Operational, Political Factors Driving Risk Management Practices

A study by The Bank of New York says the emergence of new 360-degree view of risk will influence investment performance

New York — October 3, 2005 — Pension plans and non-profit organizations worldwide are significantly expanding the scope of their risk management practices by increasingly considering the operational and political risk factors that can impact fund performance and future obligations, according to a study released today by The Bank of New York in partnership with Wilshire Associates, ING Group, and Harry Markowitz, Ph. D., 1990 Nobel Prize winner in Economics.

The study, "New Frontiers of Risk: The 360 Degree Risk Manager for Pensions and Nonprofits," found that while market risk remains the foremost concern for plan sponsors, managers are now spending close to 40 percent of their risk-related time on operational and political considerations — an increase of nearly 20 percent from five years ago — and about 80 percent indicate they will increase the time spent on operational risk over the next five years.

The study identifies a new standard for risk managers — an all-encompassing, 360-degree view of risk — that will impact a firm's ability to achieve positive investment results.

According to the study, several factors are influencing this standard including:

  • Widespread under-funding of pension funds. Of the participants who provided funding status, more than half categorized their funds as "under-funded" across all types of pension plans.

  • Significant changes in plan allocations and strategies. In the last five years many study participants have introduced or increased allocations to non-traditional investments such as real estate, private equity, hedge funds, derivatives and commodities. More than one-third of the participants have invested more aggressively; two in five of these plans have done so simply to maintain returns, where target returns remain about 8% nominally on average.

  • Complexity of global markets and changing equity allocations. During the last five years, nearly 55 percent of study participants increased their allocation to non-domestic equities and 46 percent increased their allocation to emerging market equities.

  • Interconnection of political, legal and natural risks. Legal and regulatory changes, disaster recovery, and extreme or unanticipated events are substantial and growing.

"The study shows that investors increasingly recognize the non-traditional risk factors associated with the global investment landscape, namely operational and political risk. The challenge for all organizations will be embracing this new 360-degree view and taking the formal steps necessary for eliminating, transferring or managing critical risks," said Debra Baker, managing director and head of Global Risk Services for The Bank of New York.

Operational Risk: A Broad Risk Narrowly Understood

The two operational risks that most concern pension funds and non-profits are headline risk (exposure to negative press) and service-level risk (failure to achieve prescribed service goals). Plan sponsors felt the most essential elements in mitigating such risks were effective senior leadership, culture of integrity and financial reporting.

"The survey shows a growing appreciation for risk management," noted Robert Raab, Jr., vice chairman and senior managing director, Wilshire Associates, who heads up the Wilshire Analytics business unit. "While operational and political risk management are still in the early stages of evolution, plan sponsors and nonprofits look to third-party resources to measure, monitor and analyze these risks, just as they do when assessing market risk. Working together, plan sponsors and industry providers are developing advanced analytics and reporting required to quantify risk level and focus on interventions."

Political Risk: The Need for Reassessment

Even given the rise in attention paid to political risk, only 36 percent of study participants indicated that their pension funds measure political risk in some form. In assessing political risk, plan sponsors identified legal and regulatory changes — such as the European Union Pensions Directive, Myners Report, Sarbanes Oxley Act and USA Patriot Act — as the dominant factors to be considered. Of those who do attempt to quantify their exposure to political risk, corporate funds tend to use external sources, such as asset managers, rating agencies and consultants, while public funds tend to use internal resources.

"Political risk can impact a plan sponsor in many ways, such as through legislative and regulatory changes, political unrest, corruption and contractual issues. Given the movement to less familiar asset classes and emerging markets, as well greater public scrutiny of specific pension fund investments, assessing political risk has clearly emerged as one of the three pillars for building an all-encompassing risk profile," said Violeta Ciurel, general manager, Global Pension of ING Group.

Market Risk: Expanding the Frontier

Because comprehensive risk management systems and analytical frameworks are available and widely utilized, the study found that plan sponsors can ably evaluate fund-wide allocation decisions, broadly monitor market risks, and tap new asset classes with more security and knowledge than ever before. In assessing the relative importance of various market risks, participants rate asset allocation as the most critical, with other risks related to fund level decisions — such as the risk of underperforming relative to the capital market benchmark and fund liabilities — as the next highest-rated market risks.

"The study results will surely be a source of satisfaction to the many that have helped to bring portfolio theory and techniques to their present state," said Harry Markowitz, who is best known his pioneering work in the theory of financial economics, which helped earn him the Nobel Prize in Economics in 1990. "However, the fact that theory is widely used in practice should be a sobering thought that causes the theoretician to ask what more can be done to better serve practice. Clearly risk needs to be controlled along the new frontier as well as the old frontier."

In addition to the analysis of participants' responses, the study also offers investors detailed checklists of best practices related to dealing with market, operational and political risk.

Results were compiled from surveys of more than 75 representatives from leading pension institutions and nonprofit organizations from around the world. It is the latest in a series of studies conducted by The Bank of New York, including ones on institutional demand for hedge funds (Institutional Demand for Hedge Funds: New Opportunities and New Standards, The Bank of New York/Casey, Quirk and Acito 2004) and criteria for success in the global fund management arena (Future Leaders in Investment Management: Survival of the Fittest, The Bank of New York, 2005).

The Bank of New York's Global Risk Services division provides performance measurement, analytics, compliance reporting, risk budgeting and other risk measures to institutional clients worldwide. This division supports multi-faceted market segments including pensions, investment managers, insurance companies and banks. The Bank has been providing variations of risk products and services to clients for nearly 30 years.

Supply chain executives are discovering new ways to apply technology and innovative processes to the challenge of managing uncertainty. Read more in Rethinking Risk, cover story in the August/September 2005 issue of Supply & Demand Chain Executive.

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