ThereÆs an element of crystal-ball gazing in any risk management exercise. The more complex your portfolio, the cloudier things become. Pension plan sponsors, who need to consistently monitor the impact of risks on plan assets, liabilities and surplus, require particularly good vision. Fortunately, there are increasingly sophisticated tools on the market to aid their task. RiskMetrics, for example, recently unveiled PensionManager 1.0, which incorporates Value at Risk (VaR) research methodologies, developed in association with JP Morgan.
VaR is an increasingly popular statistical measure of risk exposure that was developed in the late 1980s for the trading desks of large financial institutions. In contrast to many measures of risk, such as standard deviation and tracking error, VaR is expressed in intuitive rather than mathematical terms. Under a VaR calculation, for example, a portfolio may be said to have a 5% chance of losing $2 million in the next week.
While the use of VaR has spread to many different financial areas, including pension funds, it is of less value to nonlinear portfolios. Risk management experts also warn that VaR has no established industry standard or best practice. Different companies selling VaR tools use different methodologies, so comparison between calculations can be complicated.
RiskMetrics - a 1998 spin-off from J.P. Morgan - is one of the driving forces behind the rising popularity of VaR for risk management. To the extent that a dominant methodology exists, RiskMetricsÆ version is probably it.
ôDue to market volatility, there is a growing need for [pension] plan sponsors to examine risks over a spectrum of future dates,ö says Michael Granito, head of J.P. Morgan Investment ManagementÆs Strategic Investment Advisory Group. To this end, PensionManager uses parametric and historical simulations to evaluate events over intermediate horizons of up to three years. According to Granito, by evaluating this time frame pension plan sponsors are better equipped to capture cycle-related market risks that can impact key pension financial variable, such as asset allocation and risk budget criteria.
Peter Yuen, corporate finance actuary with Novartis Corporation, says that the intermediate horizon built into PensionManager is valuable because it helps gauge the ability to meet future liabilities.
The liabilities in a pension fund differentiate it from many other type of portfolios. PensionManager calculates risk for the different measures of pension liabilities: vested benefit obligation (VBO), accumulated benefit obligation (ABO) and projected benefit obligation (PBO). These can be specified by cash streams or present values. On the asset side, PensionManager considers volatilities of both indices returns and managers' excess returns (alphas), as well as all correlations. Customizable reports present VaR for assets (by asset class), liabilities, surplus, funded ratio, and pension expense at various horizons.
Because VaR doesnÆt measure event risk, from market crashes for example, PensionManager also has a stress-testing functional that allows plan sponsors to recreate historical conditions, such as the crash of Æ87, to see how their portfolio would fare.
Plan sponsors subscribing to PensionManager keep all confidential client and portfolio data at their physical site in a database provided by RiskMetrics. All market data, analytics and the software itself can be accessed from anywhere via the internet. Technical support for the software is provided by RiskMetrics, while J.P. Morgan handles customer consultation on the use and methodology of the software.