Study: pension funds should amend ALM risk models

European pension funds would experience greater stability if regulators amended asset liability management (ALM) rules to permit short-term risk taking using internal risk management models, a new paper argues.

The study, entitled Impact of regulations on the ALM of European pension funds, from the Nice-based EDHEC Risk and Asset Management Research Centre, looked at the impact of the accounting and prudential constraints that ALM has on pension funds in the Netherlands, UK, Germany and Switzerland.

The analysis concluded that, as long-term investors governed by short-term regulatory constraints, pension funds will have to work to overcome "short-sighted strategies" that prove "counterproductive", and work with pensions regulators to take a long-term approach both to investing pension fund assets and to regulating pension funds.

"If the aim of prudential regulation is to ensure the stability of the retirement system and the continued payment of satisfactory pension benefits, it should seek to avoid short-termism; instead, it should focus on fostering sound risk management practices. These practices, which rely on modern ALM techniques and internal models, will make it possible for pension funds to overcome most of the challenges they face," the report says.

The researchers assert that pension funds will only be able to mitigate risk and meet medium-term funding requirements if they invest in building internal risk management models. Customised internal models are particularly relevant for pension funds in risk management planning, the authors argue, because no standard formula can capture the diversity of the pension landscape and the variety of protection mechanisms.

"Pension funds facing risk-based prudential regulations will greatly benefit from building internal models. Doing so will enable them to have funding requirements more closely aligned with the nature of their risks and to enjoy reduced quantitative requirements. For instance, when risk management relies on these models to reduce the likelihood of underfunding, a smaller capital buffer is required. In addition, when internal models show that there is significantly less risk over the medium term than over the short term, as with real liabilities, funding requirements will be reduced," the report concludes.

The study can be found at: www.edhec-risk.com.

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