Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

In "New reporting trend may ultimately put pain in rearview mirror" (Retirement Townhall, March 23, 2011), Milliman Inc. executive Bart Pushaw cites "Big Baths and Pension Accounting" by Susan Mangiero (March 9, 2011) and "Rewriting Pension History" by Michael Rapoport (Wall Street Journal, March 9, 2011) in his discussion about pension plan reporting reform. Specifically, Pushaw talks about the convergence of U.S. Generally Accepted Accounting Principles ("GAAP") with international standards and the likelihood that plan sponsors' earnings "would be automatically increased, and expenses decreased, for future years" because of accelerated "hits" when performance is poor. He adds that a move towards more realistic representation of the funding status of a particular defined benefit plan will encourage the use of liability driven investing ("LDI") as a way to "avoid the significant mark-to-market hits that are expected in the future."

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According to an October 2009 study entitled "Reactions to an EDHEC Study on the Impact of Regulatory Constraints on the ALM of Pension Funds" by researcher Samuel Sender, regulations discourage European retirement plan managers from focusing on long-term risk management objectives. The study further suggests that risk management is far superior to risk measurement if a focus on funding ratios steals resources better spent on ensuring the long-term viability of the plan. The 142 respondents cite a fear of tighter accounting rules and concern that regulators need to "provide incentives" to build internal models. Nearly eighty percent of survey-takers "report that dynamic strategies are difficult to implement because management agreement is needed to rebalance a portfolio." Click here to access the study.

In contrast, a new poll conducted by SEI suggests that pension risk management is a top priority for executives in Canada, Netherlands, UK and the United States. According to the November 18, 2009 press release released by SEI, "the percentage of pensions employing a Liability Driven Investing strategy has nearly triped over the past three years from 20 percents in 2007 to 54 percent in 2009. Queries about pension benchmarks sugges that decision-makers are veering away from absolute return in favor of "improved funded status." Click to read "SEI Global Poll: 3rd Annual Liability Driven Investing Poll Finds A Significant Increase in Adoption" (November 18, 2009).

A 2008 survey created by Pension Governance, Incorporated (now rebranded as Investment Governance, Inc.) supports the notion that more work remains to be done, by far. Click to read "Pension Risk Management: Derivatives, Fiduciary Duty and Process."

Each survey-taker was asked to self-identify as a USER if he/she works for a plan that trades derivatives in its own name. A NON-USER works for a plan that does not trade derivatives directly but may nevertheless be exposed indirectly if any of the plan's asset managers trade derivatives.

• Plan size seems to be one factor that distinguishes USERS from NON-USERS, with 39% of USERS managing plans in excess of $5 billion versus 14% of NON-USERS associated with plans larger than $5 billion.
• Pension decision-making appears to vary considerably by job function, with 48% (37%) of USERS (NON-USERS) choosing "Other" rather than selecting from given titles such as Actuary, Benefits Committee Member, CFO or Human Resources Officer.
• Time allocation varies considerably with 64% (40%) of USERS (NON-USERS) saying they devote 75 to 100 percent of their work week on pension issues. In contrast, 37% of NON-USERS say they spend 0 to 24% of their work week on pension issues.
• A majority of USERS (64%) and NON-USERS (48%) have had discussions about the concept of a fiduciary duty to hedge asset-related risks. A smaller number say they have discussed the concept of a fiduciary duty to hedge liability-related risks.
• Few plans currently embrace an enterprise risk management approach with 59% (57%) of USERS (NON-USERS) responding that their organization does not use a risk budget. When asked if their organization has or is planning to hire a Chief Risk Officer, 57% (64%) of USERS (NON-USERS) answered "No."
• NON-USERS cite numerous reasons for not using derivatives directly, including, but not limited to, "Lack of Fiduciary Understanding" (25%), "Perception of Excess Risk" (31%), "Considered Too Complex" (23%), "Prohibition Against Possible Leverage" (19%) and/or "Defined Benefit Plan Risk Not Considered Significant" (28%).
• A query about whether survey-takers review external money managers' risk management policies results in 70% (58%) of USERS (NON-USERS) responding "Yes." Fifty-two percent (57%) of USERS (NON-USERS) say they review external money managers' valuation policies. This survey did not drill down with respect to the rigor of questions being asked.
• Survey respondents seem to rely mainly on elementary tools to measure risk. Eighty-three percent (64%) of USERS (NON-USERS) rank Standard Deviation first in importance. Seventy-nine percent (63%) of USERS (NON-USERS) rank Correlation second. Only one-third (38%) of NON-USERS cite Stress Testing (Simulation). Four out of 10 USERS cite Value at Risk in contrast to 23% of NON-USERS who do the same.
• Survey respondents worry about the future with 58% (60%) of USERS (NON-USERS) ranking "Accounting Impact" as a concern. Other concerns were also noted to include "Regulation," "Longevity of Plan Participants" and "Fiduciary Pressure."

