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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.