European pension funds have blinkered view of risk

The liability-hedging portfolio of European pension funds is imprecisely modelled at nearly half of the pension funds as measured in a EDHEC-Risk Institute survey.The survey, which covered 129 asset/liability management specialists, from pension funds, their advisers, regulators and funds managers, found the majority of respondents have a blinkered view of their risks.

Accounting risk, the volatility from the pension fund in the sponsor’s books, is managed by only 33 per cent of respondents, and more than 50 per cent ignore sponsor risk, or the risk of a bankrupt sponsor leaving a pension fund with deficits.

The author of the report, Samuel Sender, who is applied research manager at EDHEC-Risk Institute, said the first challenge for a pension fund involves meeting its liability by fully or partially hedging it away.

He said the second challenge for pension funds is to gain access to performance through optimal diversification within and between asset classes.

“Most respondents use market indices to define the investment benchmarks of investment funds, even though market indices are weighted by capitalisation and are known to be highly inefficient.

“Additionally even though they are the longest-term investors and are not subject to liquidity risk, pension funds invest relatively little in potentially illiquid assets and therefore do not benefit from the related risk premium.”

The last challenge for pension funds, he said, was to respect their minimum funding ratios by insuring risks away.

To manage the prudential constraints, 28 per cent of respondents use risk-controlled investing strategies, and 56 per cent use economic/regulatory capital.

“Like RCI economic capital relies on the measure of risk budget and of a surplus. Economic capital, however involves a discretionary, rather than a rule-based, investment strategy and possible delays.”