Step 1 – Preparation – Clearly written goals and objectives

Posted on November 21, 2012


The Pension Risk Management Framework “PRMF”

“If one does not know to which port one is sailing, no wind is favourable.”

–  Seneca

Pension funds should start the process of taking control of their fund by defining the situation clearly and realistically, by setting clear goals and objectives that can be written down into a robust Pension Risk Management Framework “PRMF” document. First of all, the PRMF must clearly state the date that all parties agree full funding should be reached, for example, 2032. From there, a number of key factors can be identified and agreed.

The required rate of return needed from the assets as well as the necessary contributions to reach this date, for example Libor + 3.00%, must be calculated and included in the PRMF. Next, the framework clearly lays out the risk appetite of the trustees and the sponsor, so that all stakeholders understand each other’s goals and constraints. For example a pension fund might agree that their risk appetite is a 10% relative drop in funding level or a £100 million absolute drop in funding level in any one year. Next, the liquidity requirements needed to pay the pensioners and meet any potential collateral requirements are identified, measured, and laid out in the document. This is increasingly important since most pension funds in the UK are closed to future accrual which may result  in (deficit) contributions being less than  the pensions in payment. This situation is known as negative cashflow and introduces another risk which is the path dependency of the investment returns versus the liabilities. This requires the pension fund to think about assets that have greater income security year-on-year, for example credit, see steps 4 and 5.  All assumptions, like the equity risk premium or the likelihood of mean reversion in bond yields, must be realistic rather than aspirational.

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”

– William Ward

This PRMF document forms the operating system, a pension’s iTunes if you like, for any funding, investment and risk management decisions and actions. The PRMF allows the stakeholders to move away from a traditional asset based asset allocation framework to a risk based asset allocation framework; all key factors are considered simultaneously and, vitally, all decisions are completely informed. Without a well thought-out PRMF in place, pension funds are likely to struggle to generate the returns needed to meet their liabilities without running too much risk. In this period of economic and political uncertainty it is difficult to foresee what challenges and delays to the investment and funding plan lie ahead. It is therefore crucial to constantly be reminded of the fund’s goal, the fund’s PRMF.

In agreeing an effective PRMF, trustees and sponsors – in conjunction with their advisors – must be productively paranoid. The process necessarily leads them to ask questions like “How could this situation get worse?” “What if the Eurozone debt crisis deepens?” “What if this low growth environment in the UK and globally persists, and gilt yields start to resemble the Japanese curve?”. The stakeholders must be comfortable that solutions to these situations exist, and that the PRMF they are laying out is sufficiently inclusive to allow for effective action when the time calls.

With the PRMF in place, stakeholders are now able to make informed, effective and fast decisions.  Continually readjusting the sails is the most important part of navigating towards a goal, and pension funds must be able to do this effectively; it sounds simple, but without all the goals, risks and constraints laid out in a PRMF document, pension funds have struggled to make decisions at all. The next step in this initial phase of preparation and planning is to agree and make clear responsibilities for making and carrying out decisions, setting hard deadlines for completion and review.

“I may say that this is the greatest factor — the way in which the expedition is equipped — the way in which every difficulty is foreseen, and precautions taken for meeting or avoiding it. Victory awaits him who has everything in order — luck, people call it. Defeat is certain for him who has neglected to take the necessary precautions in time; this is called bad luck.”

— from The South Pole, by Roald Amundsen

Finally, as we will see later on, in step 7 is to follow-up, monitor the decision, compare actual results with expected results, and then generate new solutions, new courses of action, and readjust the sails.

Unsurprisingly perhaps, clients who have implemented the PRMF and the 7 steps approach have been able to enhance their governance and achieve better results. Stating the goal and possible problems clearly significantly improves a pension plan’s governance structure by encouraging accountability, transparency and discipline between all key stakeholders. The framework, rather than constraining the pension fund, allows the stakeholders to be creative and develop many new solutions, as we will see later in the 7 steps, to meeting the goal of generating consistent and sustainable real returns to pay the pensioners and reach full funding. And it’s not just conjecture: research by Professor Gordon Clark from Oxford University shows that an enhanced governance framework can lead to a governance premium on investment returns, thereby materially improving the funding position of a fund.