In the aftermath of last year’s liability-driven investment (LDI) crisis, the need for a more responsible approach to risk management has never been greater.
Where traditionally investors looked to asset liability models to understand the risks being taken, the LDI crisis highlighted the need for DB schemes to consider risk in a more holistic way.
Risk is multifaceted and simply focusing on traditional quantifiable risks is no longer enough. To have a robust risk strategy, trustees must now consider qualitative risks — even if these are hard to measure — to ensure their scheme is on a secure footing and mitigate the impact of future black swan events. In its recent guidance to trustees, the Pensions Regulator has stated trustees must have “robust and effective operational processes in place to ensure the resilience…to market shocks and reduce the risks to …acceptable levels.”
Managing the unknowns
A scheme’s ability to navigate and manage hitherto unforeseen unknowns can be influenced by its governance model of choice. Similarly, a scheme’s investment strategy and approach to implementation can affect its exposure to different qualitative risk factors, which can consequently impact portfolio resilience in the event of market volatility.
Last year’s LDI crisis demonstrated this. As gilt yields rose at an unprecedented rate following the Chancellor’s mini-budget, DB schemes faced unique challenges influenced by their governance model, approach to implementation, and investment mandate.
However, out of every crisis comes the opportunity to re-examine what worked well, and what could be done differently ahead of future events.
Building resilient portfolios
SEI recently published a whitepaper that considers six factors that are considered essential to building resilient client portfolios:
1) Having the ability to adjust a client’s asset allocation: Having the governance in place to adjust client asset allocations quickly and efficiently can be critical. This helps pension schemes to respond appropriately in times of stress and take advantage of opportunities as and when they arise.
2) Assessing liquidity comprehensively: Portfolios need to be able to comfortably meet expected and unexpected cash flow requirements, even in the middle of extreme stress events. Liquidity stress testing during normal times can be of huge value. Having a robust liquidity framework in place should prevent schemes from experiencing cash flow issues or needing emergency funding from sponsors to meet cash flow requirements.
3) Leveraging a unified investment platform across clients: This provides transparency and daily oversight down to the holding level, and therefore, a granular view of risk in the portfolio.
4) Adopting open architecture: This provides a choice of means to implement an investment strategy, so schemes are not overly beholden on a single manager’s operating model.
5) Prioritising ‘no frills’ implementation: It is important to use traditional building blocks, such as stocks, bonds, and alternative asset classes to create client portfolios, and avoid undue complexity which may introduce its own specific tail risk. Leverage should be used thoughtfully for hedging or risk management purposes.
6) Ensuring diversification across a number of parameters: Diversification is key to building resilient client portfolios. For example, global diversification helped mitigate the impact of UK assets declining over the course of the LDI crisis. Furthermore, an active approach can bring valuable style and manager diversification during a volatile period, creating significant value for clients.
A brighter future with resilience at its core
Pension schemes have recently experienced significant challenges, but there are lessons we can learn and implement moving forward.
Looking ahead, schemes will need to approach risk management more holistically, focusing on both quantitative and qualitative risks. Trustees will need to ensure they have considered the resiliency of their portfolios and operational procedures to adverse shocks and put in place the necessary changes to portfolios and/or governance to become sufficiently robust.
If the last few years in markets have taught us anything, it is that black swan events are not so rare. By taking a more holistic approach to risk management, trustees can point towards a brighter future with increased peace of mind.
Charles Marandu is managing director for the institutional client strategy team at SEI
