Risky business

In an increasingly complex investment world, risk management has become a critical issue for pension funds. Over the last few years, regulatory initiatives, better funding and a focus on liability matching has helped pension funds get to grips with their risk budgets. Still, say observers, current market conditions have revealed that there is more to be done.

Across Europe, pension schemes have developed risk models that include liabilities. "There is an increasing awareness and management of a broader range of risks than has been traditionally considered by pension schemes," says Steve Auckett, a financial solutions product specialist at Insight Investments. "When people talk about risk, they talk about negatives, but its more about understanding risk in relation to liabilities and removing the risks that you don't think will be rewarded."

An increase in funding levels has certainly helped. Greenwich Associates' 2007 Continental European Investment Management Study reveals that the average ratio of assets to liabilities of pension plans increased to 118% in 2007, and the proportion of pensions considered seriously under-funded fell to a multi-year low. This contrasts with 2003 figures, when pension funds could cover only 93% of their liabilities.

Now, says Greenwich, funds have the opportunity to reduce the risk profiles of their portfolios and match them closer to their liabilities. Some 30% of continental institutions are now using some form of asset-liability matching strategy in their portfolios and 15% report using liability driven investment approaches, 28% are using absolute return strategies for a portion of their assets and 20% have implemented hedging overlay strategies to actively manage specific risks such as currency exposure.

"For a few years pension funds were so under-funded that their options were limited," says Mark Azzopardi, head of insurance and pensions and BNP Paribas Asset Management. "Now, being better funded, they are being more strategic about the decisions they are making. Our view is that a lot more will happen in the risk management side than we have seen in the last few years."


Pension funds have for the most part moved away from the asset class mismatch born out of 70% and 80% equity exposures, although some consultants argue that many still have too high an exposure at around 60%. "It just doesn't stack up when you're looking at the level of risk," says one. The more sophisticated schemes are looking at options as a way of managing equity exposure. As far as derivative instruments are concerned, however, most are focusing on interest and inflation products to mitigate risks.

"The easiest place to start with is interest rate and inflation rate risk," explains Paul Trickett, European head of investment consulting at Watson Wyatt. "Hedging has become almost so mainstream that there is a vast amount of interest in trying to manage wanted and unwanted interest rate risk."

Managing interest and inflation risk has meant the value of over-the-counter (OTC) transactions completed by Watson Wyatt in 2007 almost doubled to reach around £35bn (€46bn), as pension funds use interest rate and inflation swaps. According to the firm, a typical £500m swap executed around June last year would have reduced the financial impact of recent interest rate falls by around £40m.

In 2006, Watson Wyatt's structured products team advised on £13.7bn of executed transactions with banks, of which £12.4bn related to managing interest rate risk, with inflation and interest rate swaps and swaptions typically being used. This was almost double the figure of the year before.

Recently, however, the credit crisis delayed the execution of derivatives-based liability hedging, with ISDA agreements and documentation required to execute transactions taking longer to process because "they contain more onerous legal conditions than in the past and there is a general mood of risk aversion among banks".

Claus Jorgenson, head of equities at PKA, the Danish grouping of eight schemes that invest collectively, says it has been helped by higher interest rates. "That is the main risk for us," he says. "We are continuously developing our risk models and interest rate is the main part of that." The scheme has also completed a project on inflation risk which looked at the extent that assets were linked to inflation. "Some of the assets that we are considering increasing our allocation to have very good exposure to inflation, such as infrastructure, index-linked bonds, and forestry, which is a very good hedge on our inflation risk."

However, some critics point out that there can be too much focus on removing risk. "Removing unrewarded risk is clearly a sensible thing to do," says Auckett. "Why take risk unless you're going to benefit from it? But removing all your inflation or interest rate or equity risk is not necessarily always the right thing for pension funds, because the risks that are embedded in some of those decisions are there because they will hopefully be rewarded.

He argues that the cost of hedging on a long-term basis may still be expensive for many schemes, and not worth it in the long run.

Bart Heenk, managing director of SEI Investments in the Netherlands, agrees. "Too many pension funds are concerned about interest rate risk and equity risk. In my view that is focusing on the wrong issues. If pension funds cannot bear interest rate risk or equity risk they are in the wrong business and shouldn't be a pension fund." He argues that interest rate is easy to manage because "it's a liquid top market".

Managing inflation through swaps is more problematic because "there aren't enough instruments around to manage inflation risk properly, at least in terms of index-linked bonds or direct inflation-linked swaps," says Heenk. "If you're a large pension fund and you want to hedge your inflation risk, you'd have trouble doing it."


