De Nederlandsche Bank (DNB) advocates strict separation of risk management and fiduciary management. But Lodewijk van Pol, head of fiduciary management at Lombard Odier, argues that risk management and fiduciary management are joined together at the hip and that is just the way it should be.
Pension fund objectives - securing nominal payments and the pursuit of indexation ambition (targets) - and the interests of participants and those of pensionable age, are best served if asset management and risk management are under integrated control.
I will try to avoid a semantic discussion about defining risk management and describing fiduciary management. Instead, I will present a vision based on daily practice and connected to that, choosing a suitable fiduciary manager.
Separation of risk management and asset management increases implementation risk and implementation costs. Two characteristics distinguish the fiduciary manager from a traditional asset manager: implementation according to the 'best practice' principle - active, or passive through outsourcing to other parties - and balance sheet management.
This last principle is actually the crux of fiduciary management and ensures the connection to the pension fund objectives and available risk budget of the pension fund. Think, for example, of the reliable and effective interest rate matching and daily monitoring and reporting of the coverage ratio and risk positions in the investment portfolio.
Not only do you need detailed knowledge of the structure of the pension fund, its objectives and liabilities, but also the entire asset management organisation, the procedures, the people, the systems and reporting should be based on that. This adds up to a well-oiled machine with risk budgeting and pension objectives as a starting point.
As soon as the asset manager - as often happened in traditional pension fund management - merely has to focus on an imposed investment benchmark, with or without an outperformance objective, the connection with the objectives of the pension fund is compromised and the view on an effective implementation of the chosen investment strategy is clouded.
That is exactly the point that DNB is warning us about and which has been pointed out by the Frijns Committee. ‘Alignment of interest' is the key phrase here. How can you achieve that if the responsibility of risk management and asset management is separated and in different hands, as far as that is even feasible? Is DNB maybe confusing risk monitoring with risk management?
Fiduciary management offers a solution for a dynamic investment policy. The aftermath of the credit crisis has started a discussion about the added value of asset liability management, and particularly about the apparently static assumptions with regard to investment risks and risk premiums.
One also wonders if and how the investment policy can be made dependent on the coverage ratio of the pension fund. In a lot of ALM studies a fairly rigid investment policy is assumed with fixed norms and bandwidths with regard to the asset allocation.
This is contrary to the premium and indexation policy that in many cases is indeed dependent on the coverage ratio and the objectives of the pension fund. This question is even more interesting in view of the decreasing effectiveness of premium policy and the relatively small relevant role of indexation policy in an actual deflationary economic environment.
But the pitfall of a dynamic investment policy is the slide towards opportunistic tactical asset allocation or mechanic or procyclical investing - not to mention the system risks of portfolio insurance of similar non-linear solutions. Dynamic investment policy is, therefore, an unruly matter that demands common sense on the one hand, and in-depth analysis and discipline on the other hand.
If a pension fund wants to get a grip on it and be more 'in control', fiduciary management or integrated asset management would be the way to go, in my opinion.
The million-dollar question for the pension fund board is always the same: how does the investment policy help me to meet the pension fund objectives? That is often unclear, precisely because asset management and risk management are presented as two separate disciplines.
This schism should not be enlarged. It should be removed. Fiduciary management achieves the symbiosis of risk management and asset management, painting a clear picture. This approach allows the pension fund board to receive the correct reports, to ask the right questions and to take the correct decisions.
This is an abridged version of an article by Lodewijk van Pol, published in the upcoming March edition of IPE.