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Sponsors to push for increased VaR focus

Scheme sponsors are likely to begin pushing for increased focus on pensions risk management, according to the UK-based consultancy firm Redington Partners, in the wake of increasing regulatory focus on asset risk factors such as ‘value-at-risk' (VaR).

Robert Gardner, co-founder and partner at Redington Partners, told IPE that sponsors are likely to want to get more involved in the way the corporate pension fund is run if the UK Accounting Standards Board (ASB) implements changes requiring firms to report their value-at-risk within their balance sheets.

Pension funds usually seek an optimum of 95% VaR over a one-year period, representing a one in 20 confidence level, according to Redington, and calculate this by assessing the potential correlation risk attributed to each risk type - for example equity, currency, interest rate market risk, credit, inflation and longevity risk - and the effects of diversification within the overall portfolio.

But he suggests pension funds may need to divert resources away from asset management and place increased in-house focus on ensuring the asset allocation and risk strategies of the pension fund are sufficiently stress-tested on a regular basis, especially in the wake of the ongoing credit crisis and increasing regulatory scrutiny on the risk value of pension assets.

More specifically, he noted the Pension Protection Fund recently suggested it would prefer to move towards a risk-based levy, which would require pension funds to disclose their VaR assessment and pay a levy to the lifeboat fund according to that.

This would mean a pension fund with 19% VaR, for example, might be required to pay a higher levy than a pension fund with 9% VaR.

The result may therefore be employers and pension fund sponsors will expect to become more involved in the level of the VaR if accounting rules change to require their disclosure on balance sheets - a move which should be welcomed in some respects, suggests Gardner, if it means employers pay more attention to the importance of the pension fund.

That said, increased focus on VaR as one part of an overall ongoing risk assessment means pension funds may need to divert assets and attention away from asset management.

"Pension funds are spending a lot on asset management, but they need to be diverting resources to risk management in-house. They spend a lot of money on bond managers and hedge fund managers, but there needs to be an allocation there to risk management. A lot of sponsors and CFOs are very sensitive to the volatility on their balance sheet," said Gardner.

Some pension funds have tried to tackle the asset liability management of the scheme over the last few years by moving towards liability-driven investment (LDI). However, Redington has found most pension funds are still facing inflationary pressures on their VaR and risk profiling, because LDI only addressees the interest rate risk in circumstances where inflationary moves are effectively correlated to interest rates activity.

This risk is now being shown to be difficult to address as sensitivity analysis - revealing factors not considered when looking at VaR on its own - reveals UK long-term bond rates have dropped over the last year but 30 year inflation has risen from 3.2% to 3.8% within the 12 months, creating an additional risk premium to UK pension funds of £50bn (€63bn).

The practice of regularly assessing VaR along with other sensitivity analyses is already being widely adopted elsewhere in Europe. The Swedish regulator, Finansinpektionen, requires pension funds and insurance companies to disclose their VaR assessment.

At the same time however, Gardner's business partner, Dawid Konotey-Ahulu believes it is not just pension funds which are likely to see a power shift in light of the recent credit crisis pressures, as he believes there will undoubtedly have been a shift in power among asset management houses and investment banks towards the risk management teams.

"The governance and relative strength of risk officers and the organisational strength of risk management has gone up," said Konotey-Ahulu.

"A successful fund manager could in the past have shouted louder than the risk officer, but that has changed. We will have seen a shift in the balance of power between the risk control function and the people who take risks."

 

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