HOW SHOULD PENSION FUNDS MANAGE RISK?

Journal of Applied Corporate Finance S U M M E R 1 9 9 8 V O L U M E 1 1 . 2

How Should Pension Funds Manage Risk? by Keith P. Ambachtsheer, KPA Advisory Services Ltd.

VOLUME 11 NUMBER 2 SUMMER 1998122

HOW SHOULD PENSIONFUNDS MANAGE RISK?

by Keith P. Ambachtsheer,KPA Advisory Services Ltd.

122BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

1. Peter L. Bernstein, Against The Gods, John Wiley & Sons, 1996.2. The legal framework for corporate pension plans in the U.S. is set out in the Employee Retirement Income Security

Act (ERISA) of 1974, and a series of subsequent interpretive bulletins issued by the Department of Labor. ERISA focuses on“the interests of the beneficiaries” of pension plans. It does not adequately recognize that in a going concern context,shareholders also have a material financial interest in how well a pension fund performs in the sense that they typicallyunderwrite whatever contribution rate is required to keep the plan fully funded.

mastery of risk.”1 The implication is that for institutions to be modern, they must

have mastered risk. By this standard, most pension funds are not yet modern

institutions, for they are still struggling with both the concept of risk, and the

practicalities of managing and measuring it in useful ways.

The trouble often starts by focusing on the wrong risk, such as the

possibility of a low performance ranking in a pension fund return universe. A

low return relative to other pension funds may be an embarrassment risk for

pension fund fiduciaries, but may in fact be the unavoidable by-product of a

good risk management decision when seen from the perspective of the pension

plan stakeholders. Pension fund fiduciaries need reminding that they have a

legal and moral obligation to place the financial welfare of the pension plan

stakeholders ahead of their own perceived needs.2

However, the trouble many pension funds continue to have with risk is not

only a matter of the wrong perspective. Even fiduciaries who want to do the

right thing are still short of the right tools. This article is addressed to them. Its

goal is to construct a risk management tool kit which will help pension

fiduciaries discharge their fiduciary obligations.

n his recent best-selling book about the history of risk and its

management, Peter Bernstein asserts: “The revolutionary idea that

defines the boundary between modern times and the past is the

I


Three Features of Good Risk ManagementTools

Before assembling the risk management toolkit, it is helpful to set out the specifications whichwould make it “good.” Here are three:

1. Good risk management tools are contextual.They are grounded in what Peter Drucker oncecalled “the theory of the business.”3

2. Good risk management tools facilitate goodorganization design, delegation, decision-making,and learning.

3. Good risk management tools permit “goodenough” measurement, both before and after thefact.

We will see whether the tools built in this articlecan pass these three tests.

THE THEORY OF THE PENSION FUNDBUSINESS AND ITS IMPLICATIONS

The essence of Peter Drucker’s 1994 HBRarticle “The Theory of the Business” is that behindevery organization lie assumptions about its mis-sion, the context in which that mission is to beaccomplished, and the core competencies requiredto achieve it. Thus the theory of a pension fundbusiness could be stated as “turning the costs ofundertaking risks and the costs of operations intovalue for its stakeholders.”4

Such a theory of the pension fund business hasclear implications for what the business needs tomeasure. First, it needs to be able to measure the risksbeing taken. Second, its needs to be able to convertmeasured risks into costs. Third, it needs to be ableto combine risk costs with operating costs into ameasure of the total cost of gross value production.Finally, it needs to be able to apply this cost againsta relevant measure of fund return (i.e. gross valuebeing produced) to arrive at net value produced forstakeholders.5

A critical strategic metric for assessing thefinancial health of a pension plan that promisesdefined benefits is the “funded ratio” of its balance

sheet—that is, the ratio of marked-to-market planassets to marked-to-market accrued plan liabilities.A funded ratio of 1.0 means assets equal liabilities.A ratio of less than 1.0 means there are unfundedliabilities on the balance sheet. A ratio in excess of1.0 means there are surplus assets on the balancesheet. Generally, funded ratios under 1.0 implymore default risk and higher contribution rates forplan stakeholders. Funded ratios over 1.0 imply lessdefault risk and lower contribution rates for stake-holders.6 Thus we can say that, at a strategic level,pension fund risk is closely tied to unexpecteddeclines in a pension plan’s funded ratio.

