April 9, 2010

Dr. Susan Mangiero, CEO of Investment Governance, Inc., interviews Mr. Bruce Curwood regarding the development of risk management strategies by pension trustees in the U.S. and Canada. Mr. Curwood is director of investment strategy for Russell Investments, Canada where his primary responsibilities include investment research and client service for institutional clients. Immediately prior to Russell, Mr. Curwood served as the first treasurer for the University of Toronto, where his responsibilities included the direct and indirect management of more than $2 billion in assets.


Susan: Welcome Bruce. Your background is terrific. I know you’ve also been prolific in terms of writing about risk management. We’ve added several of your papers to FiduciaryX.com for subscribers to enjoy.

Bruce: Great.

Susan: Let’s start with the first question about your motivation in writing so much about risk management. It seems to suggest that there is a change in terms of focus on risk management. Do you agree?

Bruce: Well, I’ve been writing on this area and involved in it for over 10 years. The reason I got into it was because I saw that a lot of my clients were missing the big picture, which in most cases was governance and risk management. But I do agree with you that there’s a great deal more interest in risk management today than ever before.  Over the last 10 years we have had two major events: the tech wreck and now the global financial crisis. It’s been a bit of a rollercoaster ride for investors and they really want a break from the turbulence. A recent institutional plan sponsor survey, the MetLife U.S. Pension Risk Behavior Index, notes that, after two major crises in the last decade, sponsors are far more concerned with investment fund risk than ever before. The survey reflects that plan governance has escalated from the ninth spot a year ago to the third spot in terms of importance. That’s even ahead of asset allocation, which was the number one concern last year. There seems to be a growing recognition that improving risk management and decision-making are essential first steps to achieving long-term success. Now, that said, institutional investors should be defined by their actions not just their words. So far I’ve only witnessed a few of the mega funds -- those funds over $30 billion dollars -- initiating major governance risk management initiatives. A good example would be Ontario Teachers’ Pension Plan in Canada. They got to the heart of the issue when they started in the early 1990s by placing risk management and governance at the pinnacle of their strategy. They’ve been a good role model for other plan sponsors. Recently what we’ve seen both in the U.S. and Canada are large funds like the Caisse (Caisse de dépôt et placement du Québec) in Canada and CalPERS (California Public Employees' Retirement System) in the U.S. who have basically taken up the same mantra. Each organization has engaged a chief risk officer and added some 20 new staff in risk management. These funds are going through the arduous process of building a culture of risk-adjusted decision-making. This is a complete change in terms of policy, process, and philosophy. This approach needs to be more broad-based throughout the institutional investment industry. Smaller funds have to start adopting this same approach. Maybe not with the same resources, but they still have to jump into this area and do what they can to improve governance and risk management.

Susan: Bruce, your comments lead to a very interesting question we hear from a lot of pensions, endowments, foundations, college plans and so forth. With their staffs being cut for budget reasons, how can they realistically tackle risk management? Is outsourcing the risk management function a possibility? If so, which service provider in the investment management ecosystem should be paid to assume those responsibilities?

Bruce: This is a good question. Governance entails the creation of an effective decision and oversight structure that is customized to one’s plan and is constantly refined to bring about successful decision-making. It requires that an appropriate risk management policy, process, and set of practices be created and followed. Risk management oversight is a clear duty of the board. Part of good governance requires that the trustees determine the business model necessary to meet their funds’ specific goals and particulars such as dollar assets under management and available resources.  So size, as you point out, is indeed a major factor. But whether a plan is a mega fund or a significantly smaller fund, a good risk management process is indeed a necessity. As you point out, the smaller funds that lack the economies of scale probably need to partner with an external party. Their consultants and investment managers are probably best positioned to assist them in making complex investment decisions. However, trustees can’t delegate risk management to a third party and must remain a major part of the process. They alone are responsible for setting the primary goal, agreeing on risk tolerance and risk capacity and relevant time horizons. They must also put in place appropriate due diligence procedures  as it relates to the selection of outside service providers or, more broadly, the people who are going to assist them or their partners with appropriate reporting and oversight.

