Employing a solvency manager could be the solution to trustees’ growing workload, with daily asset allocation reviews and risk component modelling becoming par for the course

In the March issue of PM I set out some of the many challenges facing trustees. These included the increased complexity of investment issues and the explosion in choice of products. So as not to depress you too much, I suggested a possible solution, which we would call a ‘solvency management’ solution.

Overhaul, not MOT

The aim of solvency management is to move away from the ‘change the oil and check the tyre pressure’ approach, whereby investments are considered each quarter with a major strategic review every few years. Instead, the focus is on a holistic, dynamic solution, where the professional solvency manager provides day-to-day management of the relationship between the assets and the liabilities. New investment opportunities are continuously considered and implemented by the solvency manager, rather than by lay trustees. This is a move away from the traditional investment consultant relationship, where the trustees take nearly all the major decisions.

For most pension fund trustees their main strategic objective is to improve and/or stabilise the funding level, ie remain solvent. The table to the right attempts to summarise this using a typical set of trustee objectives and a statement about their tolerance to risk. These would be set by the trustees following input from a number of parties including the actuary, solvency manager (replacing the traditional investment adviser) and sponsoring employer.

These become the solvency manager’s objectives and risk tolerance.

The solvency manager is then paid based on whether they achieve the objectives above within the agreed risk tolerance. Because they are actually implementing the strategy, they are held responsible for the results. Linking the solvency manager’s pay to risk, as well as returns, means they probably can’t put it all in equities (or on the horses) and hope for the best.

Trustees as NEDs

Given the change of approach, the relationship between the trustees and investment adviser would need to be reviewed. Under a solvency management approach, trustees are not required to dedicate (even) more time to investment. Instead, they focus on setting and reviewing their high level objectives (funding level, investment return and risk) as described above. The detailed ongoing implementation is delegated to the solvency manager, including choice of investments, fund managers and derivatives. However, the trustees may choose to specify certain key investment limits eg no more than 30% of the portfolio in illiquid assets.

The trustees effectively act as non-executive directors responsible for reviewing strategy and key restrictions, with implementation delegated to the executive directors – in this case the solvency manager. This is how most large businesses operate.

While it sounds like a radical departure from the traditional method, this structure is used by many larger European pension funds. Successful examples include PGGM in the Netherlands and ATP in Denmark, who employ in-house investment professionals. For those that can’t build their own in-house team – which is most UK pension funds – the solvency manager can fulfill this role. The aim is a much smoother and more responsive ride on the funding level journey.

The production plant

Having set out the idea, how would it work in practice, and what difference would it make to the investment portfolio? We move from the boardroom to the production plant.

In our case study below we assume the trustees are targeting a return of around 2% a year above liabilities and that they want to avoid the funding level falling more than 10% behind schedule at any point in the next five years. What components will we need at the production plant?

Traditional asset allocation

With a target return of 2% above liabilities, a typical investment portfolio would be split as follows: equity – 60%; bonds – 30%; property – 10%. According to the Pension Regulator’s Purple Book 2007 this asset allocation is typical for UK pension funds, almost regardless of funding level, size of fund or strength of sponsor.

The decision to invest like this would typically have been taken after an asset-liability modelling exercise, following the last actuarial valuation. Traditionally, only equities and bonds were included (property if you were lucky). Any additional asset classes would be added in later, and would often not be modelled fully.

The asset classes above tend to combine different risk factors. For example, corporate bonds will be a combination of credit risk and interest rate risk.

Risk allocation

A key development in recent years is we are now able to split many investments into their risk components.

Let’s say you hold a Ford corporate bond, but decide you no longer want the credit exposure to Ford. You can now purchase a derivative, called a credit default swap, to remove your Ford credit risk. This leaves you with only the interest rate risk of the bond. The ability to split investments into the risk components offers many more investment options, but substantially increases complexity. It means a fundamental rethink is needed on how the assets and liabilities are modelled and managed.

The solvency manager would model the best possible solution using all risk and return factors. They would exclude (or reduce exposure to) any risk factors that the trustees are not comfortable with, eg illiquid investments. A sample risk allocation based upon our case study is shown in chart one, where risk is compared to the liability values. The risk/return factors are grouped into:

1. Market exposure – for example, an index-tracker.
2. Manager exposure – returns are primarily driven by manager skill, although this may include some market exposure.
3. Hybrid exposure – it is not practical/possible to separate market exposure from manager skill.

In the current market conditions a sample portfolio might look like chart two. The solvency manager would continually review the risk and asset exposures and adjust the portfolio and fund managers to reflect these views. For example, the interest rate and inflation swap overlays – which aim to hedge some of the key liability risks – may not cover all of the portfolio at present due to the high price of this protection.

The solvency manager would also provide full operational support, given the increase in types of investments and number of managers. This could include negotiating and signing the investment management agreements and overseeing collateral management for derivatives.

You might think a solvency management solution is only available to the larger pension funds. However, there is no reason why trustees of medium-sized pension funds, and possibly even some smaller pension funds couldn’t adopt a solvency management approach. In fact, it may involve less trustee time spent on detailed investment matters and a more strategic focus.

Finally, some good news for trustees.

Phil Page is client manager at Cardano

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