The Impact of Regulatory Constraints on the ALM of European Pension Funds

At the end of 2009, as part of the EDHEC/AXA Investment Managers (AXA IM) research chair on “Regulation and Institutional Investment,” EDHEC-Risk Institute sent out a “call for reaction” to a study we had published earlier in the year¹ on prudential and accounting regulations and how they should be embedded in the ALM of pension funds, with a particular focus on the Netherlands, the United Kingdom, Switzerland, and Germany.

We also published a study in the spring of last year that attempted to evaluate the reasons for current pension fund underfunding². The main conclusions of the latter study were that:

• Regulations have tightened, making it important for the ALM of pension funds to take them into account. This tightening of regulations has sometimes had the perverse effect of leading to the closure of defined-benefit pension funds.

• Modern ALM techniques, such as dynamic liability-driven investments, are instrumental in preserving minimum funding ratios. When these techniques are burdensome, either because management agreement is needed to rebalance a portfolio or because smaller schemes make continuous monitoring difficult, derivatives can be used.

• Overall, current funding shortfalls reflect mainly the reluctance of pension funds and their sponsors to use modern ALM techniques and take regulatory constraints into account.

• Pension funds have a unique ability to behave as very long-term investors, as pension liabilities are a by-product of the employment contract, and no client-run is possible. As a result, they can benefit from investment opportunities that require a long horizon, whether for illiquid investments or for assets whose term structure of risk slopes downward (that is, in which time reduces risk).

• The increased short-termism of regulations, with the proposed IAS 19 reform implying full recognition of the volatility of the profit and loss (P&L) of pension funds in the P&L of the sponsor, adds to the excessive focus of investors on the P&L and makes the long-term replication of liabilities difficult, in particular for real liabilities. After all, matching these liabilities requires real assets, assets that imply short-term volatility in the accounts.

• After the crisis, which has left many pension funds underfunded, regulators have been tempted to require higher funding ratios as a means of mitigating the effects of downturns. In our view, however, risk management is more likely than high funding ratios to ensure that liabilities are covered, so it should be favoured. “The idea that risk management is best reflected in an internal model is especially relevant for pension funds; after all, no standard formula can capture the diversity of the pension landscape and the variety of protection mechanisms” (Amenc et al. 2009, 151).

In general, we argue that regulations should give pension funds incentives to build internal models that are full risk management systems rather than risk measurement tools: risk management is always useful.

The call for reaction was meant to allow the respondent to express an opinion on these crucial themes. The questions were posed in a neutral manner to allow EDHEC-Risk to analyse the use and perceived efficiency of ALM tools and concepts, rather than merely to elucidate the degree to which practitioners agree with the conclusions of our research.

Reactions

The responses to our call for reaction³ corroborate the arguments made in the EDHEC study (Amenc et al. 2009) on the impact of accounting and prudential regulations on the ALM of European pension funds.

In particular, respondents agree that pension funds should take a long-term approach to investing, but they also think that they should manage their short-term constraints; they agree that risk management protects minimum funding ratios better than high funding ratios do, and as such they believe strongly that regulations should encourage risk management—for instance, by allowing internal models.

Dutch pension funds, which have already implemented risk-based regulation with strict minimum funding ratios, are supportive of the idea that minimum funding ratios should be implemented, as these ratios foster risk management. British pension funds, by contrast, with their chronic underfunding, fear that minimum funding ratios would involve a counterproductive tightening of prudential regulation of pension funds.

Respondents also point out, as we do, that the funding ratio of the pension fund is not, on its own, a sufficient indicator of the degree of protection afforded pension benefits: the risk to the benefits depends on the combined risk of underfunding and sponsor default. Respondents argue that the use of modern ALM techniques cannot fully ensure that a pension fund is never underfunded, not only because funding depends on the contribution policy but also because longevity risk has added significantly to liabilities.

As a consequence, a specific measurement of the combined risk of sponsor default and underfunding is required. Contributions must be raised or assets may be pledged by the sponsor when this combined risk arises.

Last, 78.5% of pension funds report that dynamic strategies are difficult to implement because management agreement is needed to rebalance a portfolio. Organisational problems keep pension funds from benefiting from dynamic investment strategies, even though these strategies are viewed with favour by both academics and practitioners: at the same time, 73.2% of pension funds agree that dynamic strategies ensure that minimum funding constraints are met.

About Samuel Sender

Samuel Sender has participated in the activities of the EDHEC-Risk Institute since 2006, first as a research associate—at the same time he was a consultant to financial institutions on ALM, capital and solvency management, hedging strategies, and the design of associated tools and methods. He is now a full-time applied research manager at the EDHEC-Risk Institute. He has a degree in Statistics and Economics from ENSAE (Ecole Nationale de la Statistique et de l'Administration Economique) in Paris.