Risk is not a four-letter word; unintended risk is. Investors need to take some risk in order to achieve their goals.
Historically, technology has been used to measure risk rather than to gain a deeper understanding of it and its management. Asset managers have created risk models to measure short-term risk.
In the case of pension funds, the key risk is not asset-related but the impairment of the fund’s mission, which combines the purpose of the fund, the stakes of various parties and the time horizon.
For a pension fund, the purpose is to meet the fund’s liabilities in a cost-effective manner. There are often multiple interested parties whose interests have to be balanced, and the time horizon is long.
Short-term risk measurement is one of many factors that a pension fund should consider in managing its fund, but it should not be the sole focus. Risk should be thought of as a multi-faceted concept focused on the possibility of shortfall, combining four facets: size, likelihood, impact and significance, as shown in the table below:
Identifying these facets can assist plan fiduciaries in determining how critical each one is and how the governing body may act when an adverse event is experienced. To this end, strong governance—being able to meet regularly and as needed, having the resident knowledge and skills within the governing body and being able to adapt to changing conditions—can be the difference between plan fiduciaries achieving their mission or not.
For example, management may choose to ignore low-likelihood events but, as a result of periodic reviews, may choose to elevate their significance (i.e., assume said unlikely event happened, what then?). Similarly, a pension fund may need to quickly change its emphasis on significance if the corporate sponsor falls on hard times (i.e., the covenant weakens).
As a result of the past few years, many plan fiduciaries are re-evaluating their approach to identifying, measuring and managing risk. Previously, measures were focused on value at risk and tracking error approaches. Investors are exploring a number of enhancements, including the following:
- From a modelling perspective, risk is being assessed through a combination of backward- and forward-looking measures. More time is being spent on gaining a better understanding of tail risk and regimes.
- From an asset allocation perspective, risk-based asset allocation is being used by some investors to achieve return goals and better manage overall risk. This includes the use of risk factor decomposition to allow more dynamic approaches to risk management in response to market conditions and opportunities.
- From a monitoring perspective, risk dashboards that incorporate multiple measures relevant to the investor’s ultimate mission are being created. Real-time monitoring is becoming more commonplace rather than monitoring at the end of a period of time. This is critical where dynamic asset allocation is being used.
The use of risk dashboards is the logical next step in a multi-faceted approach to risk management. Ideally, they would address both the qualitative and quantitative aspects of risk, the likelihood of occurrence and the impact when realized. While each plan fiduciary will determine its own dashboard, aspects that could be included are suggested in the table below:
To illustrate the above, let’s look at one qualitative and one quantitative risk.
Qualitative — Reputational risk cannot be modelled, but it can be reviewed. There is little direct financial risk, but the impact can be extremely large if a plan sponsor’s reputation is tarnished. Management of reputational risk is not likely to be critical to a plan achieving its mission longer term. Therefore, while potentially painful for the plan sponsor, the overall significance is low.
Quantitative — Conversely, mortality risk may have a more significant impact. Mortality risk can be monitored for a pre-specified loss percentage. Management of longevity remains important in order for a plan sponsor to attain its mission. Therefore, mortality risk has medium significance.
It is not an easy task to determine which risks are most significant to the pension plan and what the impact of them may be when they occur. However, it is a worthwhile exercise for plan fiduciaries to undertake, especially in these volatile times.