Risk – beyond the numbers
Risk can always be reduced to a set of numbers. But trustees play an important role both in setting the right risk objectives and in interpreting the signals, writes Gail Moss
The financial crisis brought home in harsh relief just how exposed pension funds can be to global economic shocks and associated market downturns.
Aside from the risk of sharp contractions in equity valuations, investors have also had to get to grips with long-term low interest rates, as well as the risk of sovereign default during the euro-zone crisis, and even the potential failure of the single currency.
Now sluggish post-recession growth, low inflation, geopolitical instability and increasing life expectancy are among the challenges faced by pension fund trustees and board members. This is alongside the risk of underfunding and sponsor-associated risks, and changing national and international regulation.
“As part of a robust governance structure, risk managers and investment officers are faced with an exponentially increasing number of measures to monitor,” Ian Castledine, global head of investment risk and compliance products for Northern Trust, says. “Our recent survey shows 36% of our clients consider policy and compliance monitoring to be the most time-consuming portion of the investment process, with 82% of clients expecting to have to grow their internal resources to keep up with governance and compliance requirements.”
At a glance
• Pension fund trustees have a wide array of risk parameters to monitor and make sense of.
• Funds should manage risk within a strong governance framework that clearly lays out investment objectives and the entities responsible for each decision and action.
• A wide variety of risk management tools, many online, are now available to funds.
• But there is no substitute for good, qualitative judgement from a well constituted board of trustees.
But there are well-developed strategies and tools to help boards to face this growing challenge. Of crucial importance for defined benefit funds is the funding level. Other parameters could include the fund’s progress against any pre-agreed, longer-term ‘journey plan’ to achieve full funding, as well as funding level triggers relating to de-risking or LDI strategies.
Another is the expected portfolio return and whether the fund will generate returns in line with pre-determined objectives. Boards and management also need to monitor portfolio risk to ensure this is within an acceptable range. Some large funds will be in a position to create a dedicated risk committee but for most the responsibility for oversight of various risk metrics will be divided between the investment committee and the trustees.
Nicklas Fahlström, investment consultant, at Wassum in Stockholm points out that while it is easy to take de-risking measures, funds have to be willing to take some risk to have a chance of meeting their return targets. “They should look more closely at what risk they are prepared to take on,” he says.
Value-at-risk, hedge ratios and the fund’s liquidity position are also important. Boards and trustees should ensure that ratios are within the investment policy guidelines. In most cases the board or trustees formally set investment objectives. But there will also be input from a number of other sources, such as investment officers, portfolio managers, consultants, and fiduciary managers.
How BBVA Fondo de Pensiones sees investment risk
Risk management lies at the heart of investment strategy for BBVA Fondo de Pensiones (BBVAFP), the pension fund for Spain’s second-biggest bank, the Banco Bilbao Vizcaya Argentaria. The bank says its main focus is to make the most of the risk budget, so its approach is not to change the investment philosophy or the risk level of the portfolio.
“We are not becoming yield searchers or chasing the market, we maintain our risk budget but with a specific allocation for the actual interest rate environment,” says Fernando Aguado, CIO for institutional asset allocation at BBVAFP.
Over the past few years the pension fund has developed its investment policy by introducing new asset classes, increasing diversification and establishing an investment philosophy to match short-term performance and long-term needs.
The changes have been carried out with the help and advice of the fund’s control commission.
By far the lion’s share of the fund’s €2.56bn portfolio is invested in government bonds (60%), with 16% in corporate bonds, and 21% in equities. The latter is made up 14% Europe, 5% US and 2% Japan.
The fund returned 7.75% over the 12 months to 30 September 2014, giving an annualised return of 7.87% for the three years to that date.
Its most strongly-held conviction trades over the year, compared with neutral exposure, have been to go long equities (mainly through options) and long credit (mainly high-yield but also low investment grade).
Aguado says: “We are concerned about future issues in credit market liquidity, so we favour liquid and plain vanilla instruments.” BBVAFP has also gone short on commodities, emerging equities and euro exposure. And it has shortened its government bond duration, mainly in Europe, but excepting peripherals.
Aguado says: “All these positions are performing positively in nominal terms, but obviously the decision to shorten [government bond] duration is not adding value. It is hard to find value in fixed-income assets without increasing the portfolio’s risk profile.”
The fund is committed to protecting risk levels and also liquidity. One risk with fixed-income is, however, the status of regional government debt.
The fund is not pursuing a yield objective for the portfolio, but prefers to maintain an average weighting in national government debt, while avoiding regional debt.
Aguado says: “We believe in diversification as the most effective tool for making the most of risk. But this doesn’t mean allocating weightings to everything. You have to be sure that your investments suit your clients’ profile, and allocate the weightings carefully. There is no benefit beyond the maximum diversification point.”
BBVAPF has been working on this area with its clients – BBVA employees – for a long time, and will continue to work on it in the future as profiles change and new assets and investment opportunities appear.
Meanwhile, over the next 12 months, Aguado says it will be difficult to find value in a zero-interest-rate environment. “So we will probably have to be more active, using a greater proportion of the risk budget in relative-value trades,” he says.
Fahlström says that the sponsor company should also have input: “The sponsor has an interest in the pension fund’s long-term objectives, and although in practice the trustees or pension board set these, their members are appointed largely by the sponsor.”
