Managing pensions: A risky business

Over the course of the last five years we have witnessed how the failure to adequately identify, analyse and manage risk, particularly in the financial services sector, can have dramatic and wide-ranging consequences - publically funded and underwritten bank bailouts and asset support schemes; economies plunged into a prolonged period of zero/low economic growth: and pension funds losing shareholder value and investment returns badly damaged. All this serves as a timely reminder that effective risk management stands at the heart of sound corporate governance across all organisations and functions.

Six principles
The management of risk is a key responsibility of those charged with the governance of a public sector organisation. In its six principles, CIPFA’s Delivering Good Governance in Local Government - Framework (2007) clearly sets risk management in the context of organisational corporate governance. Principle 4 addresses risk management specifically, having four sub-principles, as follows: Being rigorous and transparent about how decisions are taken and listening and acting on the outcomes of constructive scrutiny; having good-quality information, advice and support to ensure that services are delivered effectively and are what the community wants/needs; ensuring that an effective risk management system is in place; using their legal powers to the full benefit of the citizens and communities in their area.

These principles extends in equal measure to local government organisations that act as administering authorities of the Local Government Pension Scheme (LGPS), where the pensions committee (or equivalent), as the body charged with governance of the authorities’ pensions operations, take on the responsibility for ensuring that there is effective risk management over those operations.

Consequently the need for effective risk management is reflected throughout guidance and regulation in the LGPS, notably in Regulation 12(2) of the LGPS (Management and Investment of Funds) Regulations 2009, and in the CIPFA publication Delivering Good Governance in Local Government Pension Funds (2009), which maps the CIPFA/SOLACE good governance principles against the governance compliance statement required under Regulation 31 of the Local Government Pension Scheme (Administration) Regulations 2008. 

Good governance
Risk management therefore lies at the heart of the governance process and effective risk management is a clear indicator of good governance practices. There are varying definitions of risk and, as individuals, we will all perceive risk differently. However, in a corporate context it is important that there is a single common understanding of how the organisation defines and approaches risk. In a corporate context risk may be defined as “a threat to achieving corporate objectives or outcomes” or, with a less negative perspective, “an opportunity to enhance or accelerate the achievement of corporate objectives”.

The Australian Standard AS/NZS 4360:1999 defines risk in even broader terms as “the chance of something happening that will have an impact on business objectives”, while the British Standard (BS31100:2011) is even more succinct and defines risk as the “effect of uncertainty on objectives”. The common thread between these varying definitions is that there are events or situations that can arise that, whether opportunity or threat, which may have an impact on an organisations aims. Good governance demands therefore that organisations plan and prepare for such eventualities. This is the basis of risk management.

Responsibility for risk management is an issue for all those involved in the management of the LGPS, with overall oversight falling to the body charged with the governance of the authority’s role as an LGPS administrator (the pension committee or equivalent), This role will include: determining the risk policy and ensuring that it is in line with wider organisational risk policy; setting the risk management strategy in line with the risk policy, and; overseeing the risk management process.

Meeting future pensions liabilities
Risk is central to the Local Government Pension Scheme. LGPS pension funds are in themselves risk management tools, managing the risk of future employer income streams being unable to meet future pensions liabilities by creating a reserve from which future liabilities will be met.

In turn this fund faces the risk that the fund’s assets will fall short of its liabilities. It is not unusual therefore to find that a good deal of an administering authorities risk management efforts are directed towards mitigating the risk of an overall reduction in the value of the fund, whilst seeking out positive risk opportunities to maximise investment gains.

However as a July 2012 survey by MetLife Assurance reports, investment risk is just one of a wide range of risk areas associated with pension funds. This report shows that risks around the employer covenant, longevity risk, inflation risk and governance risk also feature highly in scheme manager risk rankings.

Consequently, as with all pension schemes, risk management in the LGPS context should be considered in relation to all aspects of pension scheme management. In its forthcoming guide on managing risk in the LGPS, CIPFA has identified seven key risk areas that LGPS administering authorities should consider:

Asset/Investment risk – the risk of investments not performing (income) or increasing in value (growth) as forecast. Examples of specific risks would be Inappropriate long-term investment strategy, including not making appropriate allowance for longevity and other demographic factors; Assets and an asset category including managers not delivering the required return; Systemic risk with the possibility of interlinked and simultaneous financial market volatility; Insufficient funds to meet liabilities as they fall due; Inadequate, inappropriate or incomplete investment and actuarial advice is actioned; Counterparty failure; Equities, industry, country, size and stock risks; Fixed income, yield curve, credit risks, duration risk and market risks; Alternative assets, liquidity risk, property risk, alpha risk; Money market, credit risk and liquidity risk; Currency risks, and; Macroeconomic risks.

Employer risk – those risks that arise from the ever-changing mix of employers; from short-term and ceasing employers; and the potential for a shortfall in payments and/or orphaned liabilities

Resource and skill risk - the implications of spending cuts resulting in workforce reductions and pay freezes which may make public sector employment less attractive may put skilled resources at risk. 

Liability risk - long-term pension fund risks including inflation, life expectancy, interest rate and wage and salary inflation all will impact upon future liabilities.

Administrative risk – as an administrator of the LGPS, a local authority exposes itself to a wide range of additional risks not faced by other authorities, such as maladministration claims, capacity risk etc. Examples of specific risks would be: Level of resources and dependency on IT systems and facilities to communicate with all employers and members; Business continuity; Over reliance on key officers; Failure to provide the service in accordance with equality principles; Failure to process pension payments and lump sums on time and provide timely advice to employers, contributors and pensioners; Failure to collect and account for contributions from employers and employees on time, and; Failure to communicate or engage with stakeholders.

Regulatory and compliance risk – occupational pensions in the UK are heavily regulated, with thousands of pages of both general and LGPS-specific legislation that must be complied with.

Reputational risk – public sector pensions attract a great deal of external scrutiny and the risk of negative commentary on all aspects of their administration (particularly fund management and employer/taxpayer contribution levels) is commonplace. On the positive side, there is also the opportunity to enhance organisational reputations through demonstrable good practice.

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Effective risk management is an essential element of good governance. By identifying and managing risks through an effective policy and risk management strategy, organisations can demonstrate best practice in corporate governance, improve their financial management, secure good performance, maximise opportunities and minimise threats.

Successful risk and opportunity management should also: ensure that there is a proper balance between risk taking and the opportunities to be gained in the business environment; enable organisations to anticipate and respond positively to change; minimise injury, loss and damage to the organisation and to those outside the organisation who are dependent on the services it provides; make sure that, as the number of projects and partnerships grow, the risks they present are fully understood and taken into account in making decisions; facilitate successful delivery of services and deliver opportunities for managed growth.

A sound management technique
It is important to recognise that risk management is not an end in itself; nor will it remove risk from an organisation. However it is a sound management technique that is an essential part of any successful organisation. The benefits of an effective risk management approach for the organisation include better decision making, improved performance and delivery of services, more effective use of resources and the protection of reputation.

Further information
Managing Risk in the Local Government Pension Scheme will be published by CIPFA on 30 November 2012. For further information visit www.cipfa.org.uk