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

As 2008 rolls in, uncertainty is on the minds of many. Will there be a recession? Will market volatility persist? Will asset prices continue to converge, making it more difficult to diversify? One question in particular is oft-discussed, notably the issue of strategic asset allocation for defined benefit plans. In a December 17, 2007 news release, the California Public Employees’ Retirement System Board of Administration announced its intent to invest nearly 70 percent of its $250 billion under management to stocks. Private equity will account for 10 percent, up from 6 percent. According to Charles P. Valdes, Investment Committee Chair, “These revised allocation markers reflect the promise of our private equity, real estate, and asset-linked investment classes."

In stark contrast, the Pension Benefit Guaranty Corporation went in the opposite direction a few years ago, now bearing the burden of a positive equity risk premium. In a December 20, 2007 article entitled "The $4 billion trade-off: PBGC misses out by eschewing stocks in favor of LDI," Financial Week reporter Doug Halonen points out the perils of allocating a high percentage of assets to fixed income. He rightly points out "the irony" that numerous companies are seriously investigating the economics of adopting a liability-driven investing strategy which almost always entails a shift away from stocks to bonds and/or interest rate derivatives.

Importantly, the decision to invest in alternatives, including private equity, must reflect a careful analysis of the likely risk-return tradeoff, mapped to the objectives and constraints of a particular pension plan. A short-term focus could create upset for those exposed to holdings that more logically lend themselves to a long-term commitment. In today's "Wall St. Way: Smart People Seeking Dumb Money," New York Times reporter Eric Dash writes that investors in Ohio Public Employees Retirement System and Fidelity Investors "would have made more money this year investing in an old-fashioned index fund that tracks the S&P 500-stock index" rather than plunking down money for the IPO of "private equity powerhouse" Blackstone Group. Perhaps that's true but does it matter if their respective goals are to realize capital gain over the next five to seven years? (Note that this blog's author has no knowledge of the intent of either investor.)

Allowing for upside potential (and statistics do validate a big move into private equity by pensions, endowments and foundations), lack of liquidity and valuation difficulties are harsh realities. However, barriers are starting to soften. Barry Silbert, CEO of Restricted Stock Partners, operates the Restricted Securities Trading Network, a mechanism for trading insider stock options, convertible bonds and private investments in public equity. A recent venture capital injection is arguably a validation of this attempt to enhance fungibility of otherwise "infrequently traded" instruments. The PORTAL Alliance, brings together the Nasdaq Stock Market and leading securities firms to "create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs")." If successful in allowing for ready buys and sells, institutions may be more open to kicking the private equity tires.

For further reading, these websites (a few of many) may be of interest:

• Private Equity Council
• Private Equity Industry Guidelines Group
• PrivateEquity.com.
  

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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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Pension Governance, LLC is proud to sponsor a brand new section of the Social Science Research Network (SSRN). Part of SSRN's Financial Economics Network (FEN), Pension Risk Management publishes working and accepted paper abstracts covering a range of topics in the field. These include liability-driven investing, fiduciary assessment of hedge fund and private equity investments, organization and governance of defined benefit and defined contribution plans, selection of default investments such as target date funds, appropriateness of company stock for 401(k) plans, evaluation of money managers' fees, strategic asset allocation, fiduciary duty to hedge and use of derivatives.

Working with the SSRN team, co-editors Dr. Shantaram Hegde and Dr. Susan M. Mangiero encourage contributions in this exciting and critically important research area. At no other time has there arguably been such an urgent need to understand pension investment risk issues and competing solutions. 

Dr. Hegde is Professor of Finance at the University of Connecticut and author of many papers on derivatives, market microstructure and risk management. Click here to read his bio. Dr. Mangiero is author of Risk Management for Pensions, Endowments and Foundations. An Accredited Valuation Analyst and certified Financial Risk Manager, she is President and CEO of Pension Governance, LLC. Click here to read her bio.

Joining Dr. Hegde and Dr. Mangiero as part of the Pension Risk Management Abstracts Advisory Board is a team of experts in the areas of risk management, valuation and actuarial science:

Dr. Stephen Figlewski - Professor of Finance (New York University)

Allen Michel - Professor of Finance (Boston University)

Steven Siegel - Research Actuary (Society of Actuaries)

Gavin Watson - Business Manager for Asset Managers (RiskMetrics Group).

According to Dr. Mangiero,  "With many challenges facing pension fiduciaries, our goal is to help facilitate a conversation about pension finance, risk and valuation on behalf of investment stewards for millions of plan participants worldwide. The Pension Governance, LLC team is deeply grateful for the commitment of this top-notch team to promote good ideas in these areas. We look forward to making pension risk management the topic of choice for academic researchers and practitioners."