Castledine says a governance framework should set out clearly-defined investment objectives and who the responsible parties are for each decision and action. “The trustees are then there to oversee that the decisions at each level are made to move the plan towards the overall objectives of the investment policy,” he says.
Steven Yang Yu, co-head of ALM and investment strategy at the London-based consultancy firm Redington, describes the process his firm uses to assist clients in establishing their own strategic objectives.
“We help clients translate their objectives into a return target, clearly explaining the risks they will likely be exposed to along the way. This is intended to help them articulate a clear risk budget, such as how much risk are they willing to take to meet their objectives.”
The firm then helps clients think through and incorporate any constraints that are specific to their situation, which will be factored into the high-level asset allocation.
Risk management systems normally incorporate triggers to alert management to potential problems requiring action.
The UK’s Merchant Navy Officers Pension Fund (MNOPF) outlines its objectives through a journey-plan framework.
Bob Hymas, chief financial officer at MNOPF, says: “The journey plan specifies the agreed combination of contributions and investment return – which are expected to achieve the objective – and therefore implies a gradual increase in funding level towards the fund’s target. Triggers are then used to ensure that the targeted level of return is dynamically adjusted if there is a material divergence from the central journey plan.”
Prepare to delegate
The balance of responsibilities between trustees and management is an important issue to address.
Trustees and boards usually have ultimate responsibility for investment decisions but in practice, there is often a certain degree of delegation to executive management, with policy guidelines set by the board. Assuming a reasonably flexible investment policy, this means that it should be easier to mitigate short-term risks and exploit market opportunities.
“The governance framework should clearly lay out where the decisions and responsibilities lie,” Castledine says. “It should be robust enough to help provide complete oversight across all the dimensions of the investment policy, including the risk budget and tolerances.
“At the same time, swift action may be needed to review manager performance or shift asset allocation, and the governance process has to be efficient enough to support this. Sometimes this may involve delegating decision making to management, or a shift to more frequent trustee meetings and investment reviews.”
The trustee board can also protect the fund against irregular action by management, by appointing a third-party adviser to management is keeping within any agreed constraints.
Many funds use pre-set triggers to de-risk. “Some pension funds were caught up in the Lehman crash of 2008, but traditional de-risking models didn’t work because all the markets were highly correlated,” says Fahlström. “The triggers weren’t activated early enough, and fell out of favour, but now with more sophisticated techniques, triggers are more popular again.”
Mårten Lindeborg, head of asset management at the Swedish buffer fund AP3, believes the increased use of triggers is because pension funds are taking on too much risk or because their financial status is weak. “Regulatory changes have also forced funds to implement trigger levels to de-risk, and it might also be easier to blame a trigger-model for de-risking if it shows it was incorrect,” he says.
But Hymas believes triggers as equally important in capturing situations where the fund can de-risk earlier because the risk needed to achieve the journey plan has markedly reduced. “These triggers ensure the fund is targeting a level of return consistent with its overall objectives, and allow it to swiftly take advantage of what may be short-term market opportunities,” he says.
A toolkit of risk
A wide range of de-risking tools is now available to pension funds, covering monitoring, risk systems and general reporting.
Monitoring tools provide an up-to-date picture of a fund’s investment position, including an overall view of the assets and liabilities, together and separately. They also analyse the scheme’s sensitivities to interest rate, inflation, credit and longevity changes.
These tools make complex data simpler to understand, and can provide updates on a daily rather than quarterly or triennial basis. They are usually inexpensive.
However, they can be less flexible than risk systems, and therefore usually appeal to a different user profile.
Risk systems can run risk scenarios and model their impact on the fund’s portfolio and funding level. They are usually flexible and users can tailor the data. The downside is that they can be expensive, and require technical knowledge to get the best out of them.
“By having information at their fingertips, trustees can shift the debate with consultants and other stakeholders from one about the numbers to one about strategies for dealing with risk,” says Matthew Seymour, managing director at RiskFirst, which provides risk analytics. “Not only does this save time, it should lead to better decisions, for the benefit of all parties.”
Different products have specific features. For instance, the iRIS monitoring system, developed by Redington, enables users to identify the sources and drivers of risk and return, allowing more informed decision making.
The MNOPF uses proprietary software from its delegated chief investment officer, Towers Watson, to estimate the funding level and the progress of the journey plan on a daily basis.
If a funding trigger is breached, e-mails are automatically sent out, allowing Towers Watson to act promptly to take advantage of opportunities to de-risk. Towers Watson also uses a range of tools to ensure that the fund’s key risks are assessed in a consistent framework and that inter-relationships are captured. These tools are also frequently used to check that the portfolio adheres to the investment guidelines defined by the trustee.
It is important to take into account the strengths and weaknesses of various tools. “Tools that are tuned for long-horizon forecasts are suited for asset allocation decisions and asset-liability strategy, but may not be as strong as other tools with shorter horizon models in highlighting manager style drift or credit risk analysis,” concludes Castledine.
And while various tools and systems can monitor risk, there is no substitute for the qualitative judgement of a serious, seasoned board of trustees well versed in the pitfalls and opportunities of the modern world of pension investment.