Bonds: a Crisis Risk Indicator?

As a risk professional you've learned to classify an increase in bond's interest volatility (or standard deviation) as an indicator that bonds have become more risky. Right you are....

Now, with this knowledge, let's take a look at the next chart, presenting the long-term (10Y) interest rate of some of the leading EU member states from January 1993 to April 2014:

This chart clearly shows that :

• Since the introduction of the Euro in 1999, country spreads start declining
• Interest rates converge to the year of the famous (Lehman) crisis in 2008
• After the 2008 crisis, rating agencies wake up and spreads explode again

Let's take a look in more detail, by some log scale zooming......

To find out if the convergence of interest rates really is a kind of early warning crisis indicator, let's add some more EU countries to the chart.

Now the picture becomes clear: A structural decline in bond's standard deviation is not a decline in risk, but more the opposite....

As standard deviation decreases, (crisis) risk increases!

We can check this by looking at the cross-country standard deviation development in time:

These charts, presented on a vertical linear and log scale basis, clearly  illustrate that as soon as the standard deviation hits the 0.2% level, crisis can be expected soon.

Not only is the 0.2% SD-level an early warning indicator for the 2008 crisis that started with the bankruptcy of the Lehman Brothers bank, but it's also an indicator of 'Dot Com' crisis in 2000....

Finally
Meanwhile... as from February 2012, standard deviations are declining  again. Time to worry?

Key questions are:

• when will standard deviation hit the 0.2% floor again? 
• and when it does, will there be another crisis?

Remember lesson number 1 in risk management: Crises are unpredictable!
Nevertheless, once 0.2% SD  turns up: fasten your investment seat bells....

Links/Sources:
- Spreadsheet of charts used in this blog
- EU Interest Rates
- Big Picture Chart

Discussing Life-Cycle Pensions & Longevity

In this blog I'm going to discuss two persistent pension topics:

1. One of the most common misunderstandings in pension fund land is that an individual (member) investment policy weighs up to a collective investment approach.
2. Is there a rule of thumb that expresses 'longevity risk' in terms of the yearly return?  

1. Collective vs. Individual Investing Approach

In case of a 'healthy pension fund', new members will join as time continues. In a mature pension fund the balance of contributions, investment returns, paid pensions and costs will stabilize over time.

Therefore the duration of the obligations of a pension fund will more or less stabilize as well. The duration of an average pension fund varies often between 15 and 25 years. Long enough to define a long term investment strategy based on a mix of risky equities (e.g. 60%) and fixed income (e.g. 40%). Regardless of age or status, all members of a pension fund profit from this balanced investment approach.

In case of an individual (member) investment strategy, the risk profile of the individual investments has to be reduced as the retirement date comes near. In practice this implies that 'equities' are reduced in favor of 'fixed income' after a certain age. As the age of a pension member progresses, the duration of the individual liabilities also decreases, with an expected downfall in return as a consequence.

Let's compare three different types of investment strategies to get a clear picture of what is happening:

1. Collective Pension Fund Strategy Approach: Constant Yearly Return
   40% Fixed Income à 4% return + 60% Equities à 6% = 5.2% return yearly
    
2. Life Cycle I Approach ('100-Age' Method)
   Yearly Return (age X): X% Fixed Income à 4% + (100-X)% Equities à 6%
    
3. Life Cycle II Approach (Decreasing equities between age 45 and age 65)
   Yearly Return (age X) = MIN(MAX((6%+(44-X)*0.1%);4%);6%)

All visually expressed in the next chart:

Pension Outcomes

Now lets compare the pension outcomes of these three different investment strategies with help of the Pension Excel Calculator on basis of the next assumptions:

- Retirement age: 65 year

- Start ages 20 and 40

- 3% and 0% indexed  contributions and benefits

- Life Table NL Men 2012 (NL=Netherlands)

Results Pension Calculations (yearly paid pension):

Conclusion  I

From the above table we can conclude that switching from a collective investment approach to an individual investment approach will decrease pension benefits with roughly 10%. Think twice before you do so!

2. Longevity Risk Impact

To get an idea of the longevity impact on the pension outcomes, yearly paid pensions are calculated for different forecasted Dutch life tables (Men).

