Given the ever-greater regularity of unanticipated impactful events with equally unpredictable tipping points, we look at the importance to pension scheme fiduciaries of risk management.
In particular, we consider the need for both more inventive scenario analysis and stress testing of schemes' resilience against a multitude of everpresent and emerging risks allied to more nimble governance.
The multi-faceted nature of risk
Hands up if you thought at the beginning of the year that inflation, central bank interest rates and bond yields would rise to the degree they have? And how about government bonds being amongst the most volatile asset classes of 2022? And what about the sheer strength of the US dollar? Or that 2022 would rank amongst the coldest and wettest, yet hottest and driest on record, so heightening concerns about climate risk? I'm not seeing too many raised hands.
Although risk is one word, it isn't one number. Within pension schemes, the multi-faceted nature of risk is readily apparent, variously spanning covenant, regulatory, market, concentration, liquidity, interest rate, inflation, credit, demographic, counterparty, environmental (notably climate), social and governance (ESG), currency, operational and investment governance risk, to name those risks that typically dominate pension fiduciaries' investment risk radars1.
But what is risk?
Most textbooks characterise risk as the range of uncertainty surrounding, or the probability of, a future outcome. Others, the possibility that more things could happen than probably will happen.
Suffice to say, as events rarely unfold in the way we expect, while others occasionally catch us off guard completely, by seemingly surfacing from nowhere, it pays to expect the unexpected2. Nowhere is this truer than within the world of pension scheme investment management given the ever-present challenges to accepted macroeconomic and investment paradigms and norms, increasingly abrupt volatility spikes in public markets and the complexity of many investment and hedging strategies. Moreover, this comes against the backdrop of a world that doesn't operate predictably or conform with normally distributed outcomes or historical precedents, with largely unexpected impactful events and their capricious tipping points occurring far more often than statistically they should. Consequently, pension scheme investment management has become an increasingly complex exercise in risk management.
Separating the knowns from the unknowns
This is where the late Donald Rumsfeld's infamous 2002 quote comes in: "There are known, knowns. These are the things that we know. There are the known, unknowns… [the] things that we know we don't know. But there are also unknown, unknowns… the things we don't know we don't know."
While ridiculed at the time, Former US Secretary of Defence, Rumsfeld was simply pointing out that while the sources of some risks - the known, unknowns - are known and might even be quantifiable, others - the unknown, unknowns - the bolts from the blue, the outliers, the left tail risks or black swans3, cannot always be anticipated, let alone quantified.
As pension scheme investment management is littered with known, unknowns and unknown, unknowns, in seeking to manage both categories of risk, of varying shapes and sizes - some highly visible and quantifiable, others much less so, some potentially rewarded, others going unrewarded - pension fiduciaries must ensure that the uncertainties surrounding future outcomes are efficiently managed within acceptable tolerances. However, to do that, pension fiduciaries must, of course, understand the nature of the multitude of risks with which they are confronted and avoid tunnel vision.
Read previous Pensions Watch articles by clicking on the links below
Pensions Watch 1, Pensions Watch 2, Pensions Watch 3, Pensions Watch 4, Pensions Watch 5, Pensions Watch 6, Pensions Watch 7, Pensions Watch 8, Pensions Watch 9, Pensions Watch 10, Pensions Watch 11, Pensions Watch 12, Pensions Watch 13, Pensions Watch 14, Pensions Watch 15, Pensions Watch 16, Pensions Watch 17, Pensions Watch 18, Pensions Watch 19, Pensions Watch 20, Pensions Watch 21
1 In the UK, the key risks managed by pension fiduciaries are listed in two documents - the risk register and the Statement of Investment Principles (SIP).
2 For an insight into the top global short-term economic, societal, environmental and technological risks, associated trends and their prospective impact, according to those in the know, see: The Global Risks Report 2022 17th Edition. Insight Report. World Economic Forum. 2022.
3 Black swans are largely unpredictable, impactful events characterised by a typically remote probability of occurrence. Coined by philosopher David Hume way back in 1711, the term was popularised in 2007 by Nassim Nicholas Taleb in his eponymous best seller.
This post is funded by Columbia Threadneedle Investments