The significant increase in investment market volatility over the past six months has adversely impacted most, if not all, asset classes globally. As such, PAUL KESSELL believes it is an ideal time to reflect on how investment risk is managed and presented to fund members in Australia’s defined contribution (DC) retirement provision environment and whether there are opportunities for it to have a greater influence on the investment strategies offered by superannuation funds.
Having recently returned to Australia, after four years managing pension fund investment portfolios in the UK, I wanted to briefly reflect on the increasing importance of investment risk management in the UK’s defined benefit (DB) retirement provision system, which may provide a useful comparison with Australia.
Pension funds in the UK have been increasing their commitment to investment risk management, which has become a key input to development of the investment strategy. This really came about due to three key events; poor investment performance resulting in significant funding deficits, the pension fund moving onto the corporate balance sheet and the liabilities being discounted at a market-based rate.
DB corporate sponsors are liable for the fund’s investment risk and so have increased their active involvement in the management of all aspects of the investment strategy, including the fund’s risk profile. In practice, the corporate sponsor sets a risk budget relative to the fund’s liabilities seeking an improved investment outcome.
However, in DC arrangements members take much greater responsibility for their own retirement saving with investment risk placed wholly on the individual members rather than the fund or sponsor. This transfer of investment risk to members by the DC fund still requires of the fund a fiduciary duty to provide a robust mechanism for the investment of retirement savings. However, it would fair to surmise that members of DC funds are not comfortable with investment issues and whilst the ultimate investment choice is made by the fund members, the range of investment options offered can have a significant impact on those choices made.
A well designed scheme with appropriate governance arrangements will be better positioned to meet member expectations and display appropriate ‘due diligence’ in the event that investment performance or other circumstances lead to members being disaffected. This risk should not be underestimated in the current volatile investment market environment.
So what questions should be asked by funds to ensure appropriate ‘due diligence’ in developing the range of investment options offered:
• How extensive should the investment choice be?
• How should the default fund’s investment strategy be set?
• Are the investment options managed actively or passively and how much should be managed in-house or outsourced to fund managers?
• How should the fund communicate with members on investment issues and how can members be best engaged regarding the choices they have made?
It is not just about investment performance that funds need to exercise effective risk controls it is very much the investment processes, both at the strategic and tactical levels. A clear investment strategy needs to be developed and documented. Funds must set criteria for measuring acceptable investment parameters for the investment strategy of each investment option. Compliance and operational systems should be in place to ensure that compliance with all guidelines can be regularly monitored.
The experience in the Australian market is overwhelmingly that members select the default option irrespective of the level of choice available. This default option is developed by the superannuation fund to achieve a set of risk/return characteristics and broad asset class diversification. Given this scenario it could be said that the superannuation fund has taken on the role of fund manager for the default fund. This imposes on it a different burden of responsibility than is the case as a provider of retirement savings options.
Around the default option are a range of investment options that are presented in the PDS with set risk/return characteristics. However, it is unclear whether the actual ex-post risk profile is actively managed to this objective or how the risk/return profile has been set. Is it based on historic asset class and/or manager risk/return outcomes or is it based on forecasts of investment market returns?
The presentation of risk as ‘low’, ‘medium’ or ’high’ raises the issue of what those risk labels signify, as it is not a quantifiable analysis of the actual risk borne by the member. Is it consistent across the industry or based on how the individual fund seeks to position its range of investment options across the risk spectrum? Is this a case for the industry to set guidelines as to how this information is presented to members?
The recent investment market volatility has highlighted this issue. For example, losses have been incurred in many sub-sectors of the bond asset class, which is generally regarded as ‘low risk’. To understand and accurately assess the risk profile of the underlying investments in an investment option may require a significant commitment to the monitoring and management of such risk. From a holistic perspective, superannuation funds’ overall exposure is directly related to the combined exposure of all the investment options.
From a commercial perspective, risk management and monitoring provides important information in understanding the risk profile of the fund’s products relative to those of its competitors. This is beneficial in retention of members when investment performance is a key factor behind the success of a super fund ‘brand’.
As well, a more active risk management process will allow valid comparisons with competitor funds, enabling further differentiation and greater awareness of how the fund is positioned in the market. I believe that incorporating active risk management into all aspects of the investment strategy will improve the management and understanding of the investment options available. To do this DC pension funds must be able to answer a number of questions:
• What is the overall risk of the superannuation funds’ exposure?
• What is the risk of the individual option?
• How is the risk profile of the individual option determined? Is it based on a mean-variance analysis of historical asset class returns, or a factor analysis. Does it incorporate the risk profile of the underlying managers?
• Is the investment strategy of the investment option actively managed within the stated risk profile?
• Is the risk profile of the individual option dependant on the level of funds under management?
The fund’s brand depends ultimately on the investment performance achieved by its investment options. This places an ever increasing emphasis on risk management becoming embedded in the investment management process. As a corollary to this there may be direct financial consequences of poor investment outcomes for the funds.
Paul Kessell, CFA ([email protected]) most recently managed the investment portfolio for the £4.5 billion J Sainsbury plc corporate pension scheme in the UK. He recently returned to his hometown of Melbourne.