitored and reported through quarterly monitoring and compliance reports to the investment committee.
In general, for pension fund trustees and investment committee members, the underlying rule of risk management is to look at both sides of the balance sheet – not only returns, but also downside risk and how to protect against it. The trustees will start by drawing up an investment strategy, probably including advice from their investment managers.
And this is where those complicated products will come into play. “The key point is, don’t go for method, go for result,” says Peter Kraneveld, international pensions adviser.
“Trustees don’t need to know how an investment works, but what it actually does. They should be asking their managers what the situation is as of now, and tease the options for dealing with it out of them.”
Kraneveld says that the next step is to ask how a specific investment or strategy changes the situation, and what the effect of using it is on covering old risk, creating new risk, net returns and cost.
Some of the most commonly used products are interest rate swaps, which hedge against sudden changes in interest rates.
“When embarking on a strategy using swaps, trustees should ask, ‘does the swap level mean gearing?’ and ‘what is our long-term commitment?’,” says Rick di Mascio, chief executive of Inalytics, the London-based firm that measures investment skill. “They then need to understand what objectives the swaps are seeking to meet – then ensure regularly that they are doing the job. For example, is the movement or change in the swap portfolio what you wanted or needed? Is it what you anticipated?”
And he says trustees should take into account who is giving them the answers.
“Is it the swaps provider, who will be pricing the swaps? Is it the consultant who has constructed the risk management strategy? Also, how do the trustees measure the performance of their swaps manager, particularly if there is a performance fee?”
Geraldine Leegwater, head of investment at the ABN Amro pension fund in the Netherlands, says that it is important to ensure the pension fund has enough cash to come up with the required collateral. “You should also consider which interest rate movements you think you can handle in terms of collateral requirements,” she adds. “It is important to judge the maximum size of your derivatives exposure against potential collateral and liquidity requirements.”
A further issue to be considered is counterparty risk. Di Mascio points out that through moving into swaps, the pensions industry has shifted the counterparties for their liabilities from governments (through their Gilt portfolios) to investment banks.
“While, previously, investors relied on governments to honour the cash flows, now they’re relying on investment banks,” di Mascio says. “And although the system has been tested to a large extent during the demise of Lehmans, pension funds need to ask at what point does it become untestable. If they aren’t comfortable with that, they shouldn’t use swaps.”
Once a hedging strategy has been set up, the information flow from the fund’s investment managers becomes of key importance in helping trustees ensure that the investment objectives are being met.
The process of evaluating information from managers begins with the mandate, says Michael Cross, principal at Mercer.
“When managers are appointed, it’s crucial they should be asked what information they will provide and at what point,” he says. “That means both trustees and the investment committee can then take advice. Asset management is becoming increasingly bespoke and it may be appropriate for managers of different mandates, such as fund of hedge funds, LDI or derivatives, to provide different information and in different ways. When we run a beauty parade we often ask to see a sample reporting pack and that leads to a dialogue on the contents.”
Quality not quantity
One of the challenges facing trustees is information overload. “The first question should be ‘what do we need and why?’ and ‘what is the critical information that helps us to be in control?’,” says Leegwater.
In dealing with this, each committee should be clear about its own role in the process.
“A generalist board must know what instruments are being used and in what magnitude, what limits have been set for such derivatives and how these serve to meet the scheme’s risk management and return objectives,” says Roger Gray, chief investment officer at the UK’s Universities Superannuation Scheme. “And overall reporting on performance, scheme and mandate level risk should, of course, incorporate the relevant derivatives.”
However, while the trustee board should have an overall picture, much of the detail can be
delegated to the investment committee, which might well include a number of finance professionals.
“If the pension fund has a separate investment committee, the trustee board should receive a small number of key indicators, taking the form of a dashboard [a collection of standard data that can be presented often] or traffic light system,” says Cross. “These will allow trustees, at a glance, to see where the areas of concern are, giving them some comfort that the consultants have been looking at the full range of criteria. The investment committee will cover a broad range of areas in more detail, passing the headline figures and conclusions to the trustee board.”
“Trustee boards should make sure they understand the dashboard,” says Kraneveld.
“Having a representative of the service provider attend a discussion to ask if the dashboard is interpreted correctly may help. Boards should not hesitate to ask for changes in the dashboard. They may also want to see a longer data series in order to put recent developments in perspective.”
The frequency of information should not be subject to hard and fast rules, but meet the specific needs of trustees and committee members.
“If the portfolio is performing well and the risk indicators are OK, there’s no point in having certain information every quarter, say, just for the sake of it,” says Cross. “On the other hand, if there’s a problem in that area, trustees could step up the frequency of information for a few months.”
The same goes for committee meetings. “Pension schemes are long-term investors,” says Cross. “The short-term decisions should be made by managers. The trustee board framework isn’t suited to looking at asset management reports on a day-to-day basis.
However, real-time updates of what the scheme is worth on a weekly basis can be very useful.”
For example, online measures of estimated funding levels (based on Gilt yields and the latest available asset values) and of fund performance related to liabilities can be provided every day. Online measures can also be used for dynamic derisking where, if a specific funding level gets tripped, managers will sell some risky assets and buy bonds.
“Many trustee boards have adopted this approach because a large part of their portfolios are in liability hedging – swaps, Gilts, and so on,” says Cross. “And opportunities to lock in realised gains can be fleeting because prices are so volatile.”
Information should include both return and risk
“On the return side, trustees will compare performance with a specific benchmark,” says Cross. “In terms of risk, however, they should be asking their managers what the meaningful risk measures are, and agreeing what to monitor in advance. They should then hold managers to reporting against those benchmarks. In particular, they should watch out for measures which are frequently changed – moving the goalposts can be a sign that all is not well.”
For instance, a corporate bond manager may have ‘outperformed’ but this could simply be the result of moving into higher-yielding, high-risk assets.
Cross says that risk reporting indicators should be nailed down, including:
• Credit spread compared with the index;
• Changes in credit ratings such as downgrades of the benchmark index;
• Portfolio risk, ie, tracking error relative to the index but also the absolute volatility of the portfolio.
The tracking error of mandates is also important, says Leegwater.
“Where these don’t make sense, you come up with other risk criteria,” she says. “The criteria will then tell you about different types of risk such as concentration risk or liquidity risk.”
She says that the increased use of overlays, synthetic exposure and leverage, makes it important to consider exposure-based reporting.
“In our case,” she continues, “Standard reports would only show the market value to be €13bn, but we need to know what the total risk is, based on the exposure created at any specific time.”
But after following these steps, what do trustees do if they still don’t understand the pros and cons of a specific hedging instrument or risk management strategy?
“Ask questions and get training,” advises Kraneveld. “And if you still don’t understand it, then don’t use that particular product.”