WHAT ARE THE SOURCES OF PENSIONFUND RISK?

Before pension fund risk can be measured, itssources must be understood. Fiduciaries of pensionfunds securing defined pension benefits can chooseto expose fund stakeholders to two kinds of risks:

1. Asset Mix Policy Risk. This is the risk of areturn shortfall arising from choice of an asset mixpolicy different from a zero-risk immunizationpolicy, which would aim simply to match accruedpension liabilities with a debt securities portfoliowith the same payments duration and inflationsensitivity. In other words, an immunizing assetmix policy would aim just to maintain a pensionplan’s funded ratio. A more aggressive asset mixpolicy would aim to improve the funded ratio, butwith the risk that it could in fact worsen.

2. Implementation Risk. This is the risk of a returnshortfall arising from choice of an asset mix policyimplementation strategy involving active manage-ment of securities portfolios or direct real estate orprivate equity investment programs. Again, the aimof active management is to increase the plan’sfunded ratio by earning excess return, but with therisk that the funded ratio could be reduced.

Thus, a good pension fund risk managementtool kit must be able to deal with theconceptualization and measurement of both assetmix policy risk and implementation risk. Also, a

3. Peter Drucker, “The Theory of the Business,” Harvard Business Review,September-October, 1994.

4. This “run the pension fund like a business” paradigm is fully developed ina new book co-authored by Keith P. Ambachtsheer and D. Don Ezra, Pension FundExcellence: Creating Value For Stakeholders (John Wiley & Sons, 1998).

5. There is a close parallel between how we develop a “bottom line” here,and how it is done on a corporate income statement, with final “net income”adjusted for the cost of risk capital.

6. A confusing aspect of pension finance is that there is not just one balancesheet, but many. There are separate balance sheets for funding purposes, foraccounting statement purposes, for PBGC reporting purposes, etc. Lying under-neath all this confusion is the “true” marked-to-market balance sheet relevant forbalance sheet risk assessment.


TABLE 1 THE EVOLUTION OF RISK MANAGEMENT BY FINANCIAL INSTITUTIONS

Area 1970s 1980s 1990s

Regulation Rates regulated Deregulation GlobalizationStrategy Grow Deal with disintermediation Consolidate and integrateTechnology Mainframe PCs Powerful PCs in networksFinancial Innovation Futures Swaps, Options, Structured Products,

common risk metric is needed if these two sourcesof pension fund risk are to be converted intocomparable risk cost components, and ultimatelycombined at the total fund level.

RISK MEASUREMENT: FROM CONCEPT TOAPPLICATION

Above, we defined risk as a return shortfallrelative to some pre-established requirement orexpectation. For this definition to become useful,four further considerations must be addressed.First, we need the right return metrics. Second, weneed a way of converting possible asset mix policyand implementation decisions into potential returnshortfall magnitudes. Third, we need a way ofconverting any estimated return shortfall into mean-ingful economic consequences for pension fundstakeholders. Fourth, the framework should beconvertible from a before-the-fact decision-makingcontext to one that allows for after-the-fact moni-toring and decision assessment.

1. The Right Return Metrics. Asset mix policy riskwill depend on the potential deviation between afund’s “policy return” (that is, the estimated returnof the chosen asset mix policy, implemented pas-sively) and a fund’s “liability return” (the estimatedreturn on a portfolio of default-free bonds with thesame duration and inflation-sensitivity as the pen-sion liabilities). Implementation risk will depend onthe potential deviation between a fund’s actual returnand its passively implemented “policy return.”

2. Estimating Return Shortfall Magnitudes. Thekey metrics are the volatilities of the two sets of return

deviations (that is, deviations between “policy” and“liability” returns, and between “actual” and “policy”returns). In both cases, a negative deviation willlower the pension plan’s funded ratio.