Susan: What do you see as some of the advantages and also disadvantages of outsourcing the risk management function, after the investment committee had agreed on primary risk constructs? Let’s say a consulting firm is acting contractually as a fiduciary. How does that change the dynamics?

Bruce: The major advantage of partnering is that smaller funds can have better access to expertise, research, techniques, tools, and experience that they may be lacking due to diseconomies of scale. Third-party review may ensure that key risk exposures are not overlooked and are then properly prioritized and addressed. We’re not talking about a structural tweak here or some new black-box risk tool, but rather the hard work of building a better risk management framework and culture that is custom designed for a particular plan. As I stated earlier, trustees must recognize that one of their key duties is to develop an appropriate and comprehensive risk management system for their fund. In Canada we have the Canadian Association of Pension Supervisory Authorities which has put forward several principles on pension governance. Principle Seven states that the plan administrators should provide for the establishment of an internal control framework that is commensurate with the plan’s circumstance and which addresses the pension plan’s risk(s). Plan fiduciaries must answer two key questions: Have you identified the pension plan’s risks, and do you have a process to manage those risks? So, putting that process together in a partnership relationship is very helpful. Now, one of the major disadvantages of partnering might be that trustees shirk their oversight duties because they see this act as a means to offload a perceived problem onto a third-party or that a one-time review is somehow sufficient. They might then become disengaged from the process. Even in a full outsourcing situation, the trustees should be engaged, active and responsible for understanding and making many of the key risk tradeoffs and decisions. They must ensure proper due diligence of third-party providers as well as provide appropriate oversight and reporting.

Susan: Few organizations have a risk management policy statement. Even if they have an investment policy statement one wonders if they ought to create a detailed risk management policy statement. That would certainly be something I recommend. What do you think prevents an organization from putting in place a risk management policy statement that is similar in concept to having an investment policy statement that guides actions taken by the plan’s stewards? Also, what would you recommend as the core elements of a risk management policy statement?

Bruce: I think one of the things that stops investment stewards from creating a separate risk management policy statement is overconfidence. We’ve been far too overconfident that we can somehow forecast returns. We’ve been focusing on optimizing returns instead of really focusing on risk management itself. So, the necessity to focus on risk management hasn’t come to the forefront until the last several years. Their focus has also been, in the past, on a lot of administrative and historical matters  or micromanaging  managers. But they really haven’t dealt with the big issues like governance and risk management. Things are changing now. When you look at a risk management policy statement, it starts with some of the tough issues, which often trustees don’t want to address. For one thing, clearly defining the primary goal for the fund is critical. In many cases, investment committee members may have multiple competing goals, and they never choose between them. They are constantly trying to satisfy these multiple goals. You’ve really got to determine the true goal and work towards achieving that goal or mission, whether it’s maintaining fund surplus or something else. Everyone must agree, and they must focus their decision-making on that goal so that each and every time they are making decisions, they are seeking to ask the key question - “Well, how does this action  relate to the overall goal and what are the risks around that?” We must look at what are the major risks that these actions  entail for the fund. In addition, the risk management policy statement should state the appropriate time horizon. Again, investors face a conundrum, so to speak. In order to get better returns, you generally have to invest in risky assets. But really if you want to better match the liabilities, you generally favor fixed income strategies that have a lower return . You are always balancing this tradeoff of risk and return. You have to clearly know  what the overall goal is. You have to determine your own risk tolerance and the risk capacity for your particular enterprise or organization and understand how it all fits together. These are challenging and tough issues. Trustees must also determine and articulate their risk management beliefs. I don’t think a lot of people have done that. There are two schools of thought out there in terms of risk management beliefs. The first group says, “You know, we’re all just investors  picking up pennies in front of the proverbial steamroller,” so to speak. The market is uncertain and if you’re not careful you’re going to get burned by unpredictable events. You have to be somewhat conservative in terms of your approach (how much risk you are taking). Limit your risk, or use option strategies to protect on the downside.  On the other hand, there’s the other school of thought out there that says, “Yes, we understand that the markets  are uncertain. But with better research and by being more informed and understanding the market better, we can try to determine when the market is cheap and when it’s rich and  take the appropriate action (e.g. reduce risk when the market is pricey or frothy) .” Each one of those philosophies links to a different strategy - the conservative approach (liability-driven investing ("LDI"), liability-responsive asset allocation ("LRAA"), etc.) or the more informed judgment (enhanced asset allocation ("EAA")  or strategic tilting).  But it needs to be more than just a statement. We’re talking about policy statements, but also what I’ve always tried to address is a change in culture, process, and mindset.  Not just lofty or  empty words, but words that lead to really practical solutions. Let me outline what I see as the desirable attributes of a risk management framework: a fund-wide scope; forward-looking, clear articulation; the ability to classify risk; and a systematic approach for evaluation and consistency. Taking action is the key part about a risk management framework. Not just policy statement checklists and words. It’s about taking that framework and really putting it into action. That is why I developed the hierarchy of governing fiduciary risk, looking at multiple risk factors to guide good process. And then try to apply that to a client’s particular fund. Customization  takes this two-dimensional hierarchy and makes it a  three-dimensional hierarchy. In short, it  makes it come alive and be more relevant. A plan sponsor can focus on the key risks for its fund. Because every fund has different key risks, right? Whether your liabilities are inflation-related or not and how you invest - whether it’s outside of the country or inside of the country - and various different challenges  that each fund is faced with. Risk management has to be specific to a particular plan.

