Denmark’s biggest pension fund, ATP, with more than Dkr300bn under management and covering practically 4.9m members in the public sector, undertook a restructuring last year of its risk management process by reviewing two key areas: asset-liability modelling (ALM) and asset allocation adjusting. The two go hand in hand and ATP believes combining the two new processes is not only innovative but unique in the pension fund industry.
ATP’s risk management is based on two main principles. Firstly, it should ensure long-term pensions provisions are guaranteed by preserving their value and secondly, reserves must be able to withstand any adverse impact from short-term changes in market conditions. The size of the reserves at any given time is used to determine which principle takes precedence, such that protecting long-term value is key when reserve levels are high but restricting risk exposure to reduce short-term loss is more important when they are low.
ATP says the way forward is adopting a dynamic risk control policy based that allows ATP to maintain adequate levels of reserves at all times. The guidelines for controlling risk are laid out by the board and daily risk calculations are dependent on the fund’s new ALM structure. ATP says this means it will decrease its foreign equity weightings if risk is too high so that risk is reduced before it has the opportunity to affect the level of reserves. Conversely, it will increase its equity weightings if the level of exposure to risk is considered too low. ATP believes this process ensures long-term asset allocation targets can be reached whilst its continued ability to have its assets managed on an active basis remains intact.
These new ALM and risk management measures help ensure ATP can overcome the dilemma that the optimum investment strategy may vary over different time periods and the associated implications this has on its risk and returns. ATP says this is a common question to all pension funds and basing solutions on ad hoc considerations is no longer viable. The question is thus when and by how much the asset allocation policy needs to be adjusted in advance of any foreseen problems with respect to any ALM studies.
According to ATP, asset-liability studies generally work on the assumption that asset allocation strategies are static and only change by small limited annual revisions if necessary, but ATP’s own analyses in the past three years show this is not true over a prolonged period of time. ATP believes ALM exercises should be dynamic and supported by carefully drafted guidelines to allow for any deviations from long-term targets.
ATP’s overall investment strategy is thus always customised to cover its long-term pensions commitments and achieve its targets. ATP has implemented a new ALM structure that it has been developing in the past two years.
The new structure has a 30-year time horizon to play with and ATP says this means it can simulate a vast number of different balance sheet positions quickly and efficiently without the need of collaborating with a major US bank, as it had always previously done. Moreover, there are a number of other advantages to having an internally developed and maintained asset-liability modelling exercise, ATP points out. The model can be used much more flexibly and be run more frequently than external models, which is particularly important in times of market downturns, volatility and uncertainty. It leads to a greater understanding of issues affecting asset-liability modelling within ATP itself as well as to improved decision making concerning, among other things, the dynamic changes the new structure allows it to make to the asset allocation policy.
Not only does the new process allow ATP to determine effectively the optimum risk/return ratio in both the long and short term but also to set long-term allocation targets with respect to the main asset classes, notably foreign and domestic equities and fixed income, and its capacity to hedge interest rate risk.
Highlights and achievements
The past year has seen ATP successfully recognise the need to review its risk control and management policies to ensure its long-term pensions obligations and maintain the levels of reserves in the face of short-term adverse market conditions.
Adopting a new asset-liability modelling structure to ensure risk is effectively managed shows ATP’s commitment to its members and retirees as well as its deep understanding of how the investment industry and markets work under different and adverse conditions.
Having carefully constructed risk control guidelines determined at senior board level ensures its risk management can be successfully implemented with respect to its ALM studies. Moreover, its new ALM structure means ATP can now review and calculate its risk on a daily basis and make any necessary asset allocation adjustments the results might call for.
This ensures long-term asset allocation targets can be met whilst the level of risk the fund’s assets are exposed to can be carefully managed on an ongoing basis. This does not only apply to the risk/return ratios ATP needs to determine with respect to its investments in traditional asset classes, but also its ability to hedge interest rate risk.
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