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Institutional Investment - April 27, 2009

The Impact of Regulations on the ALM of European Pension Funds

Tightening accounting standards and prudential regulations require a clearer understanding of the risk management and investment strategies used by pension funds. Greater attention is being paid to the volatility of the surplus, and there is less tolerance of underfunding. These changes call for an improvement in ALM strategies and the use of state-of-the- art models—such as dynamic liability-driven investments—for the design of these strategies. The constraints to which pension funds are subject must be clearly understood and embedded in the investment strategies:

  • The impact of the regulatory discount rates for the definition of the portfolio that minimises regulatory risk
  • Rebalancing rules that depend on the surplus and are based on insights from dynamic asset allocation concepts and portfolio insurance techniques
  • Modelling that captures the specific risk-mitigation mechanisms available to the pension fund, such as conditional indexation, variable contributions, support from the sponsor, modification of asset allocation, support from pension insurance schemes
  • Ideally, also, taking into account the negative impact of the probability of sponsor default on the welfare of participants, and hedging this risk
  • The practice of risk management, that is, understanding and monitoring the various risk factors faced by pension funds and the design of appropriate responses to changes.

Fortunately, the tools available to pension funds managers are ever more numerous:

  • New products have also been launched to supplement ALM techniques and manage more efficiently the risks faced by pension funds.
  • New services have emerged to help smaller pension funds manage their assets with state-of-the-art techniques. Fiduciary management, for instance, may provide models to pension funds that do not have the time or capacity to develop their own.

Attention should be paid to the long-term nature of pension funds.

In the landscape for savings providers, pension funds stand out for their role as going concerns. In most countries, after all, it is the responsibility of the employer to make good on pension commitments in the event of shortfalls in the pension fund.

The long-term relationships between employees and their employers, together with the mandatory participation of employees in their occupational pension plans, relieve pension funds of the risk of client runs and surrenders faced by insurance companies and banking corporations and require monitoring of short-term risk thresholds.

By nature, pension funds can be managed as going concerns, and management should take a long-term view when determining investment policy.

In our view, the replication of wage-indexed liabilities perfectly illustrates the coming challenges for both regulatory bodies and pension funds. Pension benefits are indexed either to inflation or to wages. But inflation-linked securities are in short supply, and there is currently no wage-indexed security, so pension funds must find the appropriate assets to hedge inflation risk. Because wages are indexed to the general performance of the economy, real assets, usually equities, are necessary. However, because equities are a volatile, leading indicator of the economy, whereas wages are a lagging indicator, and smoothed at that, replication is possible only over the longer term. That pension liabilities cannot be hedged over the short term makes the importance of taking this long-term view all the greater. As a consequence, and because of their role in providing very long-term benefits, the increasing focus on the short term is worrying for pension funds.

Liabilities that are far more easily replicated over the long term naturally need long-term analyses and risk-management practices. The idea that risk management is best reflected in an internal model is especially relevant for pension funds; after all, no standard formula can capture the diversity of the pension landscape and the variety of protection mechanisms.

As a rule, recent regulation permits the use of internal models, after regulatory approval, for the definition of solvency requirements. Solvency II and the Dutch FTK are no exception, and to some degree UK regulation will extend this approval as well. Approval is primarily conditioned on the use of internal models in the following fields: design of investment strategies, risk monitoring and limit setting, definition of the indexation policy, contribution and funding policy (planning). When these conditions are met, pension funds can align funding requirements and the nature of their risks. Then, when pension funds use risk-mitigation techniques and instruments unrecognised in the standard formula (dynamic strategies, long-term investing), quantitative requirements are reduced.

In a word, accounting and prudential regulations are threatening to make defined benefit pension schemes more costly. The enclosed study concludes that dynamic ALM and internal models may be useful means of warding off this threat.

This research has benefited from the support of the "Regulation and Institutional Investment" Research Chair, AXA Investment Managers.