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As I stated during my September 11, 2008 "hard-to-value asset" testimony before the ERISA Advisory Council, there are some stellar examples of pension risk management and there is everyone else. Given the dearth of publicly available information about pension financial best practices, one can only guess at the size of each of the two buckets, “great” and “not so great” except for occasional studies that offer empirical validation. In October 2008, Pension Governance, LLC (now Pension Governance, Inc.) released a unique study about the use of derivatives by plan sponsors. Sponsored by the Society of Actuaries, “Pension Risk Management: Derivatives, Fiduciary Duty and Process” found that the “everyone else” bucket is rather large, hinting at future problems if poor process is left unchecked. (Click to read my hard-to-value asset testimony. Click to download "Pension Risk Management: Derivatives, Fiduciary Duty and Process.")

 

Now, a new report offers additional and troublesome evidence that the “everyone else” bucket remains large. Hot off the press, the MetLife U.S. Pension Risk Behavior Index^SM (“PRBI”) considers investment, liability and business risk management among the largest U.S. defined benefit pension plan sponsors. (Pension Governance, Incorporated is proud to have assisted with what we think is path-breaking research.)

 

Designed to measure both the aptitude and attitude of employee benefit decision-makers, the research creates a base case gauge as to the current state of pension risk management. Not surprisingly, respondents ranked the following risk factors as “Most Important,” in part it is believed because they are the simplest to model and measure:

 

• Asset Allocation
• Meeting Return Goals
• Underfunding of Liabilities
• Asset and Liability Mismatch

Given radically changing demographic patterns and the related, oft material economic impact on plan sponsors, it is surprising that the following risk factors were identified as relatively unimportant (and in some cases ignored altogether):

 

• Early Retirement Risk
• Mortality Risk
• Longevity Risk
• Quality of Participant Data.

Also disturbing is what appears to be a disconnect between the importance attached to prudent process by plan sponsors and the regulatory and legal reality that PRUDENT PROCESS IS IMPORTANT. Not only can plan participants suffer untold harm in the absence of a good process or the presence of a bad process, fiduciaries are professionally and personally on the hook. (As this blog has urged many times before, questions about prudent process and fiduciary duty are best answered by plan counsel.)  

 

According to the MetLife press release, dated January 26, 3009, “While respondents ascribe a particularly high rating to the quality of their Plan Governance, they do not seem to carefully consider the effectiveness of their decision making methods or how to improve the way they make decisions. This suggests that many respondents don’t perceive decision making process as an integral element of plan governance, when recent ERISA litigation would suggest just the opposite. In addition, plan sponsors report that they routinely review liability valuations and understand the drivers that contribute to their plan's liabilities. However, at the same time, they indicate that they do not actively implement or regularly review procedures to manage either mortality, longevity or early retirement risk, which are major determinants of both the timing and level of future liabilities. These inconsistencies may indicate that plan sponsors tend not to systematically consider the interrelationships among risk items and plan their implementation of risk management measures to maximize effectiveness across all items. Over time, a lack of holistic risk management may have serious repercussions, including unnecessary volatility in earnings and/or cash flow or potential plan failure. “

 

Unlike other studies, this research sought to quantify attitudes and aptitudes, in essence creating a unique score card against which subsequent results can be compared. The news is not great. On a scale of 0 to 100%, the PRBI level is 76. Roughly translated, defined benefit managers earn an average grade of C with respect to how they manage defined benefit plan risk.

 

These results beg a hugely important question. Is “mediocre” performance acceptable or does the MetLife study sound a warning that someone needs to stay after school for extra help? This blogger thinks it is the latter and welcomes your suggestions about how to fix a wobbly system. (Email PG-Info@pensiongovernance.com with comments.)

 

As I’ve said many times, reward good process and make life difficult for those who do sub-par work. With trillions of dollars at stake, how can we accept anything less?

 

Editor's Note: Click to read the MetLife press release, dated January 26, 2009, about this new study. Click to download "MetLife U.S. Pension Risk Behavior Index^SM: Study of Risk Management Attitudes and Aptitude Among Defined Benefit Pension Plan Sponsors."

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 At a time of great market turmoil, plan participants, shareholders and taxpayers want to know whether their retirement plans are in good hands. Risk is truly a four-letter word unless plan sponsors can demonstrate that a comprehensive pension risk management program is in place. Unfortunately, there is little information that details if, and to what extent, plan sponsors are doing a credible and pro-active job of identifying, measuring and mitigating a variety of risks. The risk alphabet includes, but is not limited to, asset, operational, fiduciary, legal, accounting, longevity and service provider uncertainties.

