Risk has become an increasingly narrow and technical area for defined benefit pension schemes. Ryan Boothroyd argues that embracing a holistic view of risk provides us with the greatest chance of meeting our ultimate long-term goal of paying pensions.
When you imagine the phrase “risk management” in your mind, what do you see? For some it may be an endless stream of committee meetings, logs and dashboards. For others, a series of indecipherable charts containing cryptic phrases like “funding level volatility” or “value-at-risk”.
The truth is that most people see nothing. A grey expanse. Why? Because for many pension scheme investors, the entire concept of risk management has become meaningless. Regulation, accounting standards and a desire for spurious accuracy have narrowed the definition of risk to a small number of actuarial metrics. Unfortunately, this has the potential to create overconfidence about future outcomes and a preoccupation with short-term volatility. Fertile ground for sub-optimal decision making, and ironically, more risk.
I want to address three themes. First, the cookie-cutter approach to de-risking for defined benefit schemes does not necessarily fit the unique characteristics of the LGPS. Secondly, risk management for pension schemes has become too narrowly focused, leading to a fallacy of control and an under-appreciation of multi-decade uncertainty. Finally, risk is not something to be feared and harnessing the right types of risk is a key component of a successful long-term investment strategy.
Breaking the zeitgeist
A common piece of investment advice delivered to a pension scheme at the time of an investment review might go something like this: “The funding position of the scheme improved meaningfully over the year and the scheme may wish to consider de-risking their investment portfolio”.
Typically, this involves reallocating a portion of the higher volatility assets in the portfolio (such as equities) into lower volatility assets (such as bonds). This is particularly true when those lower volatility assets are highly correlated to the scheme’s liabilities. Increasingly, this also means using specifically engineered liability-matching strategies.
The problem with this approach is that it equates “risk” with the short-term volatility of the scheme’s funding position. A phenomenon that has become more widespread as regulatory pressure to align assets with funding strategy has increased. This may be important for corporate schemes that are no longer receiving contributions, and whose shareholders scrutinise the pension deficit in their annual accounts, however it not necessarily the right metric for the LGPS.
For an open scheme, with a younger membership profile and a strong sponsor, the critical risk is failure to meet its future liabilities i.e., shortfall risk.
“De-risking” by locking in a guaranteed negative real return from defensive assets, such as index-linked gilts, increases the potential for shortfall over a 50-year period. Truly understanding shortfall risk is a complex undertaking and requires moving beyond a single metric to examine risk in a multi-faceted way.
The upshot for investment strategy is simple. Build a diversified portfolio with a greater focus on long-term real returns and have less of a pre-occupation with minimising short-term volatility. Consider risk from multiple angles and avoid the temptation for reductionism to a single data point.
16 November 2021
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Room 151’s LGPS Investment Forum
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Thinking bigger
An under-appreciated behavioural bias in setting a long-term investment strategy is the illusion of control.
Once you have built a sophisticated model of the future and distilled a complex problem into small number of moving parts, it is easy to assume that the outcome can be precisely controlled.
As a case in point, according to the LGPS Board, 14 Funds changed their 2019 discount rate to within 0.25% of the old one. This kind of tweaking is unproductive and diverts time and resources away from addressing more fundamental problems.
It can sometimes be difficult to comprehend the scale of change that can take place over a multi-decade time horizon. Few scheme valuations published in 1975 would have included the potential for a double-digit, secular collapse in global interest rates over the following 25 years.
When faced with a truly long-term problem, we should focus more on being broadly right, than precisely wrong. Minor adjustments to liability-modelling might provide a short-term sense of security over a valuation cycle, but they risk leading to decisions that are sub-optimal over a 50-year investment horizon.
Finally, we should spend more time considering the impact of truly transformational risks. An obvious example is the potential disruption from climate change. That 2019 finessing of the discount rate won’t mean much if society undergoes a shift that has a profound impact on life expectancy or fundamentally changes the role of retirement benefits. An increasing focus on scenario analysis, such as that mandated by the TCFD (Taskforce for Climate-related Financial Disclosures) climate regulation, is a progressive and forward-looking option.
Harnessing the right types of risk
Risk is not a universal concept. Different types of investors can bare a range of risks depending on their individual circumstances. Where risks are well-compensated and aligned to the structural advantages of an investor, they should be embraced not feared.
An obvious example for the LGPS is illiquidity risk (owning assets that are difficult to sell). Few investors are able to take genuine illiquidity risk and as a result there are attractive premiums to be earned. This could be through locking-up capital for a long-term infrastructure project or by being a provider of liquidity in difficult market circumstances. Unlike many others, our short-term income needs are low and we can use this to our advantage.
A counter example is inflation risk. Given the indexed nature of our liability stream, we are vulnerable to high rates of inflation, whereas those with nominal obligations are not. Ensuring that the aggregate asset portfolio meets a reasonable real return threshold and seeking contractual inflation-linked cashflows is a simple mitigant.
Taking Stock
My main takeaway is this. Risk is not bad per se. It is something that should be selectively utilised to increase portfolio returns and assessed holistically to provide the greatest chance of meeting our ultimate long-term goal of paying pensions.
Ryan Boothroyd is portfolio manager at Border to Coast.
Photo by Nicholas Cappello on Unsplash
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