The past few years have seen a stable inflation environment, along with tremendous returns in major equity markets. However, it is uncertain how long this happy economic scenario can be sustained. While equities will outperform bonds over the long term, it is quite likely that we are in for a period of market turmoil.
The start of the new millennium is therefore an excellent time for companies to implement a sound risk management programme for their worldwide pension plans, which actually resemble a multinational financial subsidiary.
For most companies, globalisation is expected to result in a significant growth in the size of this subsidiary, and therefore in its potential impact on the company’s overall well-being. This article outlines a framework that a company can use to ensure effective risk management of its multinational pension subsidiary.
Risk, by definition and by nature, cannot be completely eliminated. Rather, companies need to identify, understand and prioritise material risks with respect to their global pension promises, and to implement an approach to manage them. The various risks that are encountered can be grouped into three broad categories:
q Governance risk results from an ineffective decision-making system for the multinational pension subsidiary, including a lack of proper accountability for the decisions taken.
q Financial risk is concerned with the impact of the multinational pension subsidiary on the sponsoring company’s earnings, balance sheet and cashflows. Financial risk is simply the risk of failing to meet overall corporate financial goals and objectives.
q Operational risk is defined here as the risk of a breakdown in processes and procedures. Development of optimal governance systems and financial risk management programmes will be a wasted effort if they are not fully implemented or fail because of system shortcomings or human error.
By effectively addressing the governance, financial and operational risks at the global level, the multinational will also be able to manage an additional risk category – reputational risk. This is the risk that any negative development, such as bad press or employee action, will reflect poorly on the company’s reputation. With the trend towards defined contribution (DC) plans around the world, this will become an increasing area of concern. DC plans therefore need to be managed in accordance with the same high standards as the company’s defined benefit (DB) plans.
The design and implementation of an effective global governance system enables a company to fulfill its fiduciary responsibility. This responsibility is not just confined to the legal fiduciary board in each country. Ultimately, the corporate board of directors is accountable to both employees and shareholders. An effective governance system also helps to minimise compliance risk – the risk of not being in full compliance with the regulatory, accounting and tax requirements for pension plans in various jurisdictions.
The optimal global governance system will reflect such factors as the mix of countries, the nature of the local arrangements, relative plan sizes and availability of resources within the company. However, all good systems have certain common features:
q Broad representation: a good system steers away from the ‘silo’ mentality and involves close co-ordination across a broad range of functional areas, including human resources, treasury, financial control and legal.
q Appropriate accountability: decision-making goes through different levels of hierarchy, with the more senior executives responsible and accountable for high impact decisions such as investment, funding, benefit and expense allocation policies, while policy implementation and detailed monitoring is delegated to lower levels.
q Suitable allocation of roles by geography: the roles of the local fiduciary, local/regional management and corporate head office are all clearly delineated. An optimal structure taps into the best people and best ideas, no matter where they originate.
A comprehensive approach to financial risk management goes well beyond a narrow focus on managing investment risk (eg, market risk, credit risk, liquidity risk, performance risk) as it relates to pension assets. A sound approach seeks to understand the impact of external risk factors on the interaction between pension assets, pension liabilities and the company’s overall financial results.
Figure 1 shows the risk factors giving rise to pension financial risk, along with the levers that can be used to manage this risk. A comprehensive approach makes decisions within a framework of effective benefits, funding, investment and accounting policies. These four policy areas are interrelated – changes in one area can impact another.
The process for developing an effective financial risk management programme comprises of four steps, and is summarised in Figure 2. The starting point is to identify the company’s primary business objectives, including a specific time frame to meet these goals. This can then be translated into suitable financial objectives for the multinational pension subsidiary. Failure to identify suitable objectives and associated time horizons is often the single biggest source of financial risk.
Generally, a company wishes to manage – typically this means minimise – future cash contributions and accounting expense in the long-term, in a way that avoids harmful and unexpected financial results in the shorter term. Of particular concern to the local pension fiduciaries is the security of accrued benefits and the need to meet any minimum solvency requirements – this must always form an overriding constraint in developing a global financial risk management programme.
An effective financial risk management programme will seek to minimise the correlation between pension financial risk and overall corporate financial risk. For example, it is desirable to minimise cash demands from the global pension plans at a time when corporate cashflows are low.
