Written by Sandra Haurant
Sandra Haurant explains how pension funds’ approaches to managing risk are changing
Given the experiences of the past decade and more in the world of investment, it is perhaps not surprising that pensions investors’ attitudes to risk management have been shifting.
Two major crises, along with a raft of regulatory measures, have had a serious effect on the way the European defined benefits pensions industry approaches risk. The bursting of the technology bubble at the turn of the millennium struck a heavy blow for pension funds used to taking equity highs and lows in their stride, providing a reminder that the markets could be treacherous. Then, of course, the financial crisis of 2008/09 struck and is still continuing to play out today.
Naturally, equities once again suffered, but other asset classes have also been shaken up. Low interest rates, inflation risks and low yields have made former pension scheme portfolio mainstays like fixed interest less attractive than before. Hedge funds, too, have presented a number of concerns, not least the potential for illiquidity. Add to these issues surrounding longevity risk, with liabilities growing as people live longer lives thanks to welcome medical advances.
And then there are the related regulatory pressures, requiring European pension funds to meet ever greater governance and regulatory requirements. According to a survey, carried out by the Economist Intelligence Unit for State Street Corporation, 73 per cent of European pension schemes say that demands from internal governance and risk management functions provide a challenge, and 87 per cent think governance demands are likely to escalate over the coming five years. A Europe-wide, indeed a global, shift in attitudes to risk management has been occurring for a number of years, and the results are manifesting themselves in a number of different ways.
Closing the doors
The closure of defined benefit schemes to new entrants or accruals has been widely used as a way to manage risks in Europe - but closing a scheme of course brings its own issues. “Over the course of the past few years there has been an increase in awareness and in desire to mitigate risk,” says Towers Watson senior consultant in the pension settlement consulting business Ian Aley.
“In many respects, that is driven by the fact that many schemes are closed to new entrants and accrual. As they have closed, the timeline and ability to expose to risk is shortened.”
“By their nature, pensions are of course long-term investments, so if you are looking at a long-term timeline and that is suddenly shortened [by scheme closure], you begin to look at managing risk in a different way,” he explains.
As a result, says Aley, many schemes are looking at working out a mitigation journey plan, mapping out ways to de-risk over a number of years. “That’s the analysis side of things,” he explains. “But in terms of what they are actually doing in practice, increasingly schemes are moving towards hedging strategies, ensuring they hold assets that better match liabilities.”
Open to change
Indeed, changes in the approach to asset allocation have been seen across the continent.
The traditional asset split between equities and bonds has, some argue, been overtaken by a greater appetite for alternative asset classes. According to a survey published by consultancy firm Mercer in May 2012, the eurozone crisis has further encouraged pensions to look away from equities.
The survey, covering more than 1,200 European pension funds with assets of over €650 billion, showed an increasingly wide range of alternative asset classes being considered by pension schemes, and that around 50 per cent of schemes now hold an allocation to alternatives, up from 40 per cent last year.
That is not to say that equities no longer have a role to play. Intech’s president of its international division, David Schofield, argues that they can be extremely useful in the context of low volatility, risk controlled investment. “The crises have focused people’s minds and called into question the belief in investing in equities. They tend to be more volatile and that tends to be synonymous with risk.”
This risk used to translate into better potential returns – the risk return premium – but that is no longer necessarily the case. Nonetheless, investing in equities can form part of a risk mitigation strategy, says Schofield. “It is possible to build equity portfolios in a way that can achieve reduced risk but not reduced returns,” he says. Through an actively managed approach, Schofield says the stocks are chosen for low volatility and low correlation.
But pension funds are also looking to other asset classes in an attempt to control risk. Mercer’s European director of consulting within its investments business, Nick Sykes, said on publication of the group’s report: “Pension funds are faced with the dual challenge of managing portfolio risk brought on by market volatility, while at the same time identifying opportunities that will generate returns to support future liabilities. In their quest to control volatility without sacrificing long-term returns investors have turned their attention to alternative asset classes.”
Aley confirms: “While historically, funds might have held equities and corporate bonds, more now are considering diversifying into areas such as infrastructure, commodities and global sovereign credit.” The challenge, of course, is to keep those returns at an acceptable level, or to accept that returns will be reduced as part of the overall plan.
Not only are funds more open to different asset classes, says AXA IM’s head of liability driven investment within its fiduciary management team, Erwan Boscher, but they are becoming more flexible when it comes to the frequency of change. “Funds are more willing to adjust asset allocations relatively frequently,” says Boscher.
A broad spread
And of course, at a time when Europe itself has seen significant upheaval, collective minds in the industry have also been focused on diversification in terms of geographic exposure.
There is certainly, says Boscher, more interest in diversification away from Europe. Aley agrees: “We are seeing more diversification both in terms of asset classes and globally.”
But, in order to be an effective approach to managing risk, diversification has to be carefully balanced. “Diversification is something we have been looking at for a number of years now,” says Quantum Advisory actuary Robert Davies. “Ostensibly, it is a good thing, but it is worth being wary. Slavish diversification might be counterproductive.”
Emphasis is increasingly placed on the reduction of correlation between holdings, so that, essentially, if one investment goes down the rest will not necessarily follow. Whether that lack of correlation is achieved within a portfolio or inside specialist diversified growth funds, the aim is to reduce the risk that comes with correlated investments that could bring the whole fund down.
But while reducing correlation is important to mitigating risk, clarity and transparency is also vital for Europe’s defined benefit schemes. The more complex the asset class, the greater the potential cost in terms of monitoring and reporting on those investments, and cost is a risk that schemes are less and less able to bear. “There is increased focus on risk in terms of resources,” says Boscher. Managing those resources has become a crucial part of managing risk. The big question is: how can a scheme best allocate resources to manage risk without incurring considerable and counterproductive cost?
“We are seeing a lot of pressure on smaller pension schemes to get access to good risk management solutions,” says Boscher. “The larger schemes are able to use a mix of in-house expertise, consultancy and fiduciary managers.” Smaller schemes naturally have fewer options, and in the Netherlands those at the smaller end have been attempting to join nationwide schemes, or have been heading down the fiduciary management route, he explains.
There are as many approaches as there are DB schemes. Some can absorb lower returns with a lower risk approach, while for others that would be a dangerous move. But one thing is common to all - controlling risk and managing resources is a careful balancing act, and one that needs to be mastered if schemes are to protect themselves from any future crises.
Sandra Haurant is a freelance journalist