Life is full of risk - a fact the European pensions industry feels acutely. A market crash and new, reality-check accounting standards have conspired to put risk management at the top of the agenda for sponsors and trustees. But there are many views on what really is the wisest way to deal with financial uncertainties.

European companies are far more worried about their pensions risk than their counterparts in the US or elsewhere, according to a study by Mercer Human Resource Consulting.

It found that 29% of organisations in the UK believed the risk posed by their pension plan was serious, and 24% of companies in Continental Europe felt the same way. But only 9% of US companies thought they were at great risk, and on average, only 16 % of companies in other countries, including Canada, Australia and New Zealand, thought their pension plan was a great risk.

"The attention that risk management receives has increased tremendously since the start of the millennium," says Theo Kocken, chief executive of Cardano Risk Management in the Netherlands.

Adverse market conditions have been a big reason behind this, he says, with pension funds having to suffer the fallout of slumps in equity prices and interest rates. Another major driver has been the new accounting standards brought in throughout Europe, he says. They have made pension funds put market valuations on their liabilities - making funding ratios more sensitive to interest rate changes.

New pension regulations, too, are forcing pension funds to pay more attention to the business of risk management, especially when it comes to managing and reducing the risks of a shortfall in the funding ratio, says Kocken.

Regulations in Denmark, Netherlands and Sweden are very specific on the quantitative requirements for pension funds both to measure and control their risks, he says.

"They focus on limiting the probability of a shortfall in funding, which has seriously increased the level of professional risk management," he says. Similar measures have been announced in the UK, but these are more qualitative, he says.

"Together with accounting changes, this has induced British pension funds to improve their risk measurement and gradually they are turning towards more actively hedging their risks and optimising risk return," he says.

It is true that pension funds are paying more attention to short-term risk management, says Guus Boender, director at Dutch consultancy ORTEC. But risk management itself is of course, not new; Dutch pension funds have been doing strategic risk management for 25 years, he says.

However, funds are turning a keener eye to how risks could evolve in the next month or year, he says, adding that the new pensions law in the Netherlands is one of the reasons behind this shift. Under the new legislation, pension funds can apply for an approved internal risk model, which has to include shorter term risks, he says.

Pension funds also have their own ‘policy ladders', he says, which specify different levels of funding ratio and set out what action they intend to take at each level, eg, how their investment strategy will be at higher levels of funding.

"These policy ladders are becoming more and more explicit," says Boender. "They want to know as closely as possible what the probabilities are that they will end this year or the next with a certain funding ratio," he says.

Dutch funds are less free than in the past to deviate from certain funding ratios, and there are consequences if they do. If, for example, there is a high probability that they will finish the year with a funding ratio of 120, then they can fully index benefits, he says. If the fund were to index pensions fully when funded ratio fell below 120%, the regulator would make ‘comments', says Boender.

In the UK, at least, there may have been more talk than action over risk management. "It's true that risk management has gradually come in, but at nothing like the pace that pundits expected," says Andrew Barrie of Edinburgh-based financial risk consultancy Barrie & Hibbert.

"It has come into focus for the larger funds, but for the smaller ones, it has been more difficult because they don't have the resources," he says.

And the picture changes depending on the sponsor's line of business. "What we've seen in the UK, is that the life insurers, fund managers and banks have been much quicker at managing risks than the industrials," says Barrie. "They main reason is that they understand investment risk - it is core to their business."

Apart from size of company and its business sector, the third main catalyst for a pension scheme implementing a risk management strategy was corporate actions. "It has now become de rigeur that pension fund risk is looked at in takeover bids," he says.

Another factor driving risk-management activity at pension funds is market developments that have facilitated it, according to Kocken. There are now liquid markets for interest rate swaps and swaptions, he says, and, increasingly, inflation-linked swaps.

However, James Clunie, a pension trustee and senior lecturer in finance at the University of Edinburgh, is sceptical about the way some risk-reducing products are offered by banks. "There is a big marketing push by firms that want to sell swaps," he says. "I think there is a lot of vested interest in promoting inflation swaps," he says.

The asymmetry between the level of knowledge of those buying such products and those selling them that is a problem, says Clunie.

"Trustees have to be very careful… to deal only in products they are knowledgeable about, and that same time raise their own knowledge," he says. The skills composition of trustee boards should be well-balanced, he says, with people from the academic side as well as the practitioner side included.

Clunie says that for the majority of pension funds, the biggest risk is assets versus liabilities. "Longevity risk is a difficult risk for trustees to manage" he says, "because you are in the hands of the actuaries." But inflation risk is easier to estimate and manage given the variety of tools now available, he says.

Which particular risk looms largest for a pension fund varies from fund to fund, Clunie says. "It depends where you are at, how your assets compare with liabilities and what the contract is that you have with your sponsor," he says.

Barrie says the two dominant risks facing DB schemes in the UK are real interest rate risk and equity risk, and neither can be looked at in isolation. "They both dwarf longevity risk and credit risk," he says.

Plan-sponsor risk varies widely from case to case. "If a scheme has a weak covenant and a low funding ratio, then that is clearly a greater risk than the others," he says.

Sponsor risk has always been there - changes in accounting standards, and the poor performance of markets in the early years of the decade have simply made it more visual, says Barrie. "A lot of risks were disguised in the 1990s," he says.

While trustees are focused on the long-term ability of a pension fund to meet its liabilities, sponsors are now much more interested in the short-term risks they face, he says.