Susan: There’s so much focus right now on returns. That’s how, often times, people are getting rewarded, whether a particular portfolio exceeds a particular benchmark. I know that you’ve written an extensive amount about behavioral dynamics. How do you get people thinking that a better reward system must be tied to risk-adjusted return?

Bruce: I think the first thing you have to get them to understand is that even the experts out there can’t predict what’s going to happen in a marketplace with any consistency. They’re better than maybe some of us, but they’re probably right only  a little over 50 percent of the time. Even then, when they’re right, they can be right on direction but not on timing. So, when you start to see the unpredictability of the market and how many variables (weather, economics, human behavior etc)  affect the market, you realize that market participants are not always behaving rationally and that trades often reflect human behavior. Greed and fear  can move the market to extremes. You start to realize that it’s important not to just focus on return, but also to start focusing on the things you can control. Determining the appropriate level of risk for your fund is one of the things that you can control, as well as a better governance process You also raise a good point about the importance for incentives to properly motivate staff and service provider behavior. Trustees must ensure that they don’t create short-term incentives. Perverse incentives basically inhibit the attainment of long-term goals. This  explains why creating an annual business plan for the fund with appropriate objectives and action steps is so important. Rewards should be based on achievement of specific action steps which assist in that process. Creating a risk budget and a risk management framework are important elements of putting a disciplined process in place.

Susan: You earlier cited a matrix of multiple factors. When you think about the risk management process being built around the ability to measure, manage, and monitor various risk factors, what would you recommend people do in terms of choosing a risk management system?

