“When we understand that slide, we’ll have won the war.” General Stanley McChrystal is supposed to have said this in 2010 when commenting on a PowerPoint slide outlining the risks of the US army’s engagement in Afghanistan.
The entire slide, entitled ‘Afghan Stability/COIN Dynamics’, was taken up by a single diagram of extraordinary complexity. On it, 13 headings were coded using eight colours, with dozens of sub-heads and connecting lines.
Suffice to say, the complexity of the slide belied the fact that the military situation was impossible to simplify.
Last month, ahead of its annual Davos gathering, the World Economic Forum (WEF) published its now annual Global Risks Report. In it, survey respondents rated a high probability of occurrence to the risk of: severe income disparity, chronic fiscal imbalances, rising greenhouse gas emissions, water supply crises and the mismanagement of population ageing.
Respondents to the WEF risk survey were asked to pair the risks they thought were the most interconnected. Here, the most frequently cited vectors were religious fanaticism/terrorism, severe income disparity/backlash against globalisation, and global governance failure/systemic financial failure.
Pension funds need to allocate capital and manage risks between generations in a world where the only reliable guide is the past. And perceptions of risks, as expressed in the WEF survey, mostly extrapolate into the future the experience of the immediate past.
Accordingly, much post-crisis financial regulation has been backward-looking, seeking to redress past issues rather than making future asset bubbles less likely or seeking to incentivise asset allocation decisions that help contain climate change, for example.
In the traditional pension fund model, sound strategic asset allocation was meant to manage asset-class risks by means of a well-diversified portfolio of assets designed to capture a range of uncorrelated risk premia. Good institutional governance was meant to minimise risks that arise internally, and major external risks were largely disregarded in the analysis. Overall, a combination of actuarial science and a set of prudent assumptions was meant to ensure that the measurable risks of the member population on the liability side of the balance sheet was balanced with the harvesting of measurable risk premia that obeyed observable models.
It is right that institutional investors should look at all risks in a more holistic way. In particular they should assess the implications of some of our most serious environmental challenges. In the years that climate change has been a topic for serious debate, public sector pension funds have led the way in investing in climate change-related projects, such as alternative energy.
And there is potential for many other institutions to promote a sound and sophisticated understanding of profound global risks like climate change, particularly if they take their responsibilities seriously as intergenerational investors and managers of the associated risks. Some policy incentives, such as the opportunity to take a true long-term view, would not go amiss in the equation.
Yet there is one disruptive risk that is infrequently cited. This is the increasing focus on the short term by policy makers, and standard setters like the IASB, especially where underfunding is not permitted and pension fund deficits must be addressed immediately.
This narrow focus is likely to be the most disruptive issue to pension funds as they seek to balance the interests of generations through their asset allocation decisions.