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News ReleaseContact:Kim McKeown
For Immediate ReleaseMarketing/PR Program Manager
March 22, 2007847-706-3528 (kmckeown@soa.org)

New Survey Looks at Pension Risk Management and Impact on Funding Gap

Pension Governance, LLC and the Society of Actuaries (SOA) are proud to join forces to research current pension risk management practices. In what is believed to be a unique large-scale assessment of this critical topic area since research was done in 1998, the jointly developed survey investigates the use of derivatives and related risk and valuation policies by pension funds and their external money managers. Questions address other topics such as the role of the pension consultant, involvement of the plan actuary, new pension rules and regulations and an increased emphasis on enterprise risk management.

Global growth in futures, options and swaps dwarfs all other financial markets. According to the Bank for International Settlements, over-the-counter and exchange-traded derivatives market activity in 2006 grew to more than $400 trillion. Public and private pension plans, a second giant force, control over $10 trillion in assets. Their risk management decisions affect millions of people around the world, compelling the need to understand pension risk management as never before.

Different than even a few years ago, markets are now more volatile, increased longevity is worsening the funding gap and pension fiduciaries seek higher returns in the form of hedge funds, private equity investments and portable alpha strategies, all of which frequently involve derivative instruments. Derivatives show up in countless liability-driven investing strategies as well, making it impossible to ignore their economic impact.

Adding to the complexity of the investment decision-making process, board members, policy-makers, taxpayers, shareholders, actuaries, fiduciary liability underwriters, debt rating analysts and plan participants need and want to understand what fiduciaries are doing in the area of pension risk management. Unfortunately, a dearth of information about plan sponsors and their money managers makes it extremely difficult to head off trouble before it starts. The primary goal of this survey is to make it easier for relevant parties to identify existing risk control practices and, by extension, encourage a long overdue discussion about best practices. While this survey emphasizes defined benefit plans, risk management applies to defined contribution plans as well. When financial controls are absent or implemented poorly, fiduciaries are unable to select appropriate 401(k) investments and evaluate service providers’ fees, possibly leaving themselves exposed to lawsuits.

Author of Risk Management for Pensions, Endowments and Foundations, Dr. Susan M. Mangiero, CFA, FRM, Accredited Valuation Analyst, Accredited Investment Fiduciary Analyst and her team are responsible for survey design and statistical analysis with ongoing input from an oversight group of pension professionals assembled by the SOA. According to SOA Research Actuary Steve Siegel, "we are all very excited about the prospect of providing our members invaluable insight about this important area.”

Invitations have been sent to nearly 6,000 pension fiduciaries in the United States and Canada. Interested plan sponsors who have not received an invitation are encouraged to participate by contacting either Dr. Susan M. Mangiero at 203-261-5519 or PG-Info@pensiongovernance.com or Steve Siegel at 847-706-3578 or ssiegel@soa.org.

Participation is limited to plan sponsors only. Preliminary results will be released to attendees of the SOA's Investment Symposium in New York, April 18-20.

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With so many companies in the red when it comes to defined benefit plans, a green light from the U.S. Department of Labor to consider liabilities when making investing decisions is a big deal.

That's why over one hundred pension fiduciaries have signed up for a Financial Research Associates, LLC conference about liability-driven investing. Chaired by Dr. Susan M. Mangiero, CFA and Accredited Investment Fiduciary Analyst, the event promises to be timely and informative. Following the conference is a workshop entitled "Derivatives in an LDI Framework".

Led by Dr. Mangiero, founder of Pension Governance, LLC and Managing Member with BVA, LLC and Mr. Gavin Watson, Business Manager with the RiskMetrics Group, workshop attendees will hear about the following topics.

1. Identifying Liability-Driven Objectives and Alternative Solutions

2. Derivative Instrument Strategies

3. Modeling and Valuation Issues

Despite the many challenges of managing pension risk, fiduciaries now have some concrete solution possibilities to consider.

Editor's Note:
I'll return in a few days with much more (!) to say about LDI.

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Global Investor Magazine cites survey results from J.P. Morgan Asset Management that show a surge of interest in liability-driven investing (LDI). An impressive forty-eight percent of respondents admit to using, or planning to use, an LDI strategy. Four countries lead the way: the Netherlands, Denmark, Sweden and the UK. The common theme - regulations that "push pension schemes to value their liabilities with market rates".

Interestingly, more than seventy percent of respondents cited the need for an LDI approach, even for plans in surplus.

Some take-aways for US plans?

1. The use of derivatives by retirement plan sponsors is likely to increase as interest in LDI rises stateside.

2. Regulation and accounting standards that encourage liability management will be the likely catalysts for change.

3. Managers, consultants and plan trustees will need (and hopefully want) to become more savvy in the areas of derivative instrument valuation, risk measurement and controls.

4. Traditional asset allocation models may have to give way to a new paradigm that emphasizes portfolio splitting into separate return and liability-managed components.

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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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