In the UK, where pension funds tend to have very high allocations to equity, investment risks still dominate scheme risks in general, says Kocken. But the picture was different for most countries with DB schemes in Europe. Here, interest rate risk is significant as well, because of the interest-rate related liability value, he says.

"In the Netherlands, the pension funds are exposed to a mix of nominal interest risk and real interest rate risk, due to the conditionally indexed liabilities," he says. "In the UK the interest rate risk is mainly real interest rate exposure - so inflation linked; in Scandinavia indexation is often absent, because of bonus systems, and the interest-rate exposure is purely nominal."

Right now, one of the biggest risks for pension funds in the Netherlands is nominal interest rate risk, says Boender, because fair value in the new pensions law is defined in terms of nominal, rather than real, interest rates.

Pension funds can remove this risk from the balance sheet by using swaps, says Boender. According to reports in the press, a third of Dutch pension funds are doing just that, but a third are not, he says.

But funds are in a very difficult situation, says Boender, because while the steering mechanism of pension funds is defined in real terms, the lower limit is defined in nominal terms. "It is extremely difficult to manage that, because a decision that is good for nominal interest rates can be a bad one for real rates, and vice versa," he says.

Because of this, funds should evaluate the long-term consequences of swaps and other short investment decisions, he says, and, conversely, evaluate short-term consequences of long-term investment decisions.

As trustee of the £300m Church of Scotland pension fund, Clunie says he and his fellow trustees set up a dedicated Risk Group last year. As a tool, the group created a risk matrix which took into account the likelihood and severity, and thus importance, of various risks the fund faced, he says.

Pension funds need to look at risk in general, regulatory risk, the risk of fund failure, the risk of lack of knowledge of trustees, back office risk, stock lending risk and others, he says. The Church of Scotland pension fund is not the only fund in the not-for-profit sector to have become more rigorous about managing risks.

"A lot of not-for-profit organisations have really raised their game in the last few years," says Clunie. "There is more of a focus on best practices, and it is no longer the case that people meet once or twice a quarter and tick boxes."


There is a clean, mathematical ring to the phrase ‘risk budgeting'; the two words promise to catch danger and lock it into a steel spreadsheet. But is it really the essential way for pension funds to manage their risks?

Yes, says Kocken. "Risk budgeting is extremely important," he says, "since pension funds are only able to take limited amounts of risks and should ensure they take the maximum return out of it."

If they do not, he warns, the pension scheme will have to write off parts of the liabilities - and even close the fund entirely. So risk budgeting is the key to the sustainability of risk sharing pension funds - DB and collective DC.

The term risk budgeting has been used loosely to refer to various approaches used by investors to construct portfolios with specific risk/return characteristics, but for pension funds, it usually means an assessment of the amount of risk to be employed, and where that risk is applied.

Edinburgh consultancy Barrie & Hibbert undertakes quite a lot of work on risk budgeting, says Andrew Barrie."The really hard part is putting in place a practical risk budgeting framework," he says.

Few schemes are starting with a blank slate; there are usually positions that have been inherited, and the pension fund has to be able to see where they are at any one point, at what it all means for the risk budget, he says.

"Definitely, there is not optimal use of the risk budget," says Barrie. "It is not a case of whether, but how they are using it."

Clunie notes that opinions differ strongly on the issue of risk budgeting. "It's an approach to risk," he says. "You can make use of it but it's not the only way to think about risk"

Risk can be defined in many different ways, he says. There is no overall agreement between trustees, accountants and managers in the pensions industry, he says.

"It all depends on what is risky to you; for some people it is the volatility of returns, for others it is the difference between assets and liabilities, while for others it is the risk of choosing the wrong manager," he says, adding: "I don't think there is a single right way."

The term ‘risk budgeting' is not very clearly defined, says Boender. But in its strict definition, he says he is in favour of it.

"Pension funds should decide how much risk they have, in terms of indexation risk, sponsor risk and the amount of risk they can take by temporarily accepting underfunding," he says. Those three risks should be in accordance with the amount of risk they have in their investments, he says.

Dealing with pension fund risk was not a matter of taking steps to avoid all uncertainty. "For quite a few pension funds, it's not just about battening down all the risks," says Barrie. "If they want to do that, then a buyout is the answer. Instead, they need to manage their way out of it. They need to think about what risks they can run, and the benefits they get out of them," he says.

Some risks, such as real interest rate risk, would be seen as unrewarded risk, but equity risk can be managed through diversification. "We are starting to see greater employment of reward assets, with pension funds looking at a lot of other sources, such as property, credit and hedge funds.

"On the other side, we are starting to see funds look toward managing the real interest rate risk. That is a risk which can be managed, although this can lead to quite difficult technical situations in cases where there are not enough assets.

"Pension funds should not minimise their risks, but optimise their risk-return," says Kocken. By protecting parts of their equities investment with equity options and reducing part of the interest rate and inflation risks with nominal swaps, swaptions and inflation swaps, the risks can be steered so that every unit of risk implies a maximum amount of return.

"This avoids unnecessary risks but still leaves room for sufficient return potential," he says, adding that it is precisely the strategy that many pension funds have been implementing in the last few years.

While real risk may be hard to quantify, some charities in the UK are at least interested in lowering their perceived risk so that their pension funds have to pay less into the Pension Protection Fund PPF), says Clunie.

This can be done by using sponsor-owned assets as backing for the fund, or else by simply injecting more money into the pension fund, he says. As an example, assets such as property might be under-valued on the sponsor's balance sheet - bringing this to the attention of the PPF could be worthwhile.