Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

According to Financial Times reporter Deborah Brewster ("Investors pull out of mutual funds," April 27, 2008), nearly all U.S. mutual fund managers saw a drop in assets in Q1-2008. Sagging returns are a main driver on the retail side. Citing Strategic Insight, Brewster writes that individuals and institutions have pulled $100 billion from American, European and Japanese equity funds.

Money market funds, charging lower fees, seem to be picking up the slack. This suggests an inevitable decline in profitability for the asset management business. In "Has the Financial Industry's Heyday Come and Gone?" (April 28, 2008) Wall Street Journal reporter Justin Lahart writes that "the businesses of borrowing, lending, investing and all of the middlemen in between" are slowing and thereby creating ripples throughout the U.S. economy. With documented job cuts in the financial sector, new regulations and questions about "excess" risk, a discernible shift is underway. A shrinking financial sector and reduced availability of credit hits consumers and corporations hard.

In addition, defined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

The issue is important for many reasons, not the least of which is the impact on statutory funding requirements, cash flow and related share price. In March 2008, money manager Charles Gilbert spoke to a Society of Actuaries audience about the double whammy of falling interest rates (increases the defined benefit liabilty) and unhealthy stock returns (reduces portfolio value).

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According to its February 18, 2008 press release, the Pension Benefit Guaranty Corporation is changing its asset allocation mix to 45 percent invested in fixed income, 45 percent invested in equity and 10 percent left for alternative investments. A spokesman explains that ratcheting up on private equity funds and real estate is expected to generate higher returns but reduce risk because of greater diversification, giving "the Corporation a 57 percent likelihood of full funding within ten years compared to 19 percent under the previous policy." In the past, the PBGC mix favored bonds with 75 to 85 percent being invested in fixed income securities, including some monies earmarked for liability-driven investing ("LDI") strategies. Some PBGC critics recently cited high opportunity costs by concentrating on notes and bonds.

With an accumulated deficit of $14 billion at the end of fiscal year 2007 and the recognition of the long-term nature of its obligations, the decision was arrived at, after "an extensive review process that began in mid-2007." Interestingly, an "Investment Program Fact Sheet" seems to contradict the newfound logic, stating that "Because of the statutory restrictions on investment of the Revolving Funds and a change in PBGC's investment policy adopted in 2004, fixed-income securities dominate PBGC's asset mix." Additional text emphasizes a relatively low tolerance for uncertainty. "The current investment policy continues PBGC's investment focus of limiting financial risk exposure by investing the majority of PBGC's assets in long duration fixed-income securities in order to reduce balance sheet volatility."

It would be interesting to know more about exactly why the PBGC decided to move into real estate and private capital pools now. How did they net the expected lower risk (due to diversification) against incremental risks association with interests that seldom trade? Access to meeting minutes would make for good reading. Though it is not an official U.S. government agency ("financed by premiums paid by employers, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets"), many people believe that American taxpayers are ultimately on the hook in the event of a PBGC bailout. With a recession on the way and relatively low interest rates that push liabilities upward, bad news for this insurance agency is not out of the realm of possibility. Additionally, though premiums have increased, few economists believe that risky plans are paying their "fair share" and that "good" plans are subsidizing poor financial management elsewhere. If true, PBGC's exposure to default is that much higher.

The PBGC says it reviews its investment policy every two years. How often does it assess its outside managers? Will due diligence for alternative fund managers differ from the check-up imposed on traditional managers? How will the PBGC address valuation issues related to private equity, venture capital and real estate? What performance metrics can we expect PBGC to share with interested parties if "hard to value" assets are held at cost versus "fair market value?" Is there or will there be a Chief Risk Officer for PBGC who addresses asset-liability management on an enterprise risk basis? How will banks be impacted if private plans decide to follow PBGC's example and shy away from LDI? Will corporate plans follow suit?

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At this rate, one could spend hours blogging about sub-prime woes, risk and whether adequate controls were in place. In a December 4, 2007 Washington Post article entitled "Losses Stack Up: Local Officials in Florida Try to Assess Damage To Investments Linked to Soured Subprime Loans " by Tomoeh Murakami Tse, I was interviewed about pension risk management implications. (Click here to access the article. You may be asked to register.) The State Board of Administration of Florida itself acknowledges the importance of risk controls, both in a November 2007 account of their sub-prime losses and in later interviews about fund withdrawals, subsequent freezes prohibiting further withdrawals and the hiring of Blackrock to develop a financial game plan.

