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Stable Value Risk Management - A Checklist

Risk management is certainly an appropriate theme given recent market conditions. While it is impossible to thoroughly address this topic in a few pages, this paper offers a framework for identifying and controlling the various risks of stable value funds.

The risk management process has three steps: (1) identify sources of risk, (2) determine effective measures for each risk exposure and (3) construct robust processes to control each risk.

1. Sources of Risk in Stable Value Funds

This broad list is just a start at identifying sources of risk in stable value funds:

Source of Risk	Description
Security risks	Credit, cash flow, and liquidity risk
Portfolio management risks	Investment process, operational procedures and controls
Performance risks	Tracking error versus management benchmark or de facto participant benchmark (money market funds) Cost of sub-optimal performance
Cash flow risk	How today's cash flow decisions affect remaining participants
Contractual, legal, or accounting risks	This product is complex and has little tolerance for structural surprises

For a low risk fund, there certainly seem to be many sources of risk. This list really serves to highlight that controlling risk is more than simply limiting investment opportunities. The opposite is true - our industry has significantly reduced its investment risk by expanding risk opportunities into new industries, issuers and products. But how well do we manage the other risks on the list?

2. Measuring Sources of Risk

To quote Dan Libby (IBM Retirement Fund) from his June 1998 Stable Times article, "These funds cannot be considered well managed unless they are strategically directed and properly measured." This measurement challenge directly applies to risk management. To effectively manage risk, stable value funds must be able to measure their risk. While this sounds straightforward, the process is complex, as evident in the "checklist" that follows.

3. Controlling Risk

Development of an Investment Policy Statement is an excellent start toward controlling a fund's risk. Effective Investment Policy Statements are common in the traditional pension world, but are hard to find in the stable value world. Such documents serve as a management tool that records important decisions and provides a "road map" to future decision-making. A Policy Statement should include fund objectives, asset or product allocation, benchmark(s), evaluation criteria, and clearly defined triggers for implementing changes in manager or policy. An Investment Policy Statement should be both thorough and flexible.

From a plan sponsor's perspective when implementing the investment policy, three tools can control much of the risk. First, plans must perform thorough due diligence when selecting a bond manager or stable value manager. This process should result in a good understanding of the selected manager's investment process, organizational structure, and performance record. Second, well-designed investment guidelines control the "investment risk budget" in managing the securities. Third, plans must regularly measure and assess both the fund's risks and its performance. All three steps are necessary to fulfill a plan sponsor's minimum fiduciary duty.

From an investment manager's perspective, a sound investment process and organizational structure must be in place. Computer systems resources are clearly an important tool for controlling investment risk. A manager's systems resources should span the risk spectrum from individual security