While no one could have predicted the extreme volatility that characterizes the current state of global capital markets, it has always been known that poor risk management can make the difference between economic survival and failure. Applied to pension schemes, ineffective risk management could prevent individuals from retiring at a certain age and/or leaving the work force with much less than anticipated. Others pay the price too. Taxpayers worry about rate hikes that may be inevitable for grossly underfunded public plans. Shareholders could find themselves on the hook for corporate promises or experience depressed stock prices due to post-employment benefit obligations.

In an attempt to shed some light on this critical topic area, Pension Governance, LLC is pleased to make available a new research report that explores current pension risk management practices. In what is believed to be a unique large-scale assessment of pension risk practices since the publication of a 1998 study by Levich et al, this survey of 162 U.S. and Canadian plan sponsors seeks to: (1) understand why and how pension plans employ derivative instruments, if they are used at all (2) identify what plan sponsors are doing to address investment risk in the context of fiduciary responsibilities and (3) assess if and how plan sponsors vet the way in which their external money managers handle investment risk, including the valuation of instruments which do not trade in a ready market. The report was written by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM, with funding from the Society of Actuaries.

Each survey-taker was asked to self-identify as a USER if he/she works for a plan that trades derivatives in its own name. A NON-USER works for a plan that does not trade derivatives directly but may nevertheless be exposed indirectly if any of the plan's asset managers trade derivatives.

In answering broad questions, a large number of surveyed plan sponsors describe themselves as doing all the right things to manage investment, fiduciary and liability risks. However, answers to subsequent questions - those that query further about risk procedures and policies at a detailed level - do not support the notion that pension risk management is being addressed on a comprehensive basis by all plans represented in the survey sample.

Key findings include the following points:

• Plan size seems to be one factor that distinguishes USERS from NON-USERS, with 39% of USERS managing plans in excess of $5 billion versus 14% of NON-USERS associated with plans larger than $5 billion.
• Pension decision-making appears to vary considerably by job function, with 48% (37%) of USERS (NON-USERS) choosing "Other" rather than selecting from given titles such as Actuary, Benefits Committee Member, CFO or Human Resources Officer.
• Time allocation varies considerably with 64% (40%) of USERS (NON-USERS) saying they devote 75 to 100 percent of their work week on pension issues. In contrast, 37% of NON-USERS say they spend 0 to 24% of their work week on pension issues.
• A majority of USERS (64%) and NON-USERS (48%) have had discussions about the concept of a fiduciary duty to hedge asset-related risks. A smaller number say they have discussed the concept of a fiduciary duty to hedge liability-related risks.
• Few plans currently embrace an enterprise risk management approach with 59% (57%) of USERS (NON-USERS) responding that their organization does not use a risk budget. When asked if their organization has or is planning to hire a Chief Risk Officer, 57% (64%) of USERS (NON-USERS) answered "No."
• NON-USERS cite numerous reasons for not using derivatives directly, including, but not limited to, "Lack of Fiduciary Understanding" (25%), "Perception of Excess Risk" (31%), "Considered Too Complex" (23%), "Prohibition Against Possible Leverage" (19%) and/or "Defined Benefit Plan Risk Not Considered Significant" (28%).
• A query about whether survey-takers review external money managers' risk management policies results in 70% (58%) of USERS (NON-USERS) responding "Yes." Fifty-two percent (57%) of USERS (NON-USERS) say they review external money managers' valuation policies. This survey did not drill down with respect to the rigor of questions being asked.
• Survey respondents seem to rely mainly on elementary tools to measure risk. Eighty-three percent (64%) of USERS (NON-USERS) rank Standard Deviation first in importance. Seventy-nine percent (63%) of USERS (NON-USERS) rank Correlation second. Only one-third (38%) of NON-USERS cite Stress Testing (Simulation). Four out of 10 USERS cite Value at Risk in contrast to 23% of NON-USERS who do the same.
• Survey respondents worry about the future with 58% (60%) of USERS (NON-USERS) ranking "Accounting Impact" as a concern. Other concerns were also noted to include "Regulation," "Longevity of Plan Participants" and "Fiduciary Pressure."

Click to download the 69-page study, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero. Given the large file size, readers are encouraged to (a) first save the file (right mouse click) and then (b) open the file from wherever you have saved the file. Otherwise, you may receive an error message, depending on your computer configuration. 

The study is also available by visiting www.pensiongovernance.com. Send an email to PG-Info@pensiongovernance.com if you experience any difficulty in downloading the pdf file and/or want to comment about the study.

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According to Wall Street Journal reporter Mark Cobley ("Crunch hits complex pension investments," September 4, 2008), Liability-Driven Investing ("LDI") strategies may be creating some unexpected pain for pension funds. Touted as a way to mitigate risk, LDI depends on relatively stable market conditions. Recent volatility has upset the apple cart.