Bruce: Each fund will have different risk management needs. As you pointed out earlier, every fund is not a mega fund with huge resources that they can put into it. But they can all focus on the most important areas. Governance and objective setting are some of the first things that we like to deal with, as consultants, with our clients. After tackling these critical first step issues related to fiduciary risk, you proceed to the next important issues of asset allocation (asset liability risk), asset class strategy, manager selection and retention (structural risk) and then all the operational risks  like cost and execution. Once you get that framework in place and people understand the driving factors, they start to focus on what makes sense for their fund. A smaller fund may want to get an asset-liability study completed and then use tracking error to measure risk. This, by itself, is insufficient without better understanding (scenario analysis, stress testing, etc.). They have to go into much more detail and spend a heck of a lot more time understanding the asset-liability study. What happens a lot of the time is that trustees get a lot of information thrown their way. They may end up trying to make a snap decision which does not bode well for good process. They tend to focus on the upside of the return distribution without thinking about transparency, liquidity, leverage and the possible downside. They really have to step away from the administrative matters and the things that they like to deal with and spend a lot more time on the tough issues. Risk management and governance are two of those issues. There are lots of things that you can do in terms of governance process for a fund. But someone needs to take the bull by the horns. In many cases you would try to have the CIO and the chairperson of the plan’s investment committee and perhaps the consultant all on the same page to move the rest of the committee in the same direction. There should be a common vision for the fund. That common vision starts with asking about available resources. “What are our research capabilities and our beliefs? And we have to make timely decisions.” That’s what board effectiveness is all about. Then they can improve board effectiveness in three key areas: governance structure, governance process, and board committee membership. In terms of a good governance structure, you really want to have unambiguous accountability. You want to have a decision-making structure that everybody understands and that focuses committee members on what really matters – the plan’s primary objective, and risk management. Then you have to delegate to professionals, often your staff or service providers, so that the trustees can spend the right amount of time on these issues. In the governance process, you’ve got to have a proper business plan, agendas, and documentation. This includes good investment education, innovation and proper reporting with good oversight. The committee members have to prioritize things by importance so they can get all the things done. Remember that trustees and committee members often only meet on a quarterly basis. They generally have other full-time jobs that are not investment related. So you must  look at your board committee membership and structure. You have to look at things like tenure, recruitment, and orientation. You must suppress dysfunctional behavior. The chair has to play a big role in choosing investment committee members by expertise and experience. Those that don’t have as much in terms of expertise and experience must receive training on an ongoing basis. A self-appraisal process to refine your governance structure must be laid out upfront. So, those are the things that I would be looking at even for a smaller fund.

Susan: Bruce, when you talk about the use of an outside party, perhaps a consulting firm, to assist with the risk management function, is it a situation where plan sponsors will want to get a different consulting firm depending on the type of plan? Is that going to be an issue or do you think that most consulting firms are set up to accommodate risk management across the spectrum of situations? For example, if somebody wants to consider investing in hedge funds, in the case of a defined benefit plan let’s say, that might arguably take a different form risk management policies and procedures.

Bruce: Yes. I think that most consultants are set up to help you with asset-liability studies, but in many of these cases we’re talking about a complete risk management review. I’m not sure that all consultants are set up for that. Russell has recently put in place our own risk management service whereby we do a deep dive analysis with a client, if they so ask, and really try to understand the issues before customizing a risk management solution for them. We point out their key exposures and help them deal with those through training, education, and focus on the right issues. But everybody is going to be a little bit different in how they approach things. Many consultants have the general asset-liability capabilities to assist their clients. But  for the deep-dive, a plan sponsor may want to look beyond its particular consultant, depending on their capabilities.

Susan: You also mentioned asset-liability studies. This is a topic that seems to be gaining a lot of traction, i.e. whether to solely depend on the results of an actuarial assessment as the basis for a plan’s economic risk management decisions. There are different ways to measure actuarial risk. Some of these approaches map nicely with the economic risk management metrics. Some do not. Would you comment on what plan sponsors need to consider when using actuarial numbers in setting up a risk management program?

Bruce: I think the first thing is that you have to recognize that the actuarial and liability numbers are estimates at a point in time and subject to significant change. They are not exact. Just like performance measurement is not an exact science, neither is actuarial science. It is great in terms of its mathematics, computing risk at that point in time. But risks change over the course of time. You have to recognize that there is no perfect match in terms of assets to liabilities, in most cases, unless you are winding up your plan and even then you have discrepancies (actual versus estimates). The next thing to consider is that your investment consultant is dealing with both the assets and the liabilities, looking at the funded surplus and additionally trying to analyze a number of variables like contributions and risk tolerance. Interest rate risk is important, but that is only one driver of the plan’s ability to pay. Consultants can help  investment committee members to identify the most relevant risks and help them with mitigation strategies or recommendations to control risk from a more holistic perspective as opposed to just relying on the asset-liability study from the actuary.