3. Converting to Meaningful Economic Conse-quences. A useful first step is to convert the esti-mated return deviation volatility associated with anycontemplated decision into an adapted value-at-risk(VAR) metric. This leads to statements like “if we goahead and do this, we should expect a 20% reductionin the plan’s funded ratio in one year out of 40.” Thiskind of expectation could then be further converted,if desirable, into other economic consequences suchas the likely associated contribution rate increase.

4. Decision Monitoring and Assessment. Riskexposure decisions should be made on the expec-tation that the payoff from undertaking a given levelof risk will be sufficiently rewarded. This requiresthat actual risk exposure be monitored againstdecided (or maximum permitted) risk exposure,and that the actual value being created by the fundbe monitored against expected or required value.

THE VALUE-AT-RISK (VAR) METRIC

Designing the right pension fund risk managementapproach was the focus of a recent client symposiumsponsored by the pension performance benchmarkingfirm Cost Effectiveness Measurement (CEM).7 CEM co-founder John McLaughlin used the matrix shown asTable 1 in this article to trace the evolution of financialinstitution risk management since the 1970s.

A key point of the table is that the current focuson VAR as a key risk management tool in financial

7. Cost Effectiveness Measurement (CEM), based in Toronto, Ontario, Canada,monitors the organizational performance of about 250 pension funds around theworld aggregating to over $1.5 trillion.

Mortgage Backed Securities Exotic DerivativesCredit Markets Inflation High Rates to Stability Low RatesRisk Concerns Aggregation of data Measurement Enterprise RiskRisk Management Tools Portfolio Aggregation Duration Value-at-Risk (VAR)


management situations is no accident. It is the resultof a natural evolution. This evolution involved notonly bigger databases, more computer power, andmore complex financial instruments, but also keystrategic elements. For example, effective strategicrisk management now requires an ability to aggre-gate different micro risk exposures into overallenterprise exposure.

At the same symposium, pension fund man-ager Leo de Bever explained why his organizationhad moved to a VAR-based risk management frame-work over the course of the last two years.8 Heargued that the traditional risk management ap-proach in the pension fund industry based onsecurity type and weighting limits is becomingincreasingly problematic. The problems he identi-fied are these:

Too many rules to monitorNo aggregate measure of riskNo allowance for risk diversificationNo way to track changes in risk exposureSlow to catch mistakes and “rogue” activity

De Bever observed that the key to successfulimplementation of a new VAR-based approach wasits eventual acceptance both up and down theorganizational ladder. In other words, both thefund’s governing and operating fiduciaries need tobuy in for a VAR-based risk management approachto be successfully implemented.

RISK MEASUREMENT: A CASE STUDY

Thus the acid test for the ideas set out in thisarticle is whether they can survive application inthe real world. A case study using data from adatabase created by CEM provides further evi-dence they can. The test involved evaluating fouryears (1992-1995) of actual performance by 98 U.S.and Canadian pension funds managing combinedassets of $700 billion.9

1. The Right Return Metrics. The CEM databasecontains estimates of actual returns, policy returns,

and liability returns. Thus estimates of the devia-tions between policy returns and liability returns,and between actual returns and policy returnscould be calculated.10

2. Estimating Return Shortfall Magnitudes. Thereturn deviation data in turn permitted the calcula-tion of the volatilities (that is, standard deviations orSDs) of the two types of return deviations for eachof the 98 funds. The mean policy volatility was 9%(with a range of from 5% to 13%). The meanimplementation volatility was 2% (range 0% to 9%).

3. Converting to Meaningful Economic Conse-quences. Given the policy and implementationvolatility averages of 9% and 2%, respectively, theaverage fund appeared to have about 18% (that is,two standard deviations) of its balance sheet fundedratio at risk due to its asset mix policy decision(about 60% equity, 40% debt). That is, it is reason-able to expect an 18% drop in the funded ratio in oneyear out of 40. Similarly, the average fund had about4% of its funded ratio at risk due to its implementa-tion strategy, implying that a 4% reduction is reason-able to expect in one year out of 40.

