Traffic light system sends out the right signals
In an increasingly complex and evolving German pension fund market, sustained yields and preservation of capital are essential. Given falling interest rates in the last few years, this is becoming an ever growing challenge. Germany’s Bayerische Versorgungskammer (BVK), the pensions management company that runs 12 independent public sector and doctors pensions schemes, which have different investment needs and savings structure, believes it has the answer.
“To reduce dependency on interest rate movements, we have developed a procedure for the schemes we look after that provides broad diversification of investments from both a risk and return perspective,” the firm says.
The procedure depends on several different factors. Firstly, it considers the risk budget that the schemes’ actuarial reviews have determined.
Then it attempts to match the liabilities to the markets to ascertain the optimum investment strategy a scheme will need to adopt. BVK says this will give the schemes, their actuaries and managers a clear picture of their risk/return ratio.
Next it measures the performance of each asset class and its constituent mandates against their benchmark.
Now it assesses the efficient use of risk budgets to forecast excess returns that does not infringe on the funded level of the schemes. Finally, it monitors risk on an ongoing basis to ensure optimum risk management.
Germany still has a relatively young funded pension scheme market by Anglo-Saxon or Dutch standards and pensions vehicles there still make use of other savings models. In addition to the growing number of fledgling capital funded-style schemes, there are the more traditional Pensionskassen pay-as-you-go plans and life insurance contracts. BVK says it had to take each type into account when it developed its risk/return measurement system. “This means the risk each of the funds we administer assumes is initially linked directly to the funding type it prefers and its actuarial assumptions,” it explains.
However, liabilities change constantly as the result of multiple factors and the next step is to assess risk over certain time periods in relation to asset liability studies. BVK says its uses a five-year investment horizon to determine the optimum risk budget for each scheme.
So for each pension fund, once the risk budget is determined, it is tested over a projected period of five years. BVK says it favours a Monte Carlo simulation model, using 1,000 different coherent capital market scenarios. It believes this is more than sufficient to highlight all possibilities of the scheme becoming under-funded or risk budgets being exceeded. “It also allows extensive return forecasts, for both liabilities cover and any excess,” BVK says.
If a scheme does not make full use of its risk budget, it has two options. It may simply increase its allocation to its equity portfolios at the expense of its fixed income and interest-bearing investments. Alternatively, it can re-allocate assets within the equity portfolios to mandates that offer better return potential but with higher risk.
Those schemes whose testing revealed they were at the absolute limit of their risk budgets were tested again to see if a more efficient use of risk could be achieved by supplementary tactical allocation. This essentially involves looking at the equity investments and seeing how well they correlate to the risk budget. Changing them to reflect the scheme’s risk tolerance should enable better use of the budgets overall, BVK believes.
The next step was drafting the optimum asset allocation for each of the 12 funds. First of all, BVK needed to establish the right combination of direct investments and investing though funds. The firm used a rigorous repetition model looking at the liabilities and matching them over and over again to the performance of different asset classes and investment funds. Once this fundamental part of the strategy is determined, BVK considers how much to allocate to each mandate within the direct investment portfolios and investment funds, taking into account the optimum risk budgets it has already established for the schemes and different investment classes.
The rigorous testing process means BVK has been able to establish the best possible asset mix and allocation policy for each of the schemes it administers. “This has led to a significant increase in the average cover for the entire period we tested,” says BVK.
But it doesn’t stop there. The asset allocation strategies are implemented for two years before they are subject to review. But they form the basis of an ongoing process that allows tactical planning to ensure the risk budgets are used to the full and the investments continue to work as expected in the interim years.
Thus the risk budgets of each BVK pension fund is checked every month and tactical asset allocation is adjusted accordingly. A ‘traffic light’ system checks whether particular values exceed or fall short and so require an increase or reduction in risk.
Highlights and achievements
BVK has developed a solid and efficient risk management model. Using extensive testing and analysis enables it to consider the individual investment and return needs of each of the 12 schemes it runs to ensure that they meet their obligations and cover their liabilities.
The ‘traffic light’ system sends out the right warning or go-ahead signals for tactical allocation to supplement the basic allocation strategies that have been carefully determined using actuarial reviews and investment performance records.
So tight is the model that BVK can pinpoint unrewarded or excessive risk or areas where the schemes can afford to be a touch less cautious. Controlling risk budgets is essential for any scheme, but BVK has devised a system that will make its running of 12 different schemes with different needs and basic structures that bit easier. Germany’s new dynamic pension fund market is still finding its feet and BVK is embracing the changes to ensure it remains at the helm.