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

 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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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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In a survey co-sponsored by Pension Governance, the RiskMetrics Group and Ulysses Partners, institutional investors expressed concern about a variety of issues, including:

1. Fiduciary breach litigation
2. Underfunding
3. Asset allocation mix
4. Investment return assumptions
5. Realized investment returns
6. Investment risk
7. Valuation
8. Regulation

In excess of fifty percent of respondents said they would like to know more about risk measurement and risk management. That makes sense, given survey results that point to beta, duration and, in the case of derivatives, notional principal amount, as favored ways to track position limits. As explained in great detail in Risk Management for Pensions, Endowments and Foundations, care must be taken to properly interpret these numbers, understand their strengths and limitations and undertake a comprehensive analysis of risk. Only twelve percent of respondents declared Value of Risk as a way to track position limits. Seventy-nine percent of respondents said that they do not currently use risk budgeting.

Interestingly, forty-six percent of respondents affirmed the use of more than ten money managers. No one answered "yes" to the question: "Do you use zero money managers?" The message? Institutional investors must make sure that the risk and valuation dialogue with external managers is comprehensive and clear. Outsourcing does not absolve fiduciaries of their oversight duties.

Seventy-five percent of respondents answered that the primary responsibility for making strategic risk management decisions rests with a committee. Only two percent answered that consultants or external money managers play this role. Arguably fiduciary education is critical for all committee members who collectively decide on all things risk. (As an aside, committee decisions should reflect analysis by all members rather than having some individuals passively accept the recommendations of one or two "leaders". The author is not an attorney. Fiduciaries should seek legal counsel for advice regarding relevant duties.)

Several results merit special comment.

More than ninety percent of institutional investors with assets in excess of $1 billion said that they know the amount of leverage being used by external money managers. At the same time, they expressed concern about risk management and admitted to using only a handful of risk measurements. Additional research is required to get behind these seemingly contradictory answers.

More than sixty percent of institutional investors with assets in excess of $5 billion cite the use of custodians as providers of "independent" valuation numbers. Only forty percent of investors with assets between $1 and $5 billion use custodians for this job. As institutions gravitate towards assets for which there is no ready public market or for which public market trading occurs infrequently, contacting qualified appraisers is worth investigating. Valuation disputes often end up in arbitration, litigation or regulatory enforcement actions and more than a few experts have been disqualified for lack of specialized training. Forty-eight percent of respondents claimed a concern about how hedge fund assets are valued.

For interested readers, click here to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know". Click here to read "Asset Valuation: Not a Trivial Pursuit."

Sixty-two percent of respondents confirmed that derivatives are permitted. Worry about the risk associated with derivative use, inadequate systems to monitor and manage risk and lack of familiarity or experience with derivatives showed up most often as the reasons for prohibiting their use. Seventy percent of users cited the use of equity and fixed income derivatives. When asked about instrument categories, sixty-three percent cited the use of futures contracts, fifty percent cited the use of interest rate swaps and forty some percent checked off credit derivatives and currency swaps. About thirty percent of respondents cited the use of options, both exchange-traded and over-the-counter.

Seventy-seven percent of people who completed the survey said that they "feel that institutional investor fiduciaries are more vulnerable to being sued in the aftermath of recent corporate, government and non-profit scandals."

This begs some important questions.

1. What are fiduciaries doing to better protect themselves from allegations of breach of duty?

2. Are investment committee members being recruited, retained and compensated on the basis of their investment knowledge and experience? If not, do they plan to introduce educational and experiential requirements soon? If not, why not?

3. Do fiduciaries respond best to the carrot or the stick approach? If the latter, will an increase in litigation result in better governance? If not, what will prompt organizations in need of improvement to do a better job?

4. How will pension reform and new accounting rules affect the investment risk strategies adopted by public and private funds? (The expectation is that derivatives and related risk management strategies will climb to the top of the MUST DO list in response to anticipated reforms and new rules.)

5. How are fiduciaries carrying out their duties with respect to properly analyzing non-traditional instruments and strategies?

The development of follow-up surveys is underway. Contact Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst and certified Financial Risk Manager (FRM) for more information.

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