The outcome of this process is a well designed programme that supports the company’s financial objectives by effectively integrating the benefits, funding, accounting and investment policies of the multinational pension subsidiary.
Benefit policy The benefit programmes offered should reflect the company’s ‘total reward’ objectives and competitive market practices. Issues that need to be addressed from a risk management perspective include:
q The company’s philosophy with respect to risk sharing between the employer and employees – this helps determine the nature of benefit programmes to be offered (eg, DB, DC, hybrid). It also helps to address issues such as the appropriate policy with respect to cost-of-living increases to pensioners, or the appropriate crediting rate under cash balance plans.
q Understand/manage any potentially costly options inherent in the benefit design. Examples include direct integration of retirement benefits with social security where the latter is expected to be scaled back, guaranteed conversion rates from pensions to lump sums under defined benefit plans, and guaranteed minimum crediting rates under DC or cash balance plans. For example, Swiss DC plans are required to guarantee a minimum 4% annual return on employee account balances.
Funding and accounting policies Funding policy is concerned with the amount of capital contributed in advance to support promised benefits, while accounting policy is concerned with the recognition of annual pension expense and balance sheet accruals. There is usually a trade-off between optimising cash contributions and optimising pension expense, and the company needs to prioritise its goals. Key issues that need to be addressed from a risk management perspective include:
q Ensure adequate funding of retirement benefits to avoid sudden contribution surprises, costly penalties or negative publicity, while at the same time minimise the risk of excessive surplus build-up – particularly in those countries where the company has no control over surplus.
q Manage the level and volatility of pension expense and minimise the likelihood of a potential adverse impact on the corporate balance sheet.
The approaches that can be used to address these issues include:
q Use a consistent global standard for measuring assets and liabilities in addition to standards based on local regulatory requirements. The global standard must be based on realistic economic measures, including a consistent, market-related basis for valuing assets and liabilities. The global standard must also ensure appropriate linkage of actuarial assumptions to external capital market parameters, including consistency with the assumptions underlying the investment policy;
q Develop suitable funding and expensing policies:
l Use ‘corridors’ or ‘bands’ instead of single funding ratio targets for determining cash contributions, and use asymmetric amortisation approaches for excess assets or shortfalls (eg, amortise excesses quickly and shortfalls slowly);
l Fully exploit all available margins and smoothing techniques available for determining statutory local funding requirements and for calculating pension expense. All accounting standards (FAS 87, IAS 19, SSAP 24, etc) provide some ‘wiggle room’ in this respect;
q Use realistic asset-liability projections as part of the normal actuarial valuation process. This helps identify potential future problems and can serve as a guide to setting today’s contribution rates and pension expense.
Finally, a consistent global approach must seek to ensure that the company’s total cash resources are allocated efficiently among its various global retirement plans, and pension expense is allocated fairly across business units.
Investment policy The total investment programme can be viewed in terms of three ‘risk horizons’ – long-term policy, intermediate-term strategy and ongoing implementation. The approach to managing risk should be consistent across these three horizons, and must, in aggregate, reflect the company’s overall risk posture:
q Long-term investment policy (five or more years): uncertainty of future costs and/or benefit security are the primary concerns over this horizon. This is a function of the underlying nature of the liabilities, notably their sensitivity to inflation and interest rates, along with the long-term outlook for capital markets. The key risk management tools are the optimal debt/equity mix, the domestic/foreign split and duration of the bond portfolio.
q Intermediate-term strategy (up to five years) is concerned with where we are today in terms of the economy and the market cycle, and the intermediate-term outlook for key variables such as market returns, interest rates and manager tracking errors. This influences the financial impact of various reporting requirements such as minimum funding standards (eg, the mark-to-market minimum solvency standard in Canada) and accounting rules (eg, impact on shareholder equity under FAS 87). While this intermediate-term ‘reporting risk’ should, in the first instance, be managed through the use of appropriate actuarial tools outlined earlier, effective risk management may also call for the use of asset related tools. These include temporary departures from the long-term policy and/or the use of appropriate financial hedging instruments (eg, protective puts, interest rate swaps, currency hedging).