In a recent study by the Towers Group, risk management was found to be lacking at some organizations, arguably one cause for large losses. Describing the adverse consequences of siloed risk management functions in financial institutions, authors of "Multifunctional Integration: The Positive Side of Risk," cite the need to work across divisions. They add that  "Beyond defending against threats to the organization, a more integrated approach to risk management can drive other business and client-centric benefits, including: improved quality and transparency of information; relationship pricing; process simplicity and efficiency; more effective decision making; and overall resilience."

No surprise to this risk manager and blogger who has spent over 20 years in the areas of risk management consulting, forensic analysis, board and trustee training and process assessment. In trying to convey the importance of acting before the fact, our Pension Governance team oft-repeats the importance of a holistic investment risk orientation, commencing with comprehensive training for everyone - front, middle and back office staff included. Importantly, buy-in from the top drives the acceptance of an organizational-wide risk culture and allows for resources to purchase analytical systems, hire professionals and make sure everyone has a good understanding of checks and balances. (In a recent workshop I led on risk management, I encouraged pension fund professionals to spend time with the chief risk officers employed by their banks, mutual fund and hedge fund managers.) 

Whether separate risk management activity reflects a "penny wise, pound foolish" behavior depends on a host of factors and will vary across organizations. However, delay in implementing an effective process can be costly as pointed out in a December 2007 assessment of sub-prime litigation risk by Guy Carpenter & Company, LLC. In "What’s the State of Your State? E&O Risk Uneven across the Country," authors list six factors that give rise to litigation risk for real estate professionals (though noteworthy for other related parties, given the flurry of lawsuits now being filed). See below for excerpted text:

• Percentage of mortgages in foreclosure
• Percentage of subprime mortgages that are delinquent
• Number of litigation attorneys per mortgage industry professional
• Frequency of Truth in Lending lawsuits (per million households) through Q32006
• Frequency of banking-related lawsuits (per million households) through Q32006
• Extent to which a state is plaintiff-friendly, i.e., is deemed a “Judicial Hellhole” by the
  American Tort Reform Association (ATRA).

Mortgage bankers and real estate brokers may be getting pink slips but litigators are busier than ever. For retirement plan fiduciaries, it bears repeating. Ask external money managers if they have sub-prime problems, query about how they are addressing risk gaps and demand to know what lessons they have learned from the credit crisis.

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Disappointing many, the Federal Reserve cut rates by a smaller amount than expected. Equity investors responded with a resounding hiss, sending the Dow Jones Industrial Average down nearly 300 points. Defined benefit plan managers can't be too happy either. After all, many of them have more money allocated to stocks than bonds. Then there is the matter of reported net unfunded liabilities rising as rates fall. What's an asset allocator to do?

This blog's author recently read survey results that suggest a significant migration to more complex securities. Not surprisingly, researchers describe a struggle on the part of investors and financial advisors who need higher returns but are not always comfortable that they understand the risks. (See "Financial Advisors to Embrace More Sophisticated Investment Products Over the Next Two Years, According to New Data from Cogent Research," Insurance Newscast, December 7, 2007.) 

I hate to say it folks but here goes. Why invest in something you don't understand? Isn't that part of the reason why the sub-prime debacle is starting to make the S&L crisis look like a walk in the park? Several incidents come to mind.

Following the 1987 market crash, equity put option writers sued their brokers, saying they did not understand the nearly unbounded downside, forcing some into bankruptcy. In the early 1980's, a handful of prominent institutional investors sued their bankers for putting them into complex, new fangled derivatives. One treasurer acknowledged the need to know more, exclaiming "Due to my inexperience, I placed a great deal of reliance on the advice of market professionals….. I wish I had more training in complex government securities."

Mark my words. The courts will be hearing a lot of cases that address who ultimately has responsibility for investment strategies gone awry. Pre-exemptively, pension funds must seek legal counsel to review their fiduciary duties. Nevertheless, as strategies become more complex, there will be sufficient numbers of investors who simply do not understand the risk and, absent good process, will lose money.

This gets back to a point made many times herein. Shouldn't pension decision makers (regardless of plan design) be required and/or encouraged to have a particular familiarity (experience, education) with investment and risk management?

The fact that no such certification requirement exists amazes and disturbs. 

