| At all times, we ensure investment risk at both the total fund and individual portfolio levels is maintained within allowable ranges set by the board.
The main risk to the plan is funding risk: not having enough assets to meet pension obligations. Over the long term, pension benefits have to be in balance with contributions plus investment returns.
The plan would reach that balance and have no funding risk if all contributions could be invested in risk-free assets yielding about 4.5% plus inflation (i.e., a real return of 4.5%) from day of deposit until the last pension cheque is paid.
However, risk-free assets yield less than our long-term goal; higher yielding assets are not risk free. Canada real-return bonds come close to being risk free, but currently yield approximately 2% plus inflation at the end of 2007, down from 4% plus inflation in 1999.
At the other extreme, stocks have a higher long-term expected return but annual returns can fluctuate greatly, as recent volatility and the sharp stock market decline from 2000 to 2002 have demonstrated. This volatility could lead to unacceptably large fluctuations in annual contribution rates.
We also recognize that funding risk can come from assets or liabilities; a 1% decline in real interest rates increases liabilities by 22% on a funding basis and by 17% on a financial statement basis. The biggest risk to plan assets is a decline in equity markets.
We have developed a robust risk system that provides the fund with the flexibility to examine and compare a wide range of strategies and different asset classes, and to calculate the benefits of diversification across strategies, asset classes, departments and portfolios.
Risk budgeting
We devote considerable effort to allocating funding risk to the sub-categories of market risk and active risk: a process known as risk budgeting.
We use risk budgeting with a system that allocates risk, instead of capital, across the fund’s asset classes, with the goal of outperforming markets. To understand the long-term dynamics of the total risk in the plan, we also review the economic conditions for the different asset classes and maintain a comprehensive asset-liability model, including the results of our reviews.
Using our asset-liability model, risk budgeting seeks to find the combination of active and market risk strategies that has the best chance of being successful. We base our analysis on the history and prospects for stock and bond markets, and our assessment of the quality of our active programs.
Our main goal is to exceed market benchmark returns. But increasingly, we are using risk budgeting to monitor and manage assets relative to the liabilities (the funding risk) to help ensure the fund generates the amount needed to fund the pension plan over the long term.
We control risk at the total portfolio level by managing the various department allocations within discretionary limits. Through our risk system, we measure how much money we could lose within each portfolio, series of portfolios, across departments, across asset classes and finally at the total fund level, each to a given probability. Risk calculations are also completed relative to the plan’s liabilities and benchmarks. We compare the observed risk values to those budgeted. This also enables us to calculate the benefits of diversification across strategies, portfolios, asset classes, departments and asset classes.
Over the last decade, faster computers and better risk management software have made it possible to take into account far more information than before, particularly in assessing short-term risk, and monitoring risk more frequently.
Our main short-term market risk management tool is Value at Risk (VaR), which measures how much might be lost in the potential worst 1% of portfolio outcomes based on a long history of returns. It captures market risk for all our investments including derivatives.
VaR has been very useful in quantifying the relative size and change in both funding risk (the risk of a drop in the funding ratio) and active risk (the risk of underperforming a passive market index benchmark).
One of the insights during the technology boom of the 1990s was that, because of changes in index composition, market indexes do not have constant volatility. We found that asset mix is not as stable a measure of the plan’s exposure to market risk as we previously thought.
In Canada, the main culprit was the rise and fall of Nortel’s weight in the TSX index, making Canadian index investing more risky than it appeared to be earlier in the decade. This has caused us to pay closer attention to managing total fund risk, instead of just focusing on active risk.
Active risk
Active risk is the risk of underperforming market benchmarks due to stock selection that is aimed at adding value. If we choose to overweight individual stocks and do not replicate index weightings in our holdings, we run the risk that the market may do better than our individual stock selections.
The board approves an active management strategy annually aimed at adding value above market benchmarks. The current target is to add an average of 2.0% (before costs) per year over a four-year period. The incremental risk from active management is small and is managed through policy guidelines and procedures, including our VaR system.
Our VaR system has proven to be particularly useful in evaluating the opportunities and limiting the risks associated with this activity. Every year, we assess where we can allocate risk productively to our various active programs and use this to set an active management risk budget.
All risk allocations carry with them the obligation to deliver a return on risk, and this is incorporated as a key part of our performance evaluation and compensation programs. By measuring the expected return on risk across all opportunities, we can allocate risk capital where it has the highest payoff. Risk budgeting naturally leads to comparing return on risk, as opposed to return on assets: what matters is how much can be gained compared to the risk of loss, which does not need to be proportional to the amounts invested.
A rising share of active risk is being used in privately negotiated opportunities and instruments that do not fit neatly into a conventional stock or bond category, as well as absolute return strategies. For example, we use more than 200 external hedge fund managers selected for their ability to give us consistent risk-adjusted returns from a diversified range of strategies. |
