Pension Funds Become More "Active" in Risk Management

Right now, there is a noticeable change occurring in the approach to risk management on the buy side, particularly within the pension fund area.

Traditionally, pension funds have been measured against a few core metrics. These include duration, where the duration of the fund would roughly match the weighted average payout of the underlying pensioners; future and present; and benchmarking, where the benchmarks that were used would be selected on the average age of those same underlying pensioners and would be geared towards growth (equities) or cash liquidity and capital conservation (bonds). The core objective would be to protect the capital value of the contributions from loss and inflation, and to achieve a growth that would enable the provision of an annuity at retirement age that was appropriate for that time, and the expected draw time of that retiree.

Market changes are challenging this traditional approach.

First, the increasing longevity of the pension draw has put pressure on the pension funds, in the same way that it has various state pension plans, to fund current pensioners with current contributions, making the capital protection and growth of those contributions more difficult.

Second, the sell side of the capital markets has become increasingly volatile, which has caused risk managers to focus not just on the core fund remit, but on the absolute risk faced by the fund. It is this reason that seems to drive much of the segment's move towards more sophisticated risk analytics, systems and approaches.

Consequently, across the buy side, we are seeing more:

- VaR-based absolute risk management
- Risk budgeting, or active risk management
- Counterparty credit risk analysis

The move towards VaR-based analytics is interesting as it shows a determinedly more forward-looking approach to risk than simply comparing results with benchmark allocations (the traditional CAPM model), and illustrates some of the concerns that risk managers and their boards have regarding the market-based risk faced by the funds.

Recent market turmoil has put pressure on the liquidity of the funds, in the sense of trading liquidity and most importantly in terms of the fund valuation and the ability to create future cash flows based on the capital value, such as paying the current retirees from the current contributors. This is forcing more creative and arguably more aggressive investment strategies, including an increased risk of derivatives and non-capital markets assets, such as real estate and infrastructure.

Traditional "relative risk" measures based on allocation and CAPM models are not well suited to measuring the risk in these types of strategic environments, so the funds and their respective risk management groups are moving towards techniques and methods more associated with sell-side risk, such as VaR and tail risk analysis. Of course the benchmarks are still at the heart of the fund management, but the relative measures are less around simple allocation and more skewed towards active risk and risk budgeting where the VaR itself is the basis of the relative calculation and the excess risk represented by that active number is allocated across assets and fund subdivisions.

This analytics style is accompanied by increased focus on expected shortfall (losses beyond the VaR threshold), multi-asset stress testing and deeper quantitative analysis around the VaR distributions of the underlying asset classes and their correlations with each other.

On the credit risk side of the equation, there is a generalized concern around issuer and counterparty risk, and the correct pricing of that risk. This brings advanced measures such as PFE (potential future exposure) and CVA (credit valuation adjustment) into play. These have no real benchmarking relevance, but do have a potentially large impact on the financial stability and future liquidity of the fund.

This is a major change within the pension fund industry which in turn means that it is a major change to the financial industry, given that public and large corporate pension funds' assets under management are routinely above $100 billion, and can run close to $300 billion for the very large funds.

Moving to this new level of risk management sophistication requires investment in systems and technology, as well as in people who can properly understand, explain and apply that technology. The most challenging issue -- as always with risk management -- is the change in the internal mindset of the various stakeholders, from board members to portfolio managers. Successful enterprise risk management, whether at a pension fund or an investment bank, requires that a risk-based view is taken of strategy and control, and that risk becomes a cultural keystone of the organization.

Marcus Cree is vice president of risk solutions for SunGard's capital markets business.