GLOBAL - The number of pension funds stress-testing their assets has increased markedly since 2009, as schemes are more and more concerned about market risk, counterparty risk and liquidity risk.

According to a survey conducted by MSCI of 85 pension funds, endowments, foundations and sovereign wealth funds surveyed - with $5.5trn (€4.1trn) in assets under management - more than the two-thirds are currently running stress tests, up from only 27% in 2009.

MSCI said: "During the 2008 crisis, not accounting for liquidity and counterparty risks was a major issue for many institutions.

"The 2011 survey results show that participants have taken several important steps to understand their liquidity and counterparty risks by building proprietary databases, requiring liquidity information from external managers and restructuring their portfolios to include limited amounts of illiquid assets."

The use of stress tests enables pension funds to better understand global risk portfolio at a time when such test has become a communication vehicle between the risk manager and the board, said MSCI - but the report also revealed that a clear definition of some risks is still lacking, especially in the liquidity domain.

"There is no clear hierarchy of asset liquidity tiers, days to liquidate and illiquid versus liquid asset distinction," MSCI noted in the report, entitled 'Back to the Future of Risk Management'. "Several participants are working towards better understanding this risk and developing a measuring standard."

In comparison, counterparty risk seems to be better understood. Pension funds surveyed, including Sweden's AP2 and AP3, emphasised that managing counterparty risk was most often a project-based and proprietary process, while the custodian is viewed as the number-one counterparty risk.

However, small pension plans are still facing difficulties to 'roll up' their counterparty risk from the asset-level to the total plan-level due to limited resources as well as incomplete custodian and external manager data, MSCI conceded.

One corporate defined benefit plan surveyed said: "Summarised data that can be aggregated into risk factors are far more useful at the total plan level than lines of position data, although funds want as much information as possible from their external managers."

In addition, extreme risk hedging has also become a higher priority for pension schemes, with 41% of them now hedging extreme risk at the total plan level, against 10% in 2009.

According to the survey however, the extreme risk hedging strategy remains a solution adopted by the smaller funds, which use equity options to protect their portfolio against downside risks - since equity exposures continue to dominate total portfolio risk - as well as bond, interest rate futures and options to a lesser extent.

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