Managing risk and return

Ortec Finance specialises in financial advice and technology for improving investors’ decision making and decision monitoring, with a specialisation in pensions and wealth management

 
Author: Drs Ton van Welie, CEO, Ortec Finance
January 9, 2013

In 1985, Ortec Finance created its first mathematical models for the financial world. Over the years we have perfected our technology and developed into an independent specialist measuring and managing financial risk and return. Based on the latest i

nsights, we combine econometric and quantitative skills, business awareness and extensive practical know-how to bring practical solutions to clients around the globe.

We support our institutional and private investor clients at the highest level in making strategic, tactical and operational financial decisions, which collectively impact well over $2trn in assets. We provide consultancy services and accompanying systems for asset liability management, risk management, performance measurement, risk attribution, and financial planning. Through strong ties to academic communities, regulators and practitioners we are able to maintain our leading edge.

Funds must take certain investment risks with available capital. These risks are carried by current and future stakeholders

The global credit crisis has left its mark not only on the banking industry and the pension world, but also on housing associations, insurers and financial planners. In advising clients across each of these sectors we find ourselves placed in a truly unique position to help parties learn from and cooperate with one another to secure their financial futures.

The crisis has illustrated that having a good long-term strategy alone is not enough. It has to be followed by an implementation that is regularly monitored to assess whether the strategy and implementation are still on track. It is indispensable to have frequent and holistic information on the long- and short-term risks (and returns) that lie ahead. Focusing on just the long or just the short-term can be equally harmful. The risks are often represented by a multitude of scenarios, which project how the financial and economic variables will evolve into the future.

These can then be translated into the consequences for actual objectives. Traditionally, we see that there are different types of models and approaches which are used to generate such scenarios for different applications. Ortec Finance has fully embraced the challenge of generating realistic and dependable economic scenarios, with the objective of bringing consistency to the investment decision making and the risk management process.

Pensions expertise
It is striking to find ourselves in such a difficult struggle over recent reforms in the Dutch pension system. That perspective stands in sharp contrast with the view of pension professionals everywhere, who regard the Dutch pension system as robust and world class.

In a recent survey conducted by Mercer Australia, which ranked the overall pension systems of different countries by criteria such as adequacy, sustainability and integrity, the Netherlands ranked number two among the best-performing countries (Denmark, Netherlands, Australia, Sweden, Switzerland and Canada). Our extensive experience in each of these six and other pension countries worldwide has solidified Ortec Finance’s reputation and placed us in a very strong position for doing business on a global scale.

What is the role of the investment policy in a pension fund? The board of a pension fund formulates an ambition regarding the desired level of the pension. The fund could run the pension plan by charging the sponsor with the actuarial cost of the pension product and invest these contributions in the so-called liability-hedging portfolio. If abstaining from actuarial risk, including longevity, the plan would most certainly have a funded ratio of 100 percent.

However, the cost of such a pension system would in almost all cases be prohibitively high.

It is therefore clear that funds must take certain investment risks with the available capital. These risks are carried by the current and future stakeholders of the plan in three possible ways: premium risk, indexation risk, and the risk of funding shortfalls. The total amount of risk that all stakeholders combined are willing and legally able to bear should, in the end, precisely match the extent to which pension investors play the financial markets in order to generate the necessary returns to fulfil the formulated pension ambition.

This basic principle increasingly confronts policy makers and managers with several complex issues. Our main concern here is the manner in which the optimal strategic asset mix is determined in an asset liability management (ALM) context, and if and how one can deviate from this mix whenever either the short-term risks are too high, or the financial markets are considered significantly under or overvalued.Risk is undoubtedly the main, if not the only source of return. Consequently, one of the most important strategic decisions made in regard to pension funds is the amount of investment risk taken. Two simple observations underscore the crucial importance of this decision: first, as a rule of thumb we hold that one percent extra return is equal to 30 percent higher pensions or 30 percent lower premiums, thereby demonstrating the crucial role of investment risk in realising the formulated pension ambitions.

Avoiding shortfalls
How then is this crucial decision regarding the amount of investment risk being executed in practice? In many countries a pension fund that desires an x percent investment return determines a strategic asset allocation that seeks to realise this required return based on the expected returns of the various asset classes. In this approach therefore, the required return is the guiding principle, and the accompanying risk is often taken for granted. As a result, many of these funds have been confronted by large funding shortfalls.

Evidently, this approach is determined as highly irresponsible. A first step into the right direction is the recent emergence of liability-driven investing (LDI). But the common LDI approach is focused too squarely on existing pension liabilities, since it is based on the benefit payments resulting from those current liabilities, making it a de facto liquidation approach. LDI does not take into account the acquisition of new pension rights or the other risk-reducing effects of premium and indexation policies. The possibilities for absorbing the risks are therefore underestimated, with consequences for the strategic mixes and protection constructions that appear to be optimal in LDI.

Professional ALM chooses a holistic approach, meaning it seeks to bring into line the ambitions and corresponding risks for all stakeholders involved. The result is a complete and fair pension deal, in which all parties involved know exactly which ambition is pursued and at what risk to themselves. In this integral approach, the investment policy is a serving instrument that ensures the ambitions of the pension deal are effectively realised while simultaneously respecting the risk limits of the stakeholders.

Thus, for pension investors following this approach the investment risks and returns are never the guiding principles. Instead, it is infinitely more important how risk and return work, through pension and premium policy, toward the ambitions of the pension contract. After all, the pension and premium policy are the instruments that record how risks and returns are being absorbed and distributed by the various parties involved. An important goal of ALM studies is to support managers in shaping the pension deal and the agreements regarding risk distribution and the allocation of the assets that spring from it. Furthermore, ALM studies serve as a bridge to asset managers, enabling them to actually execute the investment policy in conformance with the pension deal.

Private wealth management
Delivering solid financial planning advice is a challenge, especially in times when markets are volatile and unpredictable. Clients and regulators increasingly demand higher quality and transparency in financial advice and products. Financial planning developments aimed at improving advisory processing and information streams are moving at a fast pace, and responding adequately and cost-effectively to these developments has become an ongoing challenge.

Meeting international and local legal and regulatory requirements is now an important driver for reorganising the advisory process centrally around the client. A client-centric approach leads to improved client satisfaction and, ultimately, client retention. Insight into risk and return is the key to solid financial advice. ALM methodologies and scenario analysis techniques are required. With these advanced techniques, advisors can provide well-founded advice and test whether the wealth objectives of their clients are feasible. Goal-oriented investing helps advisors to make the right investment choices in close consultation with their clients and can adequately establish the risk a client is willing and able to take.

Compared to other companies in the financial sector, our work also has a wider scope.

Good advice for a pension fund requires understanding the political situation, regulatory environment, and macro-economic developments among others. That stands in contrast with many other financial institutions, in which people become highly specialised, for example, in a particular financial product such as mortgage-backed securities.

We also see that many people are now looking to combine their working lives with working on socially relevant problems. In this area Ortec actively applies expertise on the financial sector in countries that have a need for micro savings, insurance, and pension products for low incomes.

For more information: www.ortecfinance.com; email: info@ortec-finance.com;
Tel: +31 10 700 5000