In some cases, a defined benefit plan enters into an interest rate swap as what is referred to as a Fixed Rate Receiver, Floating Rate Payer. Structured properly, this effectively creates a hedge against adverse interest rate moves. When interest rates fall, a defined benefit plan liability goes up but is meant to be offset by a floating rate swap obligation that goes down. (This is a gross simplication, ignoring yield curve differentials and shape, along with multiple factors that influence the size and timing of pension payouts. Additionally, a swap is usually structured to have the underlying pension liability "cash flow matched" so that the fixed rate swap receipts cover the pension IOUs.)

Unfortunately for some, worsening credit problems have led to higher LIBOR (London Interbank Offer Rate) rates, a standard floating rate swap benchmark and one gauge of the rate at which banks borrow and lend money to each other. As LIBOR goes up, floating rate swap outlays rise, negating part or all of the inherent benefits of having entered into the interest rate swap in the first place.

Another variation of LDI (and there are many) requires a pension fund to add "portable alpha," usually in the form of a hedge fund or "equitized" or "enhanced" money management fund. Essentially this is done to lower the opportunity loss when an asset allocation mix veers towards fixed income, away from equity. (This assume a positive equity risk premium whereby equities return more on average than "comparable" risk fixed income securities.) Quoting a Schroders LDI expert, Mr. Andrew Connell, increased LIBOR rates cause "the value of the assets drop and it becomes very difficult to meet benchmarks in the short term."

One solution discussed in the article is for pension plans to invest in offerings that guarantee a rate, tied to LIBOR plus a basis point spread. While it sounds good on the surface, it means that "the pension scheme invests in a portfolio of assets currently held on the bank's balance sheet, such as leveraged loans or asset-backed paper." Since we all know that nothing is free, the question becomes - What risks does a pension investor assume if this revised strategy is adopted?

On top of everything else, investment fiduciaries must properly benchmark their chosen LDI strategy, something that is easier said than done. For example, does one track the difference between required cash flows (owed to plan participants) and LDI "net" cash flows? Life remains a challenge for those now contemplating (or already taking the plunge) whether "to LDI or not to LDI."

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Besides the fact that Liability-Driven Investing ("LDI") takes multiple forms (each of which should be fully evaluated in a risk-return context), there is no universal consent about relevant action steps. As described in "Why LDI is Stuck in Neutral" by Dr. Susan Mangiero, a "roll your shirtsleeves up" approach to gathering and assimilating information makes sense.

The full text of the June 12, 2008 MoneyVoices column, published by Fundfire.com/Money-Media, a Financial Times Company, is presented below, with permission.

                                                                               * * * * * *

Why LDI is Stuck in Neutral

Guest Columnist: Susan Mangiero is president and CEO of Pension Governance, an independent research and analysis company.

Despite the hoopla, pension fund fiduciaries have yet to recognize liability-driven investing (“LDI”) as the ultimate in asset-liability management. No doubt a disappointment to the banking set, there are some legitimate reasons for its slow adoption. For starters, there is no consensus on what the term truly means, tempting one to use “loosely defined investing” as a more apt moniker.

Questions abound. When are derivatives used in lieu of cash assets only? Is a portable alpha engine an integral part of an LDI focus, or is it optional? Can LDI results be meaningfully benchmarked across plans? How does the use of LDI impact the determination of an optimal asset allocation mix? What must fiduciaries consider when assessing whether LDI-related fees are “reasonable?”

Even if everyone agrees on what LDI means, there is never a free lunch. What a plan gains in terms of risk mitigation, it will lose by assuming incremental risk. For example, using an interest rate swap introduces new uncertainties tied to counterparty default, settlement, legal standing and/or operations. A retirement plan that shifts money out of equity into typically lower yielding fixed income securities confronts opportunity cost. Add-ons in the form of alternative investments potentially juice up returns, but could wreak havoc with an existing risk budget. LDI makes sense when expected benefits exceed likely costs (direct and indirect).

Fiduciary literacy is yet another factor. Just as folks begin to ease into “new fangled” offerings, LDI forces decision-makers to take a sophisticated look at the economic funding gap. Understanding the dynamic behavior of asset and liability risk drivers is tough enough. Add a derivative instrument or hedge fund overlay and some decision-makers may dismiss LDI as complex and therefore “too risky.” More education is needed.

Deciding on the appropriateness of liability-driven investing is like anything else. Context and good process count for a lot. In some circumstances, an LDI strategy (however defined) may be a no-brainer. In other situations, its adoption could exacerbate existing problems. Regardless of outcome (“to LDI or not”), pension fiduciaries cannot escape their duty to ask questions, examine its likely risk-return impact (now and under various market scenarios) and oversee external managers’ risk controls (either as counterparties or potential alpha generators).


Disclaimer: The information provided by this article should not be construed as financial or legal advice. The reader should consult with his or her own advisors.

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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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