Successful dynamic risk management

Mike Rogers explains why pension schemes should now be looking at dynamic risk management

In June 2007, UK DB pension funding levels were high, equity markets were high and gilt markets were relatively good value. Many funds, consultants and managers identified that there was a clear opportunity for pension funds to de-risk to lock in their good funding position. Yet, very few funds changed their allocation (we estimate around one in 10 of our funds took some action to reduce risk and lock in gains). There are good reasons for this – many trustee meetings run on a quarterly cycle and there are many ‘stakeholders’ in the decision to lock in gains, all of whom need to be convinced that action is better than inaction. In short, the June 2007 opportunity lasted about two months and this was not sufficient time to complete the necessary due diligence.

A journey plan as a foundation for managing your scheme
Things have moved a long way since then. The majority of our clients have a journey plan in place with explicit objectives around funding levels, time horizon to reach those funding levels and target levels of return and risk along the way. Furthermore, while a journey plan forms the foundation for a lot of decision-making, actually it is dynamic management of the journey plan which really adds value. One aspect of this is dynamic de-risking (or re-risking) when markets provide an opportunity to lock in gains.

Constructing a successful dynamic risk management strategy
De-risking is not straightforward for UK pension funds. The sponsor’s input is required (for example to ascertain input on accounts or other company metrics); scheme actuary input is required to confirm there is no contribution impact; and trustees need to be convinced that de-risking fits with overall objectives. To maximise the chance of locking in gains if and when an opportunity arises, all of this needs to be done in advance. In short a successful dynamic risk management strategy consists of the following elements:

■ Pre-agreed funding level triggers for action

■ A default asset switch (size of switch and assets to be switched)

Considerable care is needed in designing these switches and the trigger levels. The triggers need to be set so that the decision to de-risk (or re-risk) is very clear cut when the switch takes place. Also, the triggers should not be too close – otherwise triggers will be breached too often due to normal market volatility. Finally, the amount of assets to be switched should be set at such a level that the stakeholders are happy to accept a largely automated process.

Implementation of a successful dynamic risk management strategy - monitoring
Central to implementation is reliable daily funding level reporting. Towers Watson’s proprietary tool (ALT – Asset Liability Tracker) is a sophisticated bespoke tracking tool. It provides daily funding level updates on a number of bases (eg low risk gilts, accounting, technical provisions). It is technically extremely advanced – for example tracking is based on full valuation of ‘three dimensional cashflows’ using the full yield curve. This is not a rough roll-forward, it is effectively a full actuarial valuation every day. Importantly for a dynamic risk management process, ALT provides automatic email alerts when funding triggers are close and when they are reached. That means that opportunities are identified immediately and action can be taken. Additionally, ALT provides a full suite of risk management tools so key metrics such as value at risk can be monitored.

Implementation of a successful dynamic risk management strategy – governance
The final pillar needed for success is a clearly defined governance process. Typically, stakeholders would agree a dynamic risk management governance document that would identify who is responsible for acting on email alerts, arrangements for dealing with absence, default action to take in the absence of alternative views, the process and timescale for stakeholders to provide their views, clarity over action to be taken and the balance of powers if there is a difference of view, timescales and responsibility for implementing such a switch and finally, reporting requirements.

Through Asset Liability Tracker, Towers Watson provides the tools and processes for implementing dynamic de-risking. Our approach is to design a bespoke process for each client and offer a flexible range of implementation options ranging from full engagement to full implementation through our fiduciary service.

Written by Mike Rogers, senior investment consultant, Towers Watson

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