Over the past year, Danish pension fund ATP has amended its approach to liability-driven investments, splitting the investment portfolio into separate alpha, beta, and liability hedge portfolios. This approach has won it the themed award for risk management.
Risk management has been a cornerstone in the fund’s investment management for several years, and its approach has been developed further each year since 1999.
In particular, liability-side issues have had a very substantial influence on ATP’s investments and risk management. Since 2000, ATP and other pension funds have experienced rapidly rising liabilities because of falling interest rates (assets as well as liabilities are marked-to-market in Denmark) and because of increasing life expectancy.
As a result, ATP has, over recent years, put into place far-reaching investment policies. This has been possible because of the fund’s strong focus on asset-liability modelling (ALM), especially the development of an in-house model a few years ago.
In 2001, ATP made its most important decision in this area. This was to hedge the interest rate risk on ATP’s liabilities, mainly by using interest rate swaps. Another important decision, in 2003, was to introduce a dynamic asset allocation rule. This rule links investment risk directly with the fund’s reserves and the board’s risk tolerance.
In 2005, the fund put its asset management, actuaries and ALM under common supervision. This change has led to much closer contact than before between the ALM analysts and actuaries, creating significant improvements in the modelling of liabilities and risk management. One example is that longevity effects have been included in the ALM model this year.
These measures have been major factors in the considerable improvement in ATP’s funded ratio since 2003, so that risks to the fund’s solvency have subsided. ATP’s investment returns stood at 18.9% in 2004 and at 14.5% in the first half of 2005, bolstered by high returns on interest rate swaps and Danish equities.
However, there are still significant challenges ahead. First, prospective returns on most asset classes are expected to be, at best, modest. Second, life expectancy has risen in recent years and may rise again in the future. Third, ATP needs to avoid large negative investment returns because the implied fall in reserves would reduce the risk budget, making it potentially very difficult to achieve long-term goals.
In coping with these challenges, ATP believes that the traditional investment approach, which focuses on generating high returns compared with specific market benchmarks, has little to offer. So the fund has decided instead to emphasise liabilities, and absolute risk and return.
ATP’s investment management serves two main purposes. One is to ensure that the fund’s reserves – the bonus potential – can withstand adverse financial market movements so that the fund remains solvent. The other is to achieve a high return in order to protect the long-term purchasing power of benefits.
The basic idea behind ATP’s new investment approach is that the portfolio consists of three independent elements – liability hedge, beta and alpha. Each portfolio contributes in its own way to ATP’s objectives.
The starting point is the risk-minimising portfolio which hedges liabilities to the greatest possible extent. This will underpin ATP’s reserves and its commitments to its clients. However, this risk-minimising portfolio would normally not generate any excess returns.
In order to generate higher returns and fulfil the second objective - protecting the purchasing power of benefits - some investment risk has to be accepted. Additional returns come from two sources: ‘beta’ (the excess return of asset classes over the risk-free return) and ‘alpha’ (investment skill). Beta and alpha are independent. Normally, the asset class decision – beta – is made first. Next comes the decision as to whether to attempt to generate alpha from the asset class. This “beta- trumps-alpha” approach is not efficient. Under ATP’s new approach, the amount of investment risk allocated to beta and alpha is determined by ATP’s risk budget. The size of the risk budget depends on the level of the fund’s reserves, and its objectives and risk tolerance.
ATP’s system for risk management is based both on the legislative framework for investment, and on the structure laid down by its board.

The fund has set limits for portfolios at several levels, from the overall asset allocation – with limits for interest rate, equity and foreign exchange risks and credit risks – to transaction limits for individual portfolio managers. More than 500 accounts are monitored on a daily basis. The fund’s treasury management system also enables it to monitor solvency levels, to perform the FSA resilience test, and oversee its dynamic asset allocation rule virtually online. This system of review is an outstanding feature of the fund’s risk management system.
In the past year, the splitting-up of the portfolio has had a profound effect on the fund’s risk management, investment processes, and organisation design. The three portfolios – alpha, beta, and risk minimising – are independent, and will be managed independently by separate teams.
ATP believes its new approach is more flexible and focussed than traditional approaches, and fosters better risk management and more accountability.


HIGHLIGHTS AND ACHIEVEMENTS
Over the past year, ATP has changed its approach to liability-driven investments. Instead of attempting to generate high relative returns, it now concentrates on liabilities, and absolute risk and return. The investment portfolio has been divided into separate alpha, beta, and liability hedge portfolios, run by different teams.
In contrast with the traditional way of building extra risk into the portfolio, the amount of investment risk allocated to beta and alpha is now determined by ATP’s risk budget. The size of the risk budget depends on the level of the fund’s reserves, and its objectives and risk tolerance. The fund has set limits for portfolios at several levels, from the overall asset allocation to transaction limits for individual portfolio managers. Over 500 accounts are monitored daily, while online reviews are carried out to monitor solvency levels and other parameters.
The fund’s asset management, actuaries and ALM are now under common supervision, which has significantly improved the modelling of liabilities and risk management.
Partly as a result of these measures, ATP’s funded ratio has improved considerably. The fund has also achieved outstanding investment returns — 18.9% for 2004, and 14.5% for the first half of 2005.


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