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In "A Conversation with a Fiduciary" (published by Morningstar), independent pension fiduciary Matthew D. Hutcheson provides a thought-provoking assessment of ERISA Section 404 and passive versus active investment choices for 401(k) plan participants. Click here to read the article and here to read Hutcheson's March 6,2007 testimony about 401(k) fees before the U.S. House of Representatives.

On the other side of the fence, Financial Times writer John Authers extolls the virtues of Dave Swenson's "uninstitutional portfolio" approach in his June 9, 2007 article about the Capital Asset Pricing Model and market efficiency. With more than two-thirds of the endowment fund for Yale University in alternative assets "which are not readily marketable," the contrast is telling. While the evidence seems to strongly support Swenson's approach for Yale, issues abound with respect to alternatives investments and command attention. "See "Yale puts academic theory of investment into practice.")

I co-led a workshop on the valuation of "hard to value" assets on June 12, 2007 and came away with a renewed appreciation of the fact that more than a few institutions may truly be in the dark with respect to risk factors. Worth mentioning again is that risk itself is not bad. However, risk that is ignored cannot be measured and, by extension, can certainly not be managed. For most investors, limited resources make it difficult to replicate the Connecticut Ivy's success. Addressing a recent gathering of alumni, Swenson said that "Yale is set up to make high-quality active management decisions" with a staff of twenty and a long time horizon.

The debate continues with respect to style because it is a crucial (nay impossible to ignore) element of investment management. Strategic asset allocation and tactical implementation are likewise integral determinants of fiduciary liability for a given organization. To the extent that Hutcheson reminds us to focus on the "F" word and move the conversation to process that supports duty, plan beneficiaries applaud.

Tell us what you think. Should fiduciaries do a better job of justifying when active strategies make sense? We will talk more about these issues because there is a lot to say.

Click here to email your comments. Please indicate if you would like the comments kept private.

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I am the author of a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons, 2005). A primer about risk management (no math by design), the feedback has been gratifying. I'm particularly proud of the comments citing ease of use. (The book is replete with examples, checklists and references).

However, it's no Da Vinci Code in terms of sales. While I'd like to write a sequel at some point, few are competing for the honor and no one is knocking down my door to buy the movie rights. (You can visit our online bookstore at www.pensiongovernance.com - Products, Books for what we think constitutes a good readling list.) True, it's non-fiction and written for a limited audience. Yet one wonders why, in today's benefits climate, more people aren't fast and furiously laying pen to paper to describe how to tackle what is arguably one of the most important topics in pension land - risk management. If there is a single message I can impart to those who will listen, it is this.

ANYONE involved in pension investing is a de facto risk manager. Believe it. You are.

Whether focused on the asset or liability side (or both), risk is an integral part of financial management. Those who deny this truism expose themselves to possible trouble down the road. Personal and professional liability aside, plan sponsors who passively manage risk (whether defined benefit or defined contribution) through ignorance or benign neglect invite unwelcome scrutiny. Unless they are lucky, litigation, economic loss and/or damaging headlines are high probability events.

Besides, plan sponsors who give risk management short shrift lose a precious opportunity to improve things. An effective process forces a plan sponsor to identify, measure and control risk on an ongoing basis. Taking inventory (in terms of uncovering sources of risk) enables plan sponsors to make meaningful changes. Lower costs or enhanced diversification are two of many possible benefits associated with the activity of collecting and analyzing data as part of the identification of risk drivers.

So a natural question arises.

Why don't more plan sponsors pay attention to risk management, whether for themselves or as part of hiring, reviewing and perhaps firing money managers and consultants? Asked another way, what is the tipping point beyond which risk management becomes front and center at meetings of board members, trustees, investment committees and so on?

Here are a few thoughts.

1. Based on the preliminary results of the pension risk management survey now underway, and co-sponsored by Pension Governance, LLC and the Society of Actuaries, there seems to be a HUGE gap between belief and reality. Many respondents say they actively pay attention to risk management. At the same time, they cite limited or no use of risk metrics other than standard deviation and/or correlation. (We'll talk about limitations of basic risk metrics elsewhere.) How can you improve on something you think you are already doing well?

2. Many plan sponsors are tasked with benefits-related work as an add-on to their regular job. Often, there is little organizational incentive for them to excel. In a way, it's a lose-lose proposition. They assume significant fiduciary liability with little or no recognition in the form of additional money, better title or other types of perquisites. At the same time, if they do a bad job, there is no escape. It's all downside. Sadly, there is so much perceived ambiguity about what constitutes a "good" job that it's often difficult to hold someone accountable. (Note the term "perceived" versus "real.")

