An Interview With Susan Mangiero

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Articles

Written by Journal of Indexes Editors

Friday, 05 June 2009 00:00

The challenges of late-2008 and early-2009 have many institutional investors looking to get a better handle on risk management. Journal of Indexes contributing editor Heather Bell caught up with Susan Mangiero, president of Pension Governance, Inc., a research and consulting firm focused on risk and other fiduciary concerns related to benefit plans, to discuss the latest in the field. Dr. Mangiero is the author of “Risk Management for Pensions, Endowments, and Foundations” (John Wiley & Sons, 2005) and also writes a blog, Pension Risk Matters (www.pensionriskmatters.com).

Journal of Indexes (JoI): What has the last year done to change the way pension plans manage risk, and what lessons were learned in the last year with regard to that?

Dr. Susan Mangiero (Mangiero): First of all, I hope things have changed. I think it is fair to say that people are adopting more of a risk focus because of what’s happened. But whether that’s occurring across all plans and across all plan sponsors, I’m not convinced.

What are some of the lessons learned? [To take one example], people are looking at some of the problems with alternative funds, where people couldn’t redeem out even if they were contractually allowed to do so. That surprised quite a few investors. A lot of fund managers—particularly on the hedge fund side—said, “Well, even though contractually you’re allowed to redeem, if we allow you to redeem, it could cause a run on the funds, which could exacerbate problems; then everybody loses. And so, we’re just going to forbid you to take your money.”

We know there are some lawsuits, now, against some of the asset managers that have done that. I don’t know how they’re going to end up. Redemption rights cannot be ignored.

JoI: What about valuations? Because many of those assets became very difficult to value when the market seized up last September.

Mangiero: That is another major area of focus. A lot of the alternative fund managers, hedge fund managers, private equity managers, venture capital managers and others have had to come up with mark-to-market or mark-to-model numbers. We’ve had quite a few institutions ask questions about how their asset managers are valuing things.

I think there’s still room for improvement. Some of the feedback we’ve gotten is worrisome. When we talk to institutions about what they ought to be doing with respect to setting up a valuation process, the perception is often that “it’s too much work, and we’re counting on the fund-of-fund managers and/or the investment consultants to handle that.” But we tell people all the time to make sure that, in fact, the fund-of-fund managers and the investment consultants are vetting those numbers.

We urge institutional investors to really look deep and hard at service-provider contracts, to the extent they can and to the extent that they’re made available for the institutional investors, just to make sure that somebody is kicking the tires on models, to make sure that somebody is checking the integrity of the data, to make sure that somebody is asking a hedge fund or private equity fund manager if they’re using an independent third party to value their hard-to-value positions. That’s a big element of risk management. We are finding, more and more, that institutional investors think a lot of that work is being done somewhere along the service provider food chain. We’re trying to disabuse them of that notion unless they verify that for themselves.

I’m not 100 percent convinced it is happening, but hopefully there is also more focus on monitoring of collateral and counterparty risks. Most of these over-the-counter derivative instruments involve collateral. One of the issues that’s arisen is whether anyone is monitoring the quality of the collateral. More broadly, is there enough collateral? The collateral issue also arises with respect to asset-backed securities. Many of these instruments have underlying collateral that can quickly change in value.

JoI: We’ve heard a lot of concern about leverage and a general de-leveraging across the market. Has that had follow-through in the institutional community?

Mangiero: People are more sensitive about leverage in lots of different forms: short-selling, margins, derivatives, portfolio construction.

We hear a lot of pension investment decision makers say, “Well, our investment policy statement”—assuming they have one—“prohibits the use of leverage.” But then you ask them a lot of questions about what instruments they’re holding, and at the end of the day, usually they’re holding some kind of security or have monies allocated to funds that are using derivatives or securities that embed derivatives. We tell institutional investors that the bottom line is it’s going to be almost impossible to escape exposure to leverage in some fashion. But, in the aftermath of the credit crunch, we think at least that people are looking at leverage.

Another issue that has come up, with respect to the credit problem, has been that some investors had put their money in what they thought were very liquid, relatively clear-cut “low-risk” investments. And now they find that some of those clear-cut “low-risk” funds have been investing in short-term asset-backed securities or things that were anything but low risk. There are some lawsuits related to that, alleging that those asset managers and some of the service providers, like auditors, did not really vet the true economic risks associated with what was inside the portfolios.

JoI: How did the liquidity crunch impact interest rates and how did that impact pension plans as a result?

Mangiero: For a while, as the government kept trying to depress interest rates overall by adding liquidity to the market, reported pension liabilities increased. In the aftermath of the Pension Protection Act of 2006, this was a big deal for many companies that suddenly found themselves in a position of being statutorily underfunded.

As a result, more than a few employers found themselves having to accelerate cash payments to their pension plans to restore funding normalcy. Now there are quite a few U.S. corporations seeking relief from the Pension Protection Act, saying, “Our stock has been hit so hard, and we don’t want to spend billions of dollars to top off the pension plan because of short-term issues, and we’re fine in the long term.” Preceding the central banks’ intervention, crisis conditions meant a rise in LIBOR. This resulted in higher costs for pension plan swap floating-rate payors.

JoI: Does the surge in correlations among different asset classes during times of market crisis have any impact on long-term planning?

Mangiero: I think the answer would have to be yes. It just depends, in part, on how pension plans respond. If the immediate response is to sell positions as correlations start to converge, the pension plan manager could incur transaction costs and lock in losses. 401(k) plan participants encountered the same problem.

Then there is the issue of strategic asset allocation. If investors do change the short-run mix, how is that likely to impact long-term performance?

I don’t think most investors had anticipated the flight to quality that we experienced in the fall of 2008. For example, if a pension plan had allocated money—and here I’m talking more about a defined benefit plan—let’s say, to a hedge fund that was investing a lot in equity, and the pension plan also had X percent allocated to a long-only strategy, and the equity market tanked, then all of a sudden the defined benefit plan is going to see its total portfolio drop in value from, not only the long equity allocation, but also the hedge fund allocation. I think many investment decision makers were just not prepared for that. It was kind of like a doubling-up, or worse, of the exposure to some things that were not doing well.

It’s a very tough time for people. The good news is—and this is what we’ve been encouraging, urging pensions, endowments and foundations to do—that people can use this time as an opportunity to focus on risk management, learn lessons, ask lots of tough questions, make changes now and hopefully improve the process. There are some folks who are doing a great job already. But again, the best defense is a good offense—in terms of risk management, just getting a very robust process in place. We are seeing more pension plans starting to consider [using] or just outright hiring risk managers. And I think that’s a wonderful step in the right direction.

JoI: Can you talk about how you see benchmark risk, and what the most critical issues are for pensions to consider in that area?

Mangiero: That’s a great question. It’s also one that’s difficult to answer. For example, consider liability-driven investing, a hot topic in the pension community. I ask a lot of pension plans the question, “How are you benchmarking the LDI managers?” And the answer I usually get back is, “We’re not sure how to do it yet.” Some people are using a pension surplus-at-risk measure, as opposed to value at risk. And some people are looking at a deviation around a cash flow benchmark.

I think for those involved in indexing, there’s a great opportunity to help the retirement-plan decision makers with thinking through what the benchmarks should look like.

JoI: Final thoughts?

Mangiero: I think retirement-plan decision makers are faced with many challenges, whether you’re talking about defined contribution or defined benefits. There’s almost no relief. There’s not a one-size-fits-all solution to which everybody can gravitate and try to make up for losses, try to protect themselves from losses down the road. The best defense, we think, is just having a really good process in place, so that you can identify risk drivers or risk factors, maybe before things get out of hand.