Susan: These insights are very helpful. I’d like to leave the audience with some actionable items. I know you are putting together a program about fiduciary redemption.  Would you talk about the core elements of an action plan - things that board members, trustees, analysts, and so forth can do immediately to start improving their investment governance and risk management processes?

Bruce: Trustees have become uncomfortable over the last several years, probably the last decade, with the returns that they’ve had. They’ve noticed that they have low or negative real rates of return. They’ve seen an erosion of their funded status versus their primary goal. This has left them searching for new solutions, as you point out. In the presentation I’m putting together I start with a biblical statement - Proverbs 22:3, which says: “A prudent person foresees danger and takes precautions. The simpleton goes blindly on and suffers the consequences.” You are right that I put forward three steps to trustee redemption. I’ll give you the three steps and then elaborate. First off, they have to acknowledge the problem. Second, they have to understand why change is necessary. And then they have to take action. In terms of acknowledging the problem, that’s one of the keys right now.  We’ve been talking about it even before we got on the line today. Human behavior can be irrational. Because of that, our markets are not normal. Plus markets are subject to many, many variables that most of us cannot predict. So, managing risk is a complex, pervasive problem, which most trustees have basically failed to master. Now, there’s nothing wrong with that. I mean many of us are in that same boat. So, the reality is that we have to focus more attention on this matter.  We have to understand why change is necessary. Keep in mind that there is an unfortunate Catch 22 when it comes to governance. That irrational human behavior  or  unconscious bad behavior ( which we don’t even know we’re doing it in many cases) - can undermine good governance. We have to try and put better governance in place to have more discipline and preparedness in our process. What we’ve been doing up to this point in time is to try to optimize the unpredictable, returns. We’ve kind of talked about this today - that you can’t forecast returns, so how can they be optimized? Performance is going to come the way the market dishes it out. It’s often very different than what you would have anticipated. We’ve been really focusing on the wrong variable. The third step is to take action. To do that you’ve really got to focus on the things that you can control. There are only two things you can really control, I think, as a trustee those are  outlining a good governance process, which I outlined before, and some of the steps that can be taken to achieve good governance. Secondly, trustees really must dive  into risk management, determine an acceptable level of risk and develop a risk management culture and process for their  organizations. That’s turning the equation upside down.  It’s saying that risk management has suddenly become the cornerstone of investing as opposed to strictly focusing on or over-emphasizing unpredictable returns. I think if we start to do this, the industry would benefit. We must recognize these problems, acknowledge why things have not gone well and change our approach to make things better. That’s my summary of the whole picture.

Susan: Bruce, I did have one other question. In Canada, there is so much attention paid to investment governance. The U.K., the Netherlands, Australia and others are making great strides. The U.S. seems to increasingly more proactive in terms of governance. I want to get your opinion though about why you believe pension governance or more broadly investment governance is taking a different form elsewhere, outside the United States.

Bruce: A  more aggressive risk-taking approach actually served U.S. market participants well in better economic times (the 80's & 90's). It’s also been fruitful in terms of private equity and for  various other investments . But in the new lower return environment (the new normal) it doesn’t serve them very well, particularly in terms of risk management. The rest of the world, Canada in particular, has been a little bit more on the conservative side with a logically greater focus on risk management as a result. There is a large number of experienced individuals in Canada who have been writing on this topic for some time. They have put together a body of knowledge over the course of years that has helped the rest of us to understand the issue of risk management and to understand the importance of good governance. The two are intertwined. It’s not just a duty. It’s really a major function of the fiduciaries that must take center stage. I think these advances and the events of the last two years or decade, whichever way you want to look at it, are now starting to galvanize support for good governance. I think that’s what you are seeing in the U.S. and elsewhere.

Susan: I appreciate that feedback. This has been extremely interesting. I look forward to your continued writings. Your time is also much appreciated. Thank you so much for the tips and guidance of pension plans, although arguably, a lot of what you offer likewise applies to other types of institutional investors as well.

Bruce: True. Thank you very much.

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