Implementing Change: A Risk Management Paradigm
IN PRINT ARCHIVE CIR Winter 1999
|Implementing Change: A Risk Management Paradigm for Plan Sponsors|
|by Lloyd Komori|
A defined benefit (DB) pension plan must take whatever steps are necessary and prudent to ensure it will be able to pay benefits to all plan members for the foreseeable future. In order to deliver on this "pension promise," the plan's stewards must carefully consider the anticipated requirements of the plan members (i.e. the liability stream) within the context of the future investment returns required so that benefits can be paid.
Using actuarial science to affix a future value to the liability stream, it falls on the stewards to make decisions concerning the types of investment strategies needed to meet and possibly exceed the estimated cashflow requirements. An accepted premise among plan sponsors is that the most significant factor to consider when determining investment strategy is asset allocation. According to classical investment analysis, the decision of which specific proportions of the investment port-folio to allocate to different asset classes accounts for over 80% of total investment return.
Given the importance of this factor, much time and effort is dedicated to determining the specific asset allocation strategy for the pension plan. Once this is done, the investment deliberations drill down to the next level, and focus on factors that will determine the best mix of the components available within each asset class. These investment decisions could be characterized as "tactical" in nature, because their impact seeks to add incremental value to the larger component of the total return set by the asset allocation decision.
In the midst of this time-honoured process, risk management must be added to the mix. Those responsible for the stewardship of DB pension plans feel compelled to respond to what seems to be a universal calling to improve, increase and enhance risk management capabilities. While they may feel that a response is warranted, there is little in the way of guidance to help plan sponsors decide the correct and prudent course of action.
The divergence of opinions regarding what comprises "risk management" is one reason why this topic is so difficult to deal with. If you ask someone working in the internal audit division of a large bank for their definition, it would be quite different than the response given by the individual working in the finance and control department of a large Canadian pension plan. Taking this one step further, if you were to ask the portfolio manager responsible for managing an active emerging market bond portfolio for his or her definition, the response would be different again. Given this, how can a pension plan identify the risks it faces?
We begin with a fundamental premise: all DB pension plans require a risk management framework that reflects the unique characteristics of that plan. In other words, a "one size fits all" approach is not really a good foundation upon which to build a robust risk management framework. The primary reasons to support this premise are as follows:
1. The liability structure of each pension plan is unique and requires its own unique investment strategy.
2. Each plan's particular investment strategies give rise to specific types and quantities of risks (both market and operational) which need to be addressed individually as they are identified and measured.
3. Each plan possesses different capabilities to respond to these challenges and, as such, must tailor their remedial actions accordingly.These factors, in conjunction with others, create the need for pension plans to form and execute a risk assessment process that is unique, yet founded in a well-defined and methodical manner.
The procedure described here is designed to help pension plan sponsors uncover, and hopefully quantify the risks that result from specific investment activity mandated by their overall investment strategy. It requires a phased approach, each step providing the analysis information required for the following step.
This process should not be mistaken for an optimal investment type of process which attempts to quantify an investment's return within a risk framework that is based on market volatility and behaviour that is independent of any one investor. Conversely, the approach attempts to take into consideration factors that are not market related. Instead, these factors are unique to the individual pension plan's existing infrastructure.
Figure 2 provides an example of how a project plan for a risk assessment process should be organized. Specific timelines, milestones and inter-dependencies should be established prior to commencing a project of this type, in order to reduce "project management risk."
Acquiring a Technology Solution
A pension plan executive needs to know how the initial phase of a comprehensive risk management development project comes together before authorizing the expenditure of thousands of dollars. The selection and implementation of an appropriate technology solution which addresses both existing and near-term needs can mark the end of the first critical phase of the process.
However, buying a technology solution capable of managing investment-related risk does not necessarily make your pension plan "less risky," any more than buying car insurance makes you less likely to get into an automobile accident. In fact, in some cases, having a robust risk management system can be a "bad thing" if an organization places too much emphasis on what "the system" produces, and less weight on a blend of healthy skepticism, market experience and common sense.
Nevertheless, it has become clear that the increasing volatility and complexity associated with managing the investment activity of a pension plan demands that executives carefully consider the advantages of incorporating robust and comprehensive technology into a risk management paradigm. The advantages associated with this kind of initiative come from developing a new perspective on the risks that are generated by the pension plan's investment activities.
While no measurement standard has received universal acceptance and application within the institutional investment community, it is still a good idea to begin work in this area in order to learn from the experience gained.
Attempting to determine the appropriate level of commitment an organization should consider before it begins the technology selection/implementation phase of their process is not easy. The size of the expenditure should be directly related to the specific factors that distinguish the plan to its membership. Pension plan executives need to consider the major factors that impact the financial viability of the plan, such as:
* the funding status (deficit vs. surplus);
* the nature of the investment policy and strategies (active vs. passive); and
* the execution of the investment policy (internal vs. external). These factors, in addition to others, impact both the types and nature of investment-related risks that the plan is exposed to, and must be closely examined prior to determining the appropriate investment to make in technology.
Developing a strategy to create or enhance the risk management capabilities of a pension plan should not be seen or regarded as an event-specific initiative. Such an approach puts too much at stake, and can result in "paralysis by analysis." It is more important to create the awareness that risk management should be a "state of mind" for the organization that is willing to evolve and respond to new challenges. A good approach would be to recognize at the outset that the development and enhancement of an organization's risk management strategies and processes are, in reality, a continuum critical to the future success of the pension plan.
Lloyd Komori is a Partner with Deloitte & Touche.