The recent credit crisis has shone a negative light on highly structured, leveraged products. "There are operational risk issues which arise from going into asset classes which are not mark to market," explains Amin Rajan, chief executive of think tank CREATE Research. "The real problem with the sub-prime crisis was that risk was sliced and diced and packaged, and the valuation of these instruments was done by the packagers themselves. These instruments have been sold by reputable investment banks and rating agencies. People with long memories will remember that you do not go into anything new without detailed due diligence. Every time someone talks about innovation there is something fishy there. Often it is just about fleecing the clients," he argues.

However, some participants believe that structured products will become mainstream in the long term. Philippe Carrel, executive vice-president and global head of business development for Reuters Trade and Risk Management, argues that everyone will have to consider getting involved in structured products at some point.

"New retirees will not behave like our parents used to," he argues. "Our parents had equity and pensions when they retired. They were not up to the neck in debt. They didn't own several pieces of real estate and run on five to six credit cards on maximum credit."

Carrel believes that risk will be modelled to performance, and that every aspect of performance will be risk weighted. "Moving forward, pension funds will have to get someone to invent a precise risk to payoff investment type product. Every product will have to have some form of capital protection, and some leverage effect, some portability and some convertibility. Pension funds will have to re-invent themselves five to 10 years from now," he says.

Unsurprisingly, not everybody agrees. "Structured products are really profit generators for investment banks. The alpha that may be produced is getting eaten by the structuring firm," says Marc Gross, regional director for Riskdata in London.

Gross argues that pension funds need to spend more time focusing on market risk. "There are a number of issues here. One is the breakdown of total risk into its components, which are systematic and non-systematic risk. It is important to have a sophisticated, analytic approach, particularly when you start to add alternative investments, because many of these sources of risk are either not immediately obvious, or behave like options."

Many critics agree that pension funds are in danger of ignoring market risk and oversimplifying liability issues. Fixed income, it is argued, has become too important in liability matching, with the Boots pension scheme being the often quoted example. Boots raised eyebrows when a few years ago it decided it couldn't take on any more risk and switched from equities to fixed income. But two years later, markets had risen 40% and the fund had lost out.

It is one of many reasons that Austria's APK Pensionkasse chose to go for an absolute return approach. The fund, which is an independent multi-employer scheme that runs 13 different plans, has been using derivatives for several years. It helps that in Austria pension liabilities are not discounted at market rates, but at fixed discount rates, making asset liability not as effective an approach.


Increasingly, pension schemes are turning to alternatives to match assets to liabilities. "Pension funds are diversifying away to try and remove their historical biases," says David Brierwood, chief operating officer of MSCI Barra. "One thing we are seeing is the wholesale adoption of alternatives, and thinking about it from a quantitative framework. How do you incorporate the risk return characteristics of real estate into the portfolio, for example?"

However, alternatives come with their own risk concerns. "You have to understand what type of factors are driving your risk," explains Olivier Le Marois, chief executive of Riskdata. "To use positional transparency in hedge funds, collecting the positions and trying to aggregate them just doesn't work. The reason why investors are surprised by the behaviour of hedge funds is that they are just analysing the portfolio rather than the dynamic behaviour of the manager," he argues.

Software providers have jumped on the opportunity, arguing that pension funds can greatly benefit from their expertise. Ilmarinen in Finland, for example, has implemented a risk budgeting application from New York-based provider RiskMetrics. Illmarinen is using RiskMetric's application on an application service provider basis. RiskMetrics runs the software at its site in London and Ilmarinen transmits its portfolio data to the application and receives reports back online. This is cheaper than installing the software in-house.

And ABP, the Dutch scheme which won IPE's Silver Award for Best Public Pension Fund as a result of the effectiveness of its own in-house risk management tool, has used third-party providers like Barra when it has needed support.

While other pension funds adopted the Dutch regulator's standardised solvency test, ABP has developed its own model, which can also handle illiquid assets such as hedge funds, private equity, and infrastructure, alongside traditional risk factors such as interest rates, credit, stocks, currency, and inflation.

In addition, it differentiates between ABP's liability-hedging portfolio and risk-optimising portfolios. The model is certified by the Dutch regulator for the solvency test in the financial assessment framework. It is also used for ABP's fair value risk profile and ex-ante risk management on a one year horizon.

While pension funds have much to pat themselves on the back for, consultants say there is still room for improvement. "One of the things that routinely comes up is that there is a long time between the start of a discussion about risk and any potential action," says David Fogarty, a principal at Mercer Investment Consulting.

He says it is a governance issue. There is a danger that trustees, with limited time, will take out the risks they understand and replace them with ones they don't. "It's not necessarily about size. It's about the culture of the organisation and the qualities of individual trustees." Risk management, he suggests, can only develop as fast as governance can.

"Things are moving in the right direction. It's just a question of speed," he says.