3. Not all attorneys (litigators and transactional) feel comfortable with finance concepts, let alone financial risk management. That knowledge void arguably makes it easier to let risk control gaps slide unless, or until, an egregious act occurs.

4. Establishing a financial risk management process is seldom fun (or at least sort of enjoyable) for most people. It is often a complex activity that requires copious amounts of money, time, concentration and energy, especially if a plan's investment mix (DB or DC) extends to multiple asset classes. Moreover, benchmarking the process, and making appropriate changes thereafter, likewise consumes large chunks of time and money. Is it any wonder then that its ranking on one's "to do" list plummets in the absence of a strong risk culture?

5. When market conditions are "good" and benefit costs decline as a result, people tend to get lulled into false security. Instead of focusing on structural issues, it's easier to breath a sigh of relief and say "problem solved." Alas, markets change all the time and putting off the inevitable is hardly a smart move.

So what's the tipping point that has everyone wearing "I'm a risk manager" button? Certainly lower interest rates and/or an anemic equity sector are factors, as is regulation. A few recent surveys cite mandates as a central force in encouraging, sometimes forcing, plan sponsors to radically revise their asset allocation strategies and focus on plan risk.

Most folks think we're moving closer to the pension risk management tipping point. I agree but counter that movement is relative. Until (and hopefully not "unless") plan sponsors recognize the URGENT need for financial risk management, investment stewards remain vulnerable on many counts and that is not a good thing for anyone!

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The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

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Taking time for some weekend reading, I was struck by several headlines that focus on a topic I predict we'll hear more about (much more) in coming months, namely how to best allocate assets to meet liability objectives. Here are a few examples.

"Big pension fund too equity-heavy, says consultant"

"Pension Fund to Expand Stock Buying"

"DB plan sponsors hedging their bets on hedge funds: Pension plans expected to invest $300 billion"

While a discussion of optimal asset allocation and portfolio re-balancing is left for another time and venue, a few questions and comments come to mind.

1. As new accounting rules encourage a focus on liability-driven investing, how will plan fiduciaries decide on a portfolio split between matching liabilities and generating excess return?

2. How can and should derivatives be used to transform assets and liabilities?

3. What role should alternatives play?

4. What will cause a shift away from the traditional equity-fixed income mix for defined benefit plans?

5. How should the equity risk premium be evaluated with respect to managing goals, knowing that greater reliance on fixed income is likely to widen a plan's pension deficit if equities outperform?

6. How should fiduciaries be evaluated and compensated if they focus on risk control in lieu of exceeding return targets?

7. Are decision-makers sufficiently trained to deal with surplus volatility, fat tailed distributions, side pockets and other financial delights?

8. What is the likely impact on capital markets as long-term pension investors begin to favor a radically different asset allocation mix?

As accounting rules, regulatory mandates, changing demographics and economic reality join hands, it's clear that a paradigm shift in asset allocation strategies and tactics is on its way. Are we ready?

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Diversify, diversify, diversify! No smart investor should do otherwise, right? Well suppose individuals are not even saving enough, let alone investing wisely. What then?

Sad to say, financial illiteracy is reaching crisis proportion. In a recent release, the Bureau of Economic Analysis (part of the U.S. Department of Commerce), reported a continued negative savings rate. This means that individuals are spending more than they earn. Not surprisingly, personal bankruptcies are climbing higher. According to the Administrative Office of the U.S. Courts, "bankruptcies filed in the twelve-month period ending December 31, 2005, totaled 2,078,415, up from the 1,597,462 petitions filed in the 12-month period ending December 31, 2004", reflecting a whopping 30 percent increase. Similarly significant, they report that "this was the largest number of bankruptcy petitions ever filed in any 12-month period in the history of the federal courts".

A faint glimmer of hope comes in the form of a new study from the Jump$tart Coalition for Personal Financial Literacy. High school students showed a tiny improvement in their understanding of topics such as budgeting and credit cards. Survey designer Dr. Lew Mandell acknowledges the gain but stresses the need for much more work in the area of pecuniary preparedness.

Couple these alarm bells with pension safety nets that are in serious disrepair around the world and the fact that many employers are rescinding or reducing benefits, if offered at all, and we are about ready to enter a maelstrom of unprecedented proportion.

What do you think? Crisis or not? Take this five-question survey and see what others think.

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