Fundamental Principles of Pension Fund Risk Management

Pension funds are amongst the most heavily supervised financial instruments in the world. This is because of the fact that these funds hold the retirement funds of a large number of people. This means that the risk management practices at a pension fund have to be top-notch.

The inability to manage risks can cost the pension funds dearly. This is the reason that a few fundamental principles of risk management need to be followed at every pension fund. Each fund can have its own version of risk management. However, they all generally revolve around the same best practices.

In this article, we will provide an overview of the fundamental principles of risk management that are followed by pension funds.

1. Risk Management has to be Forward-Looking: Pension funds have to ensure that all their risk management practices are forward-looking. It is common for some pension funds to base their risk numbers and decisions based on data that is rooted in the past. This can be quite problematic since the past portfolio has absolutely no bearing on the current risk of the pension fund.

   It is very important for the risk management practice to be based on the current portfolio since that is the only one that matters as far as risk management is concerned. Pension fund risk management is about combining the current portfolio with the latest available information about what the value of these assets is likely to be in the near future.

2. Risk Management has to be Time Based: It is important to realize that risk should not be expressed in absolute terms. Instead, the risk must be expressed keeping a time frame in mind.

   For instance, instead of saying that the portfolio has an 8% volatility, it should be expressed as having an 8% volatility over a one-year period. Pension funds must ensure clear internal communication about whether the value being expressed is an annualized value.

   Since pension funds hold assets over large periods of time, traditional risk measures such as value at risk may not be very useful. This is because of the fact that pension funds do not face immediate pressure to sell their assets.

3. Liquidity Costs are Based on Portfolio Sizes: Theoretically, the risk of a million-dollar portfolio and a billion-dollar portfolio would be identical if they held the same asset classes. Hence, the liquidity costs of converting the portfolio into cash should also be the same. However, this is not the case.

   It is important to understand that when large portfolios are liquidated, the supply of the relevant asset greatly increases in the market. This is what makes the price drop. For example, if someone sells a million-dollar worth of treasury bonds, the market price is unlikely to be impacted. However, if a billion-dollar worth of bonds are sold, then the price is likely to fluctuate.

   Since pension funds hold assets in large quantities, it would be prudent for pension fund managers to recognize the increased liquidity risk based on the dollar value of their investments. Many pension funds across the world simply avoid this problem by holding highly liquid government securities worth three to four years of the benefits which they expect to pay in the near future. This prevents any sudden liquidation of assets which could affect the costs of liquidation.

4. Every Risk Must be Recognized: A lot of the time, pension funds fail to take all the possible risks into account. This is because of the fact that some of the asset classes in which they invest do not provide daily updates in terms of financial values.

   For instance, it is difficult to valuate investments made in private equity, real estate, and such other asset classes. Also, many times, sovereign debt is considered to be risk-free. Both these practices skew the perception of risk in a pension fund. It is important for the pension fund to be vigilant and ensure that all risks are accurately recorded.

5. Measure Active Management Risks: Pension funds all across the world hire managers whose task is to manage risks by actively selecting the asset classes which need to be traded. However, pension funds also have another choice. They can simply choose the buy the index instead of picking individual stocks.

   The risk management framework must understand that the firm is taking additional risks by hiring managers and trying to pick individual stocks. Hence, the investors must be compensated for taking that additional risk. It is important for the pension fund to take benchmark returns while understanding the risk-return profile of the pension fund.

6. Considering the Risk of Guarantees: Pensions in many parts of the world, particularly defined benefit pension plans are protected by guarantees. These guarantees can come from a sponsoring organization or from a centralized body. In either case, it is wrong to assume that these guarantees are infallible. Pension funds should consider the fact that these guarantees may sometime not be fulfilled.

   Many pension funds consider the underfunding of a pension fund as the amount owed by the sponsor. They then apply the same principles of concentration of risk to this notional investment. This means that if the fund cannot invest 10% of its net worth in a single stock, it cannot be underfunded by more than 10%. This is because the 10% owed by the sponsor organization is considered to be an investment in their stock.

The bottom line is that pension funds must have specialized risk management policies in place. They need to build their policies in accordance with the best practices followed by the industry.