Risk management is a subject that has moved up pension fund agendas recently. Although no judgment was delivered in the court case last year between Merrill Lynch Investment Management and the Unilever Pension Fund, the issues raised are of great interest to all. It was in many ways a pity that the case was not decided legally, as the parties reached their own out of court settlement in December.
The main issue raised in the case was the unacceptable risk the fund felt the manager had run on its behalf. Arguments, therefore, centred on the contract between the parties, the manager’s risk controls and questions of trusteesí responsibilities.
It is interesting to consider what trustees have learnt from the case. According to Jane Kola, a partner with leading solicitors Sacker & Partners, trustees should now be reviewing their investment procedures; reconsidering their investment contracts; looking at their investment monitoring procedures and where necessary renew trustee training in investment issues. Most importantly of all, trustees must consider what exactly is their appetite for risk and ensure that this attitude to risk is clearly communicated to their managers and then reflected in the contracts that are drawn up between them and their investment managers.
One of the realities of life facing trustees is that their attitude to risk must affect their expectations of returns. There is, of course, no such thing as a free lunch and whilst risk can be managed
it cannot be eliminated. Trustees should therefore consider first their risk budget across the fund as a whole before considering individual manager approaches
to risk.
So, what is the state of pension fund risk today? According to Nick Kent, managing director, of Risk Reporting the reason many pension funds are unhappy with the returns achieved by their managers is that they do not understand the low levels of risk achieved at a total fund level. This is because we underestimate the effect of diversification. Trustees forget that the total fund is more important than the underlying portfolios. The majority of UK pension funds (and for that matter the majority of continental European funds) do not monitor risk on a regular basis nor do they quantify levels of investment risk. They do not evaluate portfolio exposures at the fund level (except broadly). They rarely measure risk and return and manager efficiency or skill, according to Kent – ‘The ultimate link’. All in all, a pretty damning indictment!
Kent believes that pension funds run a real risk in not using risk analysis. Cynics would argue that he would say that wouldn’t he, as he sells a risk analysis service, although I have to admit he makes a pretty convincing case.
Unfortunately, pension funds have, until recently, focused far too much on actual achieved returns and much less time has been spent looking at the risks managers have run in achieving the returns. I think we all now appreciate that outperformance requires active risk and therefore that active risk provides the potential for excess returns but we must also be aware, as was all too painfully apparent to the Unilever Pension Fund Trustees, that it also provides the potential for underperformance.
The lesson we must learn is very simply that risk levels must be clearly defined, with clear objectives, agreed benchmarks and underperformance limits. They must be monitored regularly. Risk analysis will help trustees understand the risk and return ranges and the likelihood of their occurring.
Trustees are starting to ask themselves how much risk is appropriate for their return objectives and whether such risk is acceptable. Trustees do realise there will be an upside and a downside, but the downside might well come first.
Kent has suggested some questions that trustees should ask themselves. If they don’t immediately know the answers they should find out and continue to do so in the future. These questions are: Do you know the active risk and total risk of your fund? Is your risk profile relevant to your performance objective? Do you know your risk profile? What is your downside risk, ie, How much can you lose? Is your manager efficient? Are your managers doing what you expect them to? Are they generating excess returns due to their investment approach and style?
Last year Paul Myners effectively shook up the UK investment establishment by proposing a number of radical ideas to the way in which pension funds manage their assets. The vast majority of his suggestions have been endorsed by the UK government. These ideas include the suggestion that both pension fund and manager should define risk and return objectives, monitor risk levels, make greater use of the analysis tools that are available in the marketplace, look at the fund as well as the portfolios and make greater use of investment committees.
Whilst we do not know whether we will see more court cases between trustees and their investment manager, we can be sure that life between them will never be quite the same again and if this means openness and better communication between the parties this can only be for the good.

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