4. Decision Monitoring and Assessment. Theseresults reflect a four year (1992-1995) experience,calculated after-the-fact. Did the average fund in-tend to place about 18% of its funded ratio at riskthrough its asset mix policy decision (about 60%equity:40% bonds) over this period? Did the aver-age fund intend to place about 4% of its fundedratio at risk through its implementation strategyover this period? Did the average fund realize thatthe funded ratio at risk due to the joint policy andimplementation effects was only about 18.5%, as-suming independence between the two effects? Orwere most funds too busy trying to be like every-one else?

After-the-fact risk monitoring is only half of agood risk management discipline. Indeed, it may bethe lesser half. The more important half is decidingrisk exposure limits before-the-fact, and gaugingwhat kind of pay-back is required to justify it.

8. Leo de Bever is Vice President, Research and Economics, at the OntarioTeachers’ Pension Plan Board, which is one of the global leaders in applying state-of-the-art risk management tools in a pension fund “business” context.

9. The results of this study first appeared in a series of “Ambachtsheer Letters”in the fall of 1996. This advisory letter is published by KPA Advisory Services,Toronto, ON, Canada for its clients. The study results also appear in the newPension Fund Excellence book cited in footnote 4.

10. The data is supplied directly by participating pension fund organizations toCEM on a calendar year basis. “Policy returns” are estimated based on a fund’s statedasset mix policy weights, and on the performance of benchmark portfolios that reflect“market” performance in such major asset classes as domestic and foreign equities,domestic and foreign bonds, real estate, etc. “Liability returns” are estimated based onannual changes in the yield curve for conventional and index-linked Treasury bonds,as well as on information about a pension plan’s pre-, and post-retirement inflationprotection “deal,” and its membership composition in terms of actives, deferreds, andretirees. The funds also supply a detailed breakdown of their operating costs.

After-the-fact risk monitoring is only half of a good risk management discipline.Indeed, it may be the lesser half. The more important half is deciding risk exposure

limits before-the-fact, and gauging what kind of pay-back is required to justify it.


HOW MUCH RISK EXPOSURE AND HOWMUCH SHOULD IT PAY?

A simple way to think about what risk capitalshould return is to think about the net return require-ment on venture capital. A fairly common rule ofthumb is 5% in excess of expected stock marketreturns, which we estimate at 8% today.11 This sug-gests a 13% return requirement on risk capital.

Applying this rule of thumb to the average1992-1995 funded ratio at the risk experience re-ported above, the implications are that (1) a 60-40mix of stocks and bonds needs to generate aminimum policy risk premium of 2.3% (that is, 0.13× 18%) over the liability return, and (2) the typicalimplementation strategy needs to generate a mini-mum net implementation risk premium of 0.5%(0.13 × 4%) over the policy return.

Using these standards, the average pensionfund is unambiguously generating value for stake-holders when its realized net policy risk premiumexceeds 2.3%, and when its realized net imple-mentation risk premium exceeds 0.5%. The sum ofthese two requirements adds up to a 2.8% riskpremium requirement at the total fund level forfunds with average policy and implementation riskexposures.

A somewhat more complex (but more cor-rect) approach would reduce these net risk pre-mium requirements. Recall that the funded ratio atrisk due to the joint policy and implementationeffects was only about 18.5%, assuming indepen-dence between the policy and implementationeffects. A 13% return requirement on 18.5% impliesonly a 2.4% (0.13 × 18.5%) risk premium require-ment at the total fund level.

One way to allocate this total fund 2.4% riskpremium requirement between its policy and imple-mentation components would be to base the split onthe relative magnitudes of the two underlying vola-tilities (i.e., 9:2 policy:implementation ratio). Thusthe 2.4% total splits into a 2.0% policy risk premiumrequirement (vs. 2.3% above), and a 0.4% implementa-tion risk premium requirement (vs. 0.5% above).

Thus if the average fund had actually (1) de-cided it was prepared to underwrite the risk of an18.5% drop in its funded ratio 1 year out of 40,(2) decided on the relative exposures to policy andimplementation risk reflecting average pension fundexperience, and (3) imposed a 13% return require-ment on funded ratio at risk, its “break-even” net riskpremiums would be 2.0% for policy and 0.4% forimplementation.