Life Tables

Forecast Life Table 2062 is calculated on basis of a publication of the Royal Dutch Actuarial Association.

The Forecast Life Table 2112 is (non-official; non scientific) calculated on basis of the assumption that for every age the decrease in mortality rate over the period 2062-2112 is the same as over the period 2012-2062.

Pension Outcomes per Life Table

Here are the yearly pension outcomes on basis of the forecasted life tables:

From the above table, we may conclude that the order of magnitude effect of longevity over a fifty to seventy year period is that pensions will have to be cut  roughly by 25%-30%.


Another way of looking at this longevity risk, is to try to fund the future increase in life expectation from the annual returns.

The next table shows the required return to fund the longevity impact for different forecasted life tables:

Roughly speaking, the expected long-term longevity effects take about 0.7%-1.2% of the yearly return on the long run.

Finally

Instead of developing a high tech approach, this blog intended to give you some practical insights in the order of magnitude effects of life-cycle investments and longevity impact on pension plans in general.

Hope you liked it!

Links/Downloads:

- Excel Pension Calculator including Dutch Life Tables 2012-2062 

- Excel Tables of this Blog
- Forecasted NL Life Tables  2012, 2062, 2112

- Original Pension Excel Calculator

- Publication Dutch Life tables 2012-2062 (Dutch)

- Excel Spreadsheet Forecast Dutch Life Tables 2012-2062

Chief Actuary Officer

Let's take a look at the governance of financial institutions from a risk management perspective:

Governance Risk Management

Traditional governance focuses on the organisation-structure, decision-structure, influence and power-weights of all stakeholders. Governance Risk Management focuses on how to optimize and monitor risk and value creation for all stakeholders.

Financial Risk Management Monitoring
After defining a companies Mission, Risk Appetite and Strategic Plan, the year-targets and key indicators are not only translated into a tight budget (b) of 'sales targets' and 'profits', but also into 'balance sheet budget targets' (b).

It takes a real well defined 'Governance Risk Management' to split the balance sheet into such parts (Assets, Liabilities & Capital) that responsible officers in the company are able (and can take responsibility) to monitor the actual values (a) monthly or quarterly to the final or adjusted budget values (b).

  

Officer Role Division
In a well managed and structured financial company the risk-financial roles of the companies officers can be defined as follows:

1. CIO
   The Chief Investment Officer is primarily responsible for managing the asset actuals A(a) versus the (adjusted) budget A(b). So the CIO has to manage [A(a)-A(b)] in terms of value and within defined  the investment risk budget.
    
2. CAO
   Although often unremarked, an important part of the role of the Chief Actuary Officer is to manage the actual liabilities L(a) versus the (adjusted) Liabilities budget L(b).
   This is no easy job, as most longevity and (risk free) discounting of the liabilities are hard to influence.
   Wrapping up: The CAO is responsible for managing [L(a)-L(b)].
   
   Often the role of the CAO seems to be limited to insurers or pension funds. However, also banks need an actuarial officer, as more and more (product) risks on the bank's balance sheet become economic, demographic and bio-related (mortality, disability, lifestyle).  
    
3. CRO
   Often the Chief Risk Officer is seen as someone at arms length reporting about risks to the (supervisory) board. However, one of the main roles of the CRO is to monitor Capital and Capital Requirements. He/She is responsible for realizing the sustainability of the company by managing the (adjusted) Capital budget C(b) while being confronted with continuously changinge Capital actuals C(a). So the CRO is responsible for monitoring [ [C(a)]-C(b)].  

AIRCO Management
Once the targets are set and responsibilities are defined, the hard part of managing a financial institution starts: Cooperation between the Actuarial, Investment, Risk and Capital Organisation (AIRCO) Chiefs.

During a budget year, all individual defined AIRCO budgets and actuals continuously change in practice.
As capital risk development is the complex result of Asset and Liability volatility, capital management and monitoring by (primarily) the CRO manager becomes extra complex. Especially in market crises situations (tail risks), where traditional (linear) correlations between AIRCO components fail by definition. It's the responsibility of the CRO to continuously balance between all stakeholders interests in narrow cooperation with the CAO and CIO, while staying on track with regulatory requirements.

