The subject of risk management is so very important at the moment that its seems such a pity that so few pension funds, and incidentally their advisers, really understand how to apply it.
I am therefore impressed by the current proposals of Sweden’s equivalent of the UK’s FSA, the Finansinspektionen (FI). It is not that the FI have necessarily got their proposals right for their new pension asset stress testing procedures which they call their ‘traffic light’ proposals but that they are carefully explaining their proposals and consulting (and hopefully listening) widely. The new rules may only apply to Swedish pension funds and insurance companies but pension funds in the rest of Europe, apart from Denmark who already have their own stress testing rules, would, I suggest, benefit from studying the proposals as a basis for introducing some realistic risk management techniques
The FI are in their second stage of consultation with current proposals issued in the middle of June just as the Swedish pension industry, indeed almost the whole of the Swedish business community, left on their summer holiday. The next draft of the proposals is expected on 19 September with a final draft later this year. The timetable is quite tight with the IORP (Institutions for Occupational Retirement Provisions) directive in force from 1 January 2006. Indeed the FI hopes to use Q1 asset numbers in an agreed traffic light system by the first quarter of 2006.
The traffic light system will be just a first step in the first step in the supervision of pension funds in Sweden. There are in fact many components of their future regulation which in addition to the traffic lights combines a realistic valuation of liabilities with the adoption for the first time in Sweden of the prudent person principle.
Throughout Europe we are seeing a move to mark to market asset pricing and realistic interest rate discounting of liabilities. However if the job is to be done properly it must also include realistic assumptions on mortality and administration costs.
The move to less quantitative investment rules is to be welcomed as with sensible stress testing and good risk management it should encourage sensible asset management and diversification.
FI’s supervision of the insurance sector and pension funds is apparently based upon its desire to ensure that companies and funds have the financial strength to fulfil their undertakings, that accurate and relevant information is available for policy holders and members and that the interests of policyholders are protected.
So for Swedes the question must be: will the proposed traffic light system work? The fear is that pension funds will be encouraged to simply swap equities for long bonds. The current proposals include many interesting features but changes are required. Mats Nyman, head of asset allocation research from Handelsbanken Capital Markets regards the current proposals as smarter but only somewhat kinder than the original proposals. Nyman still expects that Swedish pension funds will need to buy plenty of long bonds to reduce risk. Whether the Swedish National Debt Office will issue the
long bonds that
pension funds might well want to buy is another matter.
The really sensible change that the FI introduced with the latest traffic light proposal is to calculate total risk as the square root of the squares of the individual sector risks rather than the sum. It is a beginning of a realisation that with certain exceptions investment risks are usually not addititive. This is a real boost to proponents of the view that diversification of pension assets is important. The FI’s exceptions to the rule that there is independence between asset classes are domestic and foreign interest rates and equity prices and exchange rates.
With this proposal a fund would generally benefit from as wide a spread of assets as possible although clearly a large investment in Swedish government bonds (what the FI regard as the lowest risk asset) will provide the highest benefit. Funds with low free reserves will have little choice but to purchase more bonds with a duration that matches their liabilities.
The proposed traffic light system measures: interest rate risk; equity risk; real estate risk; credit risk and exchange rate risk. From 2007 it will also measure insurance risk. The FI is proposing to use quite high risk parameters for equities and real estate. It seems not to be interested in standard volatility or the long term. I would guess that the equity risk parameters recall the equity market collapse of just a few years ago but does real estate really warrant the same risk parameters as equity.
One of the strangest tests concerns foreign equities. The FI appears to have concluded that equities have no currency risk and any fund that hedges its foreign equities has to separately test the hedge. The result is, as Nyman points out, that some investors may end up being short foreign currency in the stress test, even if they are really fully hedged.
One area of real uncertainly concerns sanctions. A fund with poor free assets may well show yellow or even red lights in its test but the FI isn’t saying what will then happen apart from saying that such funds will be monitored. Let us hope we will be given clarification on this and the many other outstanding issues. It does however look reasonably hopeful for Swedish pension funds and very interesting for the rest of us.