Managing risk has shot to the top of the agenda for most pension funds this decade. While some capital erosion was unavoidable in the years of tumbling market values, trustees are demanding that everything be done to see that funds are better prepared the next time stocks take a dive.
The Unilever pension fund in Switzerland has dedicated mandates for its investment managers. Part of the discipline of risk management for the pension fund is therefore setting the asset allocation and the related benchmark for the investment managers, says Jeroen Katgert of Unilever.
“This role is done quarterly by our pension fund investment committee, supported by our investment controller and once every two years by a detailed asset liability study,” he says.
The exercise produces huge benefits for the fund and its members, he says. “Within the ranges of the eligible asset allocation the over-performance we achieve is more from the right allocation than from title selection from the managers. So reviewing the market trends and changing our asset allocation – within a range of 10% maximum change – accordingly does bring us benefits.”
The fund uses a consultant on risk management issues, but only as it requires one – not for every meeting, says Katgert.
And it is precisely in the risk management area that the Pension Fund for Danish Lawyers and Economists (JØP) has in increased its resources most significantly in the last year or so, says Henrik Franck, investment director of the fund, based in Copenhagen. Franck joined the fund a year ago and in that time, he says the number of staff employed in risk management has increased from zero to three people. The decline in financial markets over the last three years was definitely the catalyst to the fund’s move towards boosting its risk operations, he says. However, the department is more of a quantitative analysis department than purely a risk management one, as it assists in the strategic allocation decision making and everything relating to derivatives and performance reporting, says Franck. “We are making sure we have consistent allocations and appropriate allocations,” he says. The reporting function of the fund was also in need of upgrading. The fund’s authorities require a lot of control procedures and that is the responsibility of the new department. The exercise is not aimed at cutting risk within portfolios per se, but rather at clarifying where and why risk is taken and for what investment benefit. “In the past, our risk budgeting was not completely up to date and there is still room for improvement. But now we have much better risk control and a better understanding – both from our point of view and in order to give our governors more information.”
Ronan O’Connor, head of risk at the National Pensions Reserve Fund of Ireland, says it is important that the risk limits set are adhered to by fund managers. The commission which oversees the fund uses tracking error as a measure of the level of risk that they are prepared to tolerate.
The fund has risk systems in place for two purposes; first to make sure risk limits are adhered to and, second, to make sure the risk budget is used. The National Treasury Management Agency, which manages the NRPF, wants the managers it selects for its portfolios to make full use of their risk budgets, otherwise, it says, it will take them away.
The NRPF uses the Wilshire proprietary system to monitor risk. The agency, says O’Connor, looked at both the Wilshire and the Barra systems, but in the end, decided on the former. It is a sophisticated system, he says, which monitors down to the individual stock but also the whole portfolio.
The agency has three people working full-time in the area of risk management, says O’Connor. Only time will reveal the true benefits of the agency’s efforts into the area of risk. However, peace of mind has already been won. “We are certainly getting the benefit of knowing we are operating within our risk limits,” he says.
Claudio Gligo, executive officer at the Victoria-Volksbanken Pensionskassen in Austria, says the efforts made and resources used for risk management at his fund have been well worth it. The investment policy framework of the fund is based on a return objective, which has to be consistent with a risk objective. The return objective incorporates the minimum required return, while the risk objective includes the maximum accepted shortfall of meeting this return.

It is not fixed absolutely. Over time, as the risk tolerance of the fund varies, so the return target for pre-defined periods is flexible. Any change in the risk tolerance has a direct effect on the risk profile, and thus the composition of the portfolio. The fund uses automated systems which monitor portfolios, ensuring they are within their pre-defined limits.
The fund uses a risk management tool which helps to identify the current risk profile in conjunction with the liability profile of the fund. It makes daily calculations, ensuring compliance with the fund’s risk tolerance. The tool, says the fund, has been a great success so far. It is set up using risk/return estimates for each asset class and the correlations between the classes. Every day, results are matched with the current asset allocation and each deviation from the pre-defined limits is highlighted and triggers a change in the asset allocation structure.
Portfolio managers are required to adapt immediately if there is any violation of the risk objectives, and a separate tool has been developed which lets portfolio managers quantify the risk impact of changing an asset class allocation or security.
The risk management model allows portfolio managers to know their risk and risk budget on a daily basis, and see the impact of any management decisions before they have taken them.
Victoria-Volksbanken has used this risk management approach for the last two years. No outside consultants or advisers were used in setting up the system, says Gligo — the fund established and built it up internally.
Again, one of the primary motivators for strengthening risk management within the fund’s operations has been the slump in capital values over the last few years. “Of course it has become more important since the market has not done so well,” he says.
Ilmarinen Mutual Pensions Insurance Company in Finland also measures absolute risk by using a modified version of value-at-risk, while it calculates relative risk by tracking error, beta and absolute risk volatility. But, it says, measuring risk for derivates is different. Ilmarinen has recently added derivatives to its portfolios, and now employs two dedicated derivatives experts in its risk control and middle office teams.
Spain’s Fonditel Pensiones EGFP evaluates its funds daily at market prices according to VAR methodology. Each plan has its volatility levels set according to its investments before these are actually made. This, too, is done on a daily basis, but adjusted weekly. The current level of VAR varies between two and 3.5% depending on the plan it relates to.
But the strict nature of the risk controls that some pension funds have adopted since the market collapse at the start of the decade have been counterproductive, says one pension fund manager. Funds have been closing the stable door after the horse has bolted, shunning risk at the very point where they should have been taking it on, he says.
Pension fund managers at funds that were lucky enough to keep losses relatively light during the market slump now have enough credibility with trustees to be able to take a pragmatic approach to risk management, rather than be hemmed in by over-tight risk controls. This allows them to be more nimble in responding to, for example, last year’s market upswing.
“The important point is that trustees work with the investment manager to develop policy which responds to the liability side of the scheme,” the pension fund manager says.