Prudent investing is important enough in the Netherlands to be a legal requirement for Dutch pension funds. What is prudence though? In Proverbs, the Bible defines a prudent person as someone who “foresees the danger ahead and takes precautions.” This is a wise philosophy when it comes to retirement provision—pension fund members would expect their trustees to take precautions to steer clear of foreseeable dangers. This is exactly what the defining test for prudence entails: whether a pension board could reasonably have come up with the current investment strategy given the fund’s pension liabilities.
Prudent investing can be placed in the framework of integrated risk management, in which all elements are related to the achievement of the fund’s ultimate objectives. The starting point is to clearly define the objectives. A pension fund exists to provide retirement income for its members. Many Dutch defined benefit funds define this as two objectives:
1. Guarantee a nominal level of retirement income (the primary objective).
2. Increase this level in line with an inflation index (the secondary objective).
A crystal clear view of these objectives would help the trustees to understand what constitutes a risk (a foreseeable danger). We can make this more tangible with example risks for these objectives.
For the primary objective, interest rates present the main risk factor as they determine the prices at which deferred annuities can be purchased. This can be hedged, ideally by cash flow matching of the assets and liabilities, but in practice a partial duration match is more likely. By opting for duration matching, there may be residual exposure to curve risk: the risk that the yield curve slope or shape changes. Most Dutch pension funds have a good understanding of their exposures to curve risk.
High inflation is the primary risk, on the liability side, for the secondary objective. The conventional way to pursue indexation is to aim for real returns on the investments. This can be done by investing in risky asset classes such as equities, properties, hedge funds and private equity funds, but it is important to note that this provides an uncertain hedge against inflation risk, which can be more closely hedged with inflation-linked bonds. However, the expected returns are lower and would reduce the overall indexation potential.
In addition to the primary and secondary objectives, Dutch pension funds view socially responsible investing and sustainability as a precondition. Studies have shown that fund members highly value sustainability and want their pension monies to be invested responsibly. Recent changes in regulation have followed—pension funds must show clearly how they take socially responsible investing and sustainability into account.
In simple terms, the pension fund would make the achievement of the primary objective more certain by investing a larger portion in safe fixed income investments of appropriate maturity. Conversely, it would increase the indexation potential by investing a larger portion in equities. It becomes clear that there is a conflict between the two objectives as a focus on the one reduces the chance of meeting the other. The way to handle this conflict is to understand the risk appetite of the pension fund. Dutch regulation actually requires the pension trustees to determine the risk appetite of the members. For example, if the members are eager to pursue indexation and, as a result, reduce the certainty of their nominal benefits, then the investment strategy should reflect it.
The risk appetite serves as an input to the asset liability matching (ALM) study, which is performed to obtain a strategic asset allocation and interest rate hedging policy. Dutch pension funds clearly define tolerance bands for asset allocations and interest rate hedging, which trigger rebalancing if they are breached. The more sophisticated pension funds apply dynamic interest rate hedging, where they increase the degree of hedging at certain thresholds of the coverage ratio or interest rate. Note that such a strategic investment policy is directly related to the primary and secondary objectives by taking into account the risk appetite of the members.
Tactical asset allocation
Furthermore, a pension fund may opt to have a tactical investment policy, which allows it to take temporary opportunistic investment positions. The more organized Dutch pension funds clearly stipulate the permitted duration and size of a tactical position.
It is then time to put the theoretically optimal strategic investment policy and opportunistic tactical investment policy into practice. This is a daunting task because it normally involves collaboration with external asset managers. What makes the task difficult is ensuring that the asset managers clearly understand the needs of the pension fund. Sophisticated Dutch pension funds clearly stipulate their investment policies in their service-level agreements with the asset managers. They also work closely with the asset managers to ensure that everybody is clear on the strategic and tactical investment policies.
More collaboration with the asset managers is necessary to ensure that the periodic reports contain relevant, accurate and timely information to allow effective monitoring. Some pension funds even have their own apps with dashboards for the most important risk and performance metrics. Breaches of limits or falls in the coverage ratios prompt remedial action, which make for a sound risk management system. Such an integrated risk management system, with tools to regularly monitor the fund and its risks, helps the trustees to embody prudence.
In effect, the investment and risk reports allow the trustees to monitor whether the fund is following its strategic investment policy as not doing so would mean suboptimal investing in the light of the liabilities. Monitoring at a higher level is also crucial, though—it is crucial to monitor whether the strategic investment policy remains optimal if demographic and investment conditions (assumptions) change. Prudence dictates that fresh ALM studies should be performed on a periodic basis to adjust the strategic investment policy if necessary. Dutch pension funds also periodically evaluate their external asset managers in striving for improvements.
A holistic, integrated view to pension fund investing is a precondition for prudence. To reiterate, it is the management of risks inherent to achieving the stated objectives that is important as achieving these objectives will ensure that pensioners have sufficient retirement income, including the ambition to maintain their purchasing power. Normally it is the trustees who have the best overview of the entire process: defining the objectives, setting the investment policy and ensuring it is actually implemented and adhered to, managing the risks that arise and evaluating and revising the investment policy if necessary. It is no surprise that trustees should demonstrate proper comprehension of and control over the investment process. We at Milliman are happy to help deepen comprehension and control of these issues of risk in order to comply with the prudent person principle.