Given the recent emphasis on transparency within the pension sector, Steven Polese, business development manager at KAS BANK, explains how trustees can ensure that risks are being effectively monitored and that assets are on track as well as highlighting those risks which may be lurking just under the surface…
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Over the past decade, pension funds here in the UK and across Europe have been hit by a double-whammy of rising longevity-related costs coupled with volatile investment returns.
In the Netherlands this resulted in around 65% of all pension funds in 2008-09 becoming officially underfunded (that is, at a funding ratio of less than 105% (non-index linked); the minimum as set by the Dutch central bank since 2013).
Consequently, many members’ pension rights were severely cut to bring funding levels back to the required level. As we know, many UK DB pension schemes have also been affected for the same reasons and are similarly underfunded.
The rewards are apparent for those schemes which undertake a thorough and constant risk-monitoring strategy”
Considering the economic and market headwinds which require navigation by pension funds over differing time horizons, it is little wonder that many trustees find the monitoring of risks to be fraught with complexity.
Nevertheless, the rewards are apparent for those schemes which undertake a thorough and constant risk-monitoring strategy; Ortec Finance, a specialist risk consultant, estimates that each 1% in additional investment yield can be extrapolated to equalling roughly a 30% higher pension, or 30% lower member premiums, underlining the key role played by investment returns and the scheme’s appetite for risk.
How then, should pension managers and trustees ensure that risks are being effectively monitored and that assets are on track?
Pre-determination and triggers
One way of ensuring scheme assets are on track is through transparent and clearly defined investment parameters, agreed according to the scheme’s time horizon and risk appetite.
This asset liability management (ALM) should be accompanied by a robust decision-making process if those parameters and assumptions happen to change due to market conditions.
This profit-taking exercise can help to reduce portfolio volatility”
In this regard, triggers can be set beforehand in order to keep the scheme on the correct ‘flight path’. Schemes can automatically reduce exposure to more aggressive investments in order to lock-in profits and improvements in funding positions. This profit-taking exercise can help to reduce portfolio volatility; even if some of the upside potential of the riskier assets is missed.
Again, this is a question of pre-determined levels of strategy, risk-appetite and the goals of the scheme.
Should macro-economic triggers affect the investment decisions of the scheme? Can schemes ‘time’ the global markets through risk monitoring? Certain schemes will indeed place emphasis on employing a dynamic asset allocation strategy in an attempt to correctly ‘time’ the greater market backdrop, while others will prefer to place scrutiny on individual manager performance and selection in order to extract a greater yield from investments.
In either situation, again, triggers or strategies can be put into place, which are predetermined beforehand and are consistent with the goals and risk appetite of the pension fund.
Another important factor for any pension fund to consider in advance is the outcome of the scheme’s position when placed under different types of economic stress.
Armed with this knowledge, trustees can pre-determine investment policy to suit the scheme goals
To this end, scenario analysis can help greatly in ascertaining a fund’s vulnerability to instances of hyperinflation, deflation, stagflation, varying interest-rate environments or flash crashes in global (or isolated) equity markets.
Being able to view the scheme’s resilience to these scenarios, to decide whether to hedge or diversify certain risks exposed by such stress-testing empowers pensions managers and trustees to understand and legislate for the worst-case scenario. Armed with this knowledge, trustees and pension managers can again pre-determine investment policy to suit the scheme goals.
Worth the Risk?
When analysing the risks and returns of any given investment or manager, the pension fund must analyse the yield in comparison with the ‘risk-free rate of return’. This rate is used as a benchmark to track the return of a (closest-to) risk-free investment, such as short-dated local government debt (investment grade), or T-bills/bunds.
The pension fund must analyse the yield in comparison with the ‘risk-free rate of return”
This helps to contextualise returns when cross-referenced with the associated risk; if an emerging market corporate debt fund, for example, were to yield a 3% annual return when US 10-year treasury bills are yielding 2.75% p.a. then clearly too many risks are being taken to achieve an additional 0.25% above the benchmark T-bill rate.
Shedding Light on Dark Pools
Due to the fragmentation of investments, pension funds can sometimes unconsciously run risks which are hidden beneath the surface.
For instance, if several asset or fund managers each independently invest in a small percentage of the same shareholding, the risk run by the scheme in that one investment becomes magnified. The same can be true of concentration of investments into certain countries, sectors, currency exposures and more.
Pension funds can sometimes unconsciously run risks which are hidden beneath the surface”
Furthermore, it can be difficult to analyse data from fund managers due to non-disclosure agreements (particularly when analysing the holdings of alternative investment managers) and also due to delayed delivery of position information. It is for this reason the Dutch central bank advocates the ‘look-through’ principle when monitoring fund holdings, although pension schemes are still at the mercy of their fund managers to release such holdings information.
In order to combat this lack of transparency and fragmentation, schemes require their data, both historic and current, to be consolidated in order to be properly stress-tested, manipulated and analysed. Incidentally, with the rise of transparency of investments and costs across the institutional landscape (with the European regulations of EMIR and AIFMD acting as a catalyst) the theme of transparency is set to gather momentum in the near future.
The Custodian’s Role
A custodian bank is an independent source of information which can be oft-overlooked when viewed as simply a banking institution. The custodian, often acting independently of its clients’ asset management mandates, sits at the heart of the financial web.
As such, it is in a privileged position to consolidate the fragmented data, in addition to reporting on and analysing the historic associated risk and performance of the data as required by pension schemes.
Keeping assets on track
Keeping assets on track through sufficient monitoring of risk allows pension funds to pull levers and change the direction of the portfolio ahead of time, to avoid any nasty surprises.
The monitoring of risk, far from being a box-ticking exercise, can empower schemes to stay on track”
Of course, the fundamental risk/return tenet of modern finance cannot be ignored, but effective risk monitoring allows schemes to comprehend the value of their returns based on the actual risks taken. This data can be efficiently extrapolated and analysed by asset class, by market, by asset/fund manager, by currency/country exposure and many more methods, in order to ensure risk is diversified as far as possible and hedged where necessary.
The monitoring of risk, far from being a box-ticking exercise, can empower schemes to stay on track and maximise the ambitions of the fund for its members.
Steven Polese is business development manager at KAS BANK