In a forward-looking sense, these two riskpremium targets would become the central compo-nents of the fund’s business plan. That is, 2.0% and0.4% would become the minimum value-addedtargets for policy risk exposure and implementationrisk exposure respectively. Results in excess of theserequired targets would imply the fund is generatingpositive risk-adjusted net value-added, or RANVAfor short, for fund stakeholders.12

CAN PENSION FUNDS PRODUCEPOSITIVE RANVAs?

How tough are a 2.0% policy target and a 0.4%implementation target for net value-added to hit forthe average fund? Over the 1992-1995 period, theaverage net policy risk premium realized was 2.1%.The average net implementation risk premiumrealized was –0.2%. Thus the average 1992-1995policy RANVA was 0.1% (2.1%–2.0%). The averageimplementation RANVA was –0.6% (–0.2%–0.4%).Thus the policy target was hit, while the implemen-tation target was missed.

What about the next four years? For example,in a recent study we projected a forward-lookingpolicy risk premium of 1.2% for a 60-40 mix.13 Thisis well below the required 2.0% we calculatedabove, and which was actually realized over the1992-1995 period. At the same time, we argued thatthere was no reduction in the 60-40 mix’s fundedratio VAR. The point here is not to debate the meritsof our forward-looking policy risk premium andpolicy VAR projections. Instead, the point is thevalue of the proposed risk management frameworkas a decision-making and communication tool.

11. See Keith P. Ambachtsheer, “Why Things Are Always Different This Time,”Ambachtsheer Letter #192, January 1998. The 8% estimate is based on adding a 2%dividend yield to a 6% earnings and dividend growth projection.

12. RANVA is the equivalent measure for evaluating financial asset manage-ment organizations of Stern Stewart’s EVA measure for evaluating corporateoperating performance.

13. See Keith P. Ambachtsheer, “How Fiduciaries Should Decide Asset MixPolicy”, Ambachtsheer Letter #194, March 1998.


In a similar vein, the framework is helpful inclarifying the issues surrounding the creation ofsuccessful active management programs for pen-sion funds. The results cited above suggest that, onaverage, these programs have not been paying forthemselves. In another recent study, we showedthat a major cause of the generally poor RANVAresults for pension funds is weak governance andorganization design.14 The proposed risk manage-ment framework can play a key role in the effectivedelegation of authority between a pension fund’sgoverning, managing, and operating fiduciaries.15

The study showed that lack of delegation clarity was

especially problematical in many pension fundorganizations.

In conclusion, the risk management frameworkset out in this article offers governing, managing, andoperating fiduciaries of pension funds a consistentstructure for evaluating policy risk, implementation risk,and total fund risk—a structure that has been missing.How much of each should they expose balance sheetstakeholders to? And what paybacks on risk exposureshould be required? The answers to these difficultquestions ought to be at the core of any pension fund’sbusiness plan. However, they cannot be answeredsensibly without the right risk management framework.

These two risk premium targets would become the central components of the fund’sbusiness plan. That is, 2.0% and 0.4% would become the minimum value-added

targets for policy risk and implementation risk. Results in excess of these targetswould imply the fund is generating positive RANVA for its stakeholders.

KEITH AMBACHTSHEER

advises pension plan sponsors on governance, finance, andinvestment issues. His new book (with co-author Don Ezra)Pension Fund Excellence: Creating Value For Stakeholders has

14. The results of this study first appeared in Keith P. Ambachtsheer, “GoodGovernance Matters Most,” Ambachtsheer Letter #190, November 1997. Thestudy results are also described in the new Pension Fund Excellence book citedin note 4.

15. At Ontario Teachers’ Pension Plan Board, for example, the governingfiduciaries decide on the maximum amount of total fund implementation risk. Itis then left to the managing fiduciaries to decide how to use this risk ‘budget’ tomaximize implementation RANVA. Thus the respective responsibilities of bothgroups are very clear.

just been released by John Wiley & Sons. He is President of KPAAdvisory Services, and co-founder of Cost Effectiveness Mea-surement, based in Toronto, ON., Canada.

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HOW SHOULD PENSION FUNDS MANAGE RISK?