Structural risk management

New accounting rules (IFRS), tighter supervision requirements (Financial Testing Framework) and financial innovation have brought about an irreversible trend towards market valuation in recent years. This valuation and the difference in duration between long-term liabilities and investments, falling long-term interest rates and low returns (caused by the financial crisis among other things) have put pressure on the financial position of pension funds.

In many cases the cover ratios are now actually below the requirements set by the DNB, the Dutch Central bank (see sidebar). In particular, the DNB’s intensified regulations (see for example the ‘DNB Supervision Themes 2009’ policy document) require pension funds to identify their financial risks unambiguously.

For years the pension funds directed their attention mainly towards the actuarial risks of their liabilities and thus showed relatively little interest in market risks such as share, interest, inflation and foreign-exchange risks.

“The first step for a pension fund is to obtain a transparent picture of the financial risks that it actually runs.”

Generally speaking many pension funds perform an ALM study to determine their strategic investment mix based on expected future developments in economic variables and their pension liabilities. Their next step is to draw up an investment mandate based on the strategic mix.

In other words, they determine a Tactical Asset Allocation (TAA). The mandate is evaluated periodically using performance analyses prepared by the asset manager(s) and/or the fiduciary manager.

Medium-term risk analyses

The financial development of a pension fund and the associated risks in the period between the long-term ALM studies (15-30 years) and the short-term TAA (less than one year) are seldom considered. DNB wanted to address this situation by means of a continuity analysis, but so far this test has been defined only to a limited extent.

Due to the low cover ratios DNB has ‘forced’ pension funds to draw up recovery plans, so they are now required to address this period at least to some degree.

Structural approach

It is extremely important for pension funds to build their risk management policy structurally. Over the past 15 years Zanders has implemented and validated many financial risk models at numerous financial institutions and provided advice about risk management in general.

“Low cover ratios, the heightened risk perception and tighter regulation by DNB oblige pension funds to identify their financial risks properly.”

On the strength of this experience, Zanders has formulated some guidelines for assuring a structural policy on risk management. Here are three steps for structurally integrating a risk policy:

Step 1 Identify all financial risks

The first step for a pension fund is to obtain a transparent picture of the financial risks that it actually runs. These may typically include the market risks, such as interest rate, foreign exchange and inflation risks, but importantly there may also be a credit risk, credit spread risk, liquidity risk or operational risk.

Step 2 Measure the risks

To reach decisions about risks (such as covering the interest rate risk of the liabilities) it is extremely important to know how the risks will affect a pension fund’s financial position and to know the indexation percentage. Good risk models are necessary to obtain this picture.

Periodically - preferably monthly or quarterly - the results must be presented by means of clear and concise risk reports. The reports must contain (at least) the expected future cover ratio, its potential fluctuation, the likelihood of under-funding (a reserve deficit and cover deficit), the expected indexation percentages in the coming years and the risk levels that various risk drivers will contribute. This must be visualised using various clearly specified scenario analyses and stress tests.

Step 3 Control the risks

A risk report alone is not enough to be able to control risks. Firstly, the board of a pension fund must determine its risk appetite. This involves the board examining the identified risks and deciding ‘how much’ risk it is prepared to run, preferably for each risk driver.

The next step is to prepare a risk governance framework. This is a document that describes the organisational structure and responsibilities for managing risks, possibly including accountability for results. Based on factors including risk appetite and risk governance, the pension fund can then give its investment mandate to its asset manager(s).

Provided that all of these matters have been properly addressed, there will be a clear picture of who is responsible for what and the scope of decisionmaking powers. It is at least equally important that the risks a pension fund runs - and is prepared to accept - will be transparent.

Zanders provides advice and support for all of these matters. Specifically for pension funds, Zanders has developed a risk dashboard that produces a picture of the expected medium-term financial position and associated risks. The dashboard naturally includes all the risk criteria mentioned above and the report can be tailored to fit the client’s needs.

Ad hoc analysis can be performed with the risk dashboard, but the analysis can also be used as a regular risk report.