EDHEC-Risk Concept Industry Analysis Featured Analysis Latest EDHEC-Risk Surveys Features Interviews Indexes and Benchmarking FTSE EDHEC-Risk Efficient Index Series FTSE EDHEC-Risk ERAFP SRI Index EDHEC-Risk Alternative Indexes EDHEC IEIF Quarterly Commercial Property Index (France) Hedge Fund Index Research Equity Index Research Amundi "ETF, Indexing and Smart Beta Investment Strategies" Research Chair Rothschild & Cie "Active Allocation to Smart Factor Indices" Research Chair Index Regulation and Transparency ERI Scientific Beta Performance and Risk Reporting Hedge Fund Performance Performance Measurement for Traditional Investment CACEIS "New Frontiers in Risk Assessment and Performance Reporting" Research Chair Asset Allocation and Alternative Diversification Real Assets Meridiam Infrastructure/Campbell Lutyens "Infrastructure Equity Investment Management and Benchmarking" Research Chair Natixis "Investment and Governance Characteristics of Infrastructure Debt Instruments" Research Chair Société Générale Prime Services (Newedge) "Advanced Modelling for Alternative Investments" Research Chair CME Group "Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" Strategic Research Project Asset Allocation and Derivative Instruments Volatility Research Eurex "The Benefits of Volatility Derivatives in Equity Portfolio Management" Strategic Research Project SGCIB "Structured Investment Strategies" Research ALM and Asset Allocation Solutions ALM and Private Wealth Management AXA Investment Managers "Regulation and Institutional Investment" Research Chair BNP Paribas Investment Partners "ALM and Institutional Investment Management" Research Chair Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair Lyxor "Risk Allocation Solutions" Research Chair Merrill Lynch Wealth Management "Risk Allocation Framework for Goal-Driven Investing Strategies" Research Chair Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair Non-Financial Risks, Regulation and Innovations Risk and Regulation in the European Fund Management Industry Index Regulation and Transparency Best Execution: MiFID and TCA Mitigating Hedge Funds Operational Risks FBF "Innovations and Regulations in Investment Banking" Research Chair EDHEC-Risk Publications All EDHEC-Risk Publications EDHEC-Risk Position Papers IPE EDHEC-Risk Institute Research Insights AsianInvestor EDHEC-Risk Institute Research Insights P&I EDHEC-Risk Institute Research for Institutional Money Management Books EDHEC-Risk Newsletter Events Events organised by EDHEC-Risk Institute EDHEC-Risk Smart Beta Day Amsterdam 2017, Amsterdam, 21 November, 2017 EDHEC-Risk Smart Beta Day North America 2017, New York, 6 December, 2017 Events involving EDHEC-Risk Institute's participation EDHEC-Risk Institute Presentation Research Programmes Research Chairs and Strategic and Private Research Projects Partnership International Advisory Board Team EDHEC-Risk News EDHEC-Risk Newsletter EDHEC-Risk Press Releases EDHEC-Risk in the Press Careers EDHEC Risk Institute-Asia EDHEC Business School EDHEC-Risk Executive Education EDHEC-Risk Advances in Asset Allocation Blended Learning Programme 2017-2018 Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management Yale SOM-EDHEC-Risk Harvesting Risk Premia in Alternative Asset Classes and Investment Strategies Seminar, New Haven, 5-7 February, 2018 Investment Management Seminars Contact EDHEC-Risk Executive Education Contact Us ERI Scientific Beta EDHEC PhD in Finance
Features
Institutional Investment - June 16, 2010

EDHEC-Risk Survey of the Asset-Liability Management Practices of European Pension Funds

Why Pension Funds Should Favour Rule-Based Strategies over Discretionary Ones

EDHEC-Risk Institute took a recent survey of pension funds, their advisers, regulators, and fund managers. One hundred twenty-nine of these asset/liability management (ALM) specialists, representing assets under management (AUM) of around €3 trillion, responded to the survey. Pension funds and their sponsors account for approximately €0.9 trillion.

ALM involves covering liabilities and generating performance; in addition, pension funds must respect their minimum funding ratios, or, more broadly, achieve their goals. In the end, proper ALM requires three forms of risk management. Covering liabilities requires hedging risks; generating performance in efficient portfolios requires diversifying risks; ensuring that minimum funding ratios and other constraints are respected at all times requires insuring risks away.

The first challenge for a pension fund involves meeting its liability by fully or partially hedging it away. The survey suggests that the liability-hedging portfolio (LHP) is modelled imprecisely at 45% of pension funds. From an academic perspective, liability-driven investing (LDI) is an example of life-cycle investing (Viceira 2007).

The second challenge for pension funds is to gain access to performance through optimal diversification within an asset class and between asset classes. We find that 66% of 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. In addition, pension funds invest relatively little in alternative and potentially illiquid assets, though pension funds are the longest-term investors and are not subject to liquidity risk. The average cumulative weights of investments in hedge funds, private equity, and infrastructure come to less than 15%, and, combined with real estate, investment in these asset classes is less than 25%.

Last, pension funds must ensure they respect their minimum funding ratios and other constraints by insuring risks away. To do so, they must define risk budgets and risk-controlled investing (RCI) strategies that involve forgoing upside potential in exchange for protection on the downside. The survey suggests that pension funds generally understand risk-controlled investing more often than they use it: RCI, which insures against a fall in funding ratios below the required minimum, is understood by 53% of pension funds but used by only 27%. Twenty-eight percent of respondents use RCI, whereas 56% use economic/regulatory capital to manage prudential constraints. Like RCI, economic capital relies on the measure of a risk budget and of a surplus. Economic capital, however, involves a discretionary, as opposed to rule-based, investment strategy, and possible implementation delays. We thus recommend that pension funds rely more heavily on rule-based strategies in their economic capital models.

The majority of respondents have a blinkered view of the risks they face: prudential risk (the risk of underfunding) is managed by only 40% of respondents, accounting risk (the volatility from the pension fund in the accounts of the sponsor) by 31% of respondents. More than 50% of respondents ignore sponsor risk (the risk of a bankrupt sponsor’s leaving a pension fund with deficits).

Last, pension funds generally do not assess the adequacy of their ALM. Thirty percent of respondents do not assess the performance of the design of the performance-seeking portfolio, and more than 50% use crude outperformance measures. These failings may lead to sub-optimal decisions’ being taken again and again.

This research was produced as part of the "Regulation and Institutional Investment" research chair sponsored by AXA Investment Managers.