Longevity risk

or pension fund managers, the fact that people are living longer is not all good news. With annuities costing more, insurers demanding more information and raising prices, longevity risk has become a serious issue.

"The cost effective management of longevity risk is the big prize out there, if someone can devise it," says Paul Trickett, European head of investment consulting at Watson Wyatt.

One of the problems is that there is no effective mortality swaps market at the moment, and mortality calculations vary greatly. Cass Business School's study, Mortality Assumptions Used in the Calculation of Pensions Liabilities in the EU, revealed vast differences in how companies in different European countries measure life expectancy, leading to confusion over company pension liabilities. Banking group UBS, for example, calculated that FTSE 100 companies have a combined deficit of more than £40bn. If this pension liability were to be calculated using German mortality tables, the deficit would become a £3bn surplus - a difference of £43bn. Using Danish mortality assumptions this surplus increases to £30bn but using French mortality assumptions the £40bn deficit becomes a £63bn deficit.

It is one of the reasons that BNP Paribas's longevity bond, launched in 2004, failed to take off. Some pension funds said the bond was problematic because it made assumptions about the overall population, rather than the population of a specific scheme, which could be vastly different.

Mark Azzopardi, head of insurance and pensions at BNP Paribas, believes the product was simply ahead of its time. "The potential size of the longevity market is massive. It's going to take more than one bond to solve the industry's problems."

Earlier this year, JPMorgan took the next important step in development, with the creation of its LifeMetrics Index, designed to benchmark and trade longevity risk. The index incorporates historical and current statistics on mortality rates and life expectancy across genders, ages and nationalities. It is initially available in the US, England and Wales, although the firm intends to introduce similar indices for other countries. "We believe this index will facilitate the development of a market in tradable longevity risk," said the firm's Patrick Edsparr.

Critics point out that until mortality information improves, pension funds will have to wait a long time to mitigate longevity risk. JPMorgan's LifeMetrics platform has been developed with advisors Watson Wyatt in the UK and US, and with the Pensions Institute at Cass Business School, which also provides software to model current exposure and forecast future exposure.

Sponsor risk

hen UK pension buyout company Pension Corporation made a bid for the telecoms firm Telent's £3bn pension scheme last year, it could hardly have predicted what would happen. Under new regulations, the Pensions Regulator flexed its muscles and appointed three independent trustees to Telent. The decision came after the fund's existing trustees said they feared the company would dip into the pension scheme's £500m escrow account. The appointment almost caused the entire deal to fall apart.

It showed how seriously the government, and trustees, have taken the issue of sponsor risk.

"We've seen sponsor risk emerge quite dramatically in the last couple of years as a serious issue," explains John Gillies, director of investment strategy at Russell. "In the case of Telent, trustees thought the security they had behind the fund was being taken away. This is a theme we'll see going forward, with funds being very zealous about the security they currently enjoy and any attempts to take it away."

Under new regulations, trustees have a fiduciary duty to make a sponsor risk assessment. "You have to prove as a trustee board that you have gone through that thought process, and rightly so." says Georg Inderst, and independent trustee and consultant. "What the Pensions Regulator is saying is that you can't make sensible decisions about your funding policy if you don't have a clear assessment of your sponsor's risk."

Consultants are now offering sponsor risk assessments as part of their service offerings, as are many accountants and rating agencies. "Trustees don't necessarily have to take external advice, but the bigger ones do because that makes them less vulnerable. Still, it's another cost factor, another governance issue, and something else on the agenda to deal with," says Inderst.

For the moment, however, trustees will have to do the hard work themselves. "I think the idiosyncratic risk of each sponsoring employer is something we're going to see more work done on in the coming years. At the moment there is no ready formula for defining how much of a cushion one should have for a given level of security, or how strong a particular covenant is," explains Gillies.

Watson Wyatt's three principles of risk budgeting

1 Investors should diversify their sources of risk as much as possible

If a pension fund spends all its risk in one place, it is taking a big chance that that risk will not be rewarded. The most glaring example lies in the equity markets, which have experienced tremendous volatility, and where investors have not been rewarded for their risk. Because market conditions can and do change, Watson Wyatt recommends that investors reassess their risk budgets each year.


2 Investors should take risk only where it is likely to be rewarded

Unless risk and return are considered within the right framework, it can often be unclear just how much risk and return an investment is contributing


3 If an investor must take a specified amount of risk, they should take it where the expected return is the highest

The two most useful measures of risk are tracking error and value-at-risk. Using these measures, investors can analyse the expected return for each unit of risk that is being spent and compare strategies and assets classes to arrive at an optimal portfolio.


Source: What is Risk Budgeting? Watson Wyatt Briefing Note August 2007


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