This task is not easy, as AIRCO Management is not a one dimensional mission or game:

• Run-off
  Often AIRCO Management is merely based on regulatory AIRCO requirements, based on run-off portfolios and one-year period confidence levels (e.g. 99.5% [Solvency-II] or 99,9% [ Basel-II/III] ).
   
• Continuous business model 
  However this run-off approach is only based on a kind of default situation with a very low probability (< 1%). It's much more likely (> 99%) that a financial company will exist for more than one year.
  
  Therefore, adding one or more variations of 'continuous business model approaches' to the existing run-off approach on a board's table, will give the board a more (realistic) insight on the heavy an balanced decisions to be taken to continue and control a sustainable risk-return strategy. 

ALC-Team
To manage the complex of AIRCO effects, it's often helpful to set up an Asset Liability Capital Team (ALC-Team) within a financial institution. Main task of this team is to manage risk and returns across all AIC-axes in line with the strategic plan, the defined risk-return appetite and actual regulatory requirements.

The ALC-Team consists of the CAO, CIO an CRO and could in practice be chaired by the board's CFO, or CFRO.

This ALC-Team :

• proposes board adjustments and monitors the risk-return targets and matching policy
• makes clear what the often paradoxical and/or conflicting effects of risk-return management are for all stakeholders on basis of different future business continuity models (e.g. Run-off, Continuous business, etc.)
• Makes clear and advises what measures the board can take due to the impact on ALC of different business models views, changes in economic risks and changes in regulation.
• operates on basis of ALC reporting information,"Own Risk Assessment" reports, external Economic Risk Reports and external Regulatory Change Information.

Pitfalls

One of the most tricky pitfalls in capital management is that a financial institution tries to solve all budget variances and regulation changes only by adjusting its investment policy.

If adjusting is done 'on the fly', without considering the risk-return targets and (even worse) through the mental filter of just one of the stakeholders interests (e.g. 'shareholder value), a financial company implicitly risks to lose track of the overall strategic business targets.

If an economic or regulatory change influences the risk-return objectives, all possible instrumental options to respond, have to be taken into account. One of the most forgotten instruments to respond to market changes, is 'product management' or (new) 'product development'.

Yet, nevertheless the fact that existing (product) contracts are (short term) often hard to adapt, 'product management' is one of the most vital instruments to apply regarding the management of long term risk-return objectives.

Therefore AIRCO Management requires a planned an controlled Stakeholder Management Process in a financial institution.

Stakeholder Value (Risk) Management
Managing a company's stakeholder value implies that the effects of the economic, regulatory and own-company changes on the risk-return objectives are continuously balanced across all stakeholders (Shareholders, Clients, Asset Managers, Board/Employees).

Apart from 'HR value management', regarding possible board and employee reward and benefits adjustments, the instruments to manage and  balance Stakeholder Value:

A-1  Asset Value management
C-1. Capital Management
C-2  Shareholder Value management
L-1  Product Value Management
L-2  Client Value management

are presented in the next chart:

Conclusion
Managing a financial institution in this challenging financial decade (2010-2020) is a complex operation with multidimensional regulation and business risk-return targets. Financial Boards have to manage more truths at the same time in a highly volatile economic risk-return environment.

Surviving in this complex world urges boards to step from a traditional predictable managing approach to a more responsive managing approach, where stakeholders value is continuously monitored and adapted to the real world environment.

This new 'survival approach' urges to improve communication, process information and reporting across Assets, Liabilities and Capital Management within the organisation.

Establishing an ALC-Team approach could be a first step to improve the control on risk-return management within the organisation across all stakeholders and actively using all 'stakeholders value tools' in a balanced way.

Last but not least, the role of the Chief Actuary Officer should be more clearly defined. The CAO is, in line with Client Value objectives, primarily responsible for an adequate liability en product management, that's key in balancing the risk-return objectives of a financial institution.

Success!

Links/Sources
- Cartoon: Government Risk Management by Todd Nielsen
- Risky Business – Making Phenomenal Decisions
   (While Not Forgetting the Risk)