Risk Management
Risk measurement and management are core components of our approach to assisting each of our clients. We believe that we place a greater emphasis on risk management than any other consulting firm serving institutional investors. As such it is fair to say that we have provided risk management consulting services of varying degrees of complexity for each of our 280 retainer clients, with aggregate assets of $2.1 trillion. More specifically, we advise clients on managing and monitoring the risks associated with their long-term investment policies, and their implementation of those policies, using proprietary tools and methods.
The types of risk directly linked to investment activities are broadly described below.
Asset/liability risks
- Market risk: failure to achieve target asset returns in the long-term. Since pension liabilities are usually discounted using an expected asset return, the risk of not attaining the target asset return can translate to risk of reducing the plan’s surplus. Additionally, if inflation is much higher than expected, the pension liability can grow due to its sensitivity to inflation. If asset returns are not able to keep up with unexpected inflation, the plan’s surplus will be at risk. For endowed entities, it is important to manage the risks of not being able to meet their investment objectives by taking into account their spending policies.
Asset-only risks
- Active risk: investment managers, whether external or internal, not performing as expected
We employ proprietary models to help clients measure, monitor, and manage the risks described above.
Market Risk
We approach market risk for pension plans using the EnnisKnupp Asset/Liability Model, an integrated Monte Carlo simulation model. We have conducted asset/liability studies, which include an analysis of market risk, for over 56 clients in the last five years. By working closely with the plan’s actuary and using the plan’s liability assumptions, we are able to move beyond the basic framework of expected return and volatility of return. In fact, the asset/liability simulation allows us to translate these general types of capital market risk and return assumptions into a framework that uses plan cost and/or plan funded status as the key measured variable:
- Reward, which means lower ultimate cost to the sponsor and/or higher funded ratios.
- Risk, which is the potential for unpleasant surprises in cost or funded status results.
- Funded status and volatility.
- Contribution levels and volatility.
We employ a customized approach in which different cost measures and timeframes can be analyzed to fully explore the risk/reward landscape of any specific plan. This asset/liability framework allows our clients to fully understand the inherent risk of their investment program.
For Endowment and Foundations, we measure market risk using the EnnisKnupp Endowment Spending Simulation model. This model enables our endowed clients to understand how asset allocation can help them achieve their investment objectives while taking into account their spending policies.
Active Risk
Asset-only risks can be managed by ensuring there is a periodic (usually quarterly or monthly) monitoring protocol for investment managers. The EnnisKnupp Risk Budgeting Model can be an effective way to evaluate the sources of active management risk. This tool allows clients to examine the sources of the risk they take relative to their policy benchmarks, and reconcile those risks with their expectations for value added. We have provided consulting services using this modeling framework for approximately 100 of our retainer clients. The objective of the model is to derive a point-in-time estimate of risk exposure, and then to make forward-looking decisions accordingly. The model is forward-looking and focuses on “active” or “implementation” risk. In other words, the model assumes that asset allocation policy is set and given.
The model is founded in Modern Portfolio Theory (MPT), and uses the standard technique of calculating the risk of a multi-asset portfolio, extending it to encompass total funds composed of multiple asset classes and investment managers. It then “partitions” risk into the components contributed by each portion of the portfolio, taking into account the assets allocated to each component, its own active risk, and its correlations with other components. At the asset class level, risk is “partitioned” into two components: risk due to style (“misfit risk”) and risk due to managers’ active bets (“manager-specific risk”). At the total fund level risk is partitioned into risk due to deviation from policy targets (“allocation effect”) and risk due to implementation within asset classes (“manager effect”). The client has the flexibility to enter their expectations of value added for manager portfolios and reconcile them with the risk levels. Alternatively, the model can substitute these expectations with either historical alphas or alphas calculated based on an expected information ratio.
Below are three examples of investment risk projects that our firm has completed recently:
- Large U.S. Public Pension Fund: We assessed each publicly traded asset class’ level of active risk (relative to the asset class benchmark). We also examined the contribution to active risk of each active manager within each of the asset classes, and at the total fund level. We helped the client in determining the appropriate structure and the level of active versus passive allocation within each asset class using the risk budgeting model. We also helped the client choose appropriate risk budgets for each asset class by ensuring that risk is taken in those areas of the capital markets that is likely to be fruitful.
- Medium U.S. Public Pension Fund: We assisted the client in evaluating the risk/reward of investing in equities while taking into account the following: maturity of plan participants, funding or contribution policy, time horizon for plan (recognition of gains/losses), nature of plan benefits etc. Surplus (assets minus liabilities) was important for this client because additional benefits can be paid out to the plan participants when the surplus reaches various thresholds. We examined the liability structure of this plan based on demographics and other actuarial assumptions. We also accounted for the significant reduction in assets during 2008 due to recent market conditions. We projected the surplus/deficit position 15 years from 2008 by taking into account required contributions. Based on this long-term economic cost we compared different portfolios and finally recommended a long-term strategic asset allocation.
- Large Canadian Foundation: We have recommended an appropriate asset allocation based on the cash flow needs and risk tolerances of the Foundation. In doing so, we have helped the client in determining the appropriate level or amount of spending. Particularly, we examined two spending scenarios – a stable stream of spending versus one that is allowed to fluctuate with asset value as would be the case if spending were a strict percentage of asset value, which fluctuates with markets. Finally, we measured the merits of each spending policy using a measure called as “Depletion Risk”, the risk of failing to preserve real asset value over time. We have found that for a given level of spending, allowing the dollar amount of spending to fluctuate with the value of assets minimizes depletion risk. Stabilizing (fixing) annual spending can increase depletion risk significantly.