q Ongoing investment activity : this is concerned with active investment management risk relative to passive policy benchmarks. Specific issues involve asset mix control (ie, regular rebalancing versus tactical asset allocation), choice of manager performance benchmarks within asset classes (this can be a major challenge in countries where suitable indices do not exist), and the degree of active management risk relative to the selected asset class benchmarks. Factors that influence these decisions include:
l the company’s investment beliefs (eg, market efficiency) in a global context;
l availability of internal/external resources in each of the company’s locations;
l size of pension assets in each country and the ability to leverage manager relationships globally;
l availability of quality multinational managers who can deliver consistent, risk-adjusted value-added net of fees, in the company’s material locations;
l ability to diversify across complementary investment management styles – this would be dictated by the size of individual pension asset pools. The ability to pool pension assets across borders (eg, pan-European funds) will obviously facilitate manager diversification for the relatively small funds.
Where possible, manager guidelines should be defined in terms of tracking errors and outperformance targets rather than simple notional limits. This helps to ensure that the risks/returns inherent in the implementation are consistent with the risk/return objectives underlying the long- and intermediate-term policies. In particular, this approach helps ensure that policy implementation does not result in the company taking on more (or less) risk than it originally intended.
It’s helpful to think of the company’s investment risk posture in terms of its total ‘risk budget’. As with the optimal allocation of total global cash contributions and accounting pension expense, the question then becomes how best to allocate the total risk budget among the global pension funds? How much should be expended on ‘policy risk’ versus ‘implementation risk’ by country? The global risk budget should be allocated to those activities for which the company expects to be fairly compensated, and which it has resources to manage carefully.
No discussion on risk management is complete without a reference to ‘value at risk’ or VAR. For the multinational pension subsidiary, ALM is the most appropriate analysis in lieu of VAR. It allows the company to measure and reshape risks by identifying gaps between existing policies and corporate objectives, and by identifying alternative policies that help to fill these gaps. However, use of such models also introduce ‘modeling risk’: risk of using inappropriate models which then lead to erroneous conclusions. This can be mitigated through care in selecting the model – ensuring that the model has sound theoretical underpinnings. Having been through such a due diligence process in selecting a model, it obviously makes sense to use the same underlying model for the company’s pension plans around the world. While the model used in each country will reflect the local pension environment, it is essential that the underlying economic and capital market scenarios generated by the model are consistent across asset classes and countries.
A globally consistent model will also enable the company to assess its aggregate global financial risk exposure (ie, a global VAR) in its reporting currency. Such a global analysis could be used to examine any in-built diversification and any scope for enhancing the risk/reward trade-offs at the global level.
Any policies developed using ALM need to be evaluated for their ability to withstand shorter-term economic and market pressures. A stress test helps to assess the financial impact of extreme scenarios such as increased asset class volatilities and global correlations in down markets, whereas scenario testing requires the construction of a range of plausible scenarios with associated probabilities for their occurrence. Coming up with an adequate range of scenarios can be a challenge and introduces yet another source of risk. A good starting point is to ‘back-test’ the policies being considered using specific historical experiences (eg, 1970s style high inflation, a 1987-type global stock market collapse, the post-1989 Japanese experience and the late 1998 Russian debt crisis with its impact on high quality bond yields).
As noted earlier, operational risk results from internal or external breakdown in processes as a result of systems failure or human error and several measures can be taken to help mitigate this risk, including:
q Documentation: issue written global guidelines covering policies and procedures, use comprehensive and globally consistent investment manager and custodian contracts.
q Audits and checks: conduct regular audits of processes and procedures used to manage the multinational pension subsidiary. Use a single global custodian or record-keeper to provide timely performance and compliance reporting for all plans; use a single global actuary to provide timely, globally consistent reporting on the financial status of various plans and who can help ensure that expense and funding guidelines are fully implemented.
q Dialogue: ensure regular on-site visits by staff with global responsibilities for plan management; provide adequate training to all those who have governance responsibilities; ensure that their knowledge is kept up to date; have adequate succession planning for material locations to avoid major disruptions when key people leave.
An integrated and systematic approach to managing risks associated with its multinational pension subsidiary will help the company meet its obligations to its key stakeholders.
Sandy Chotai is a global asset consultant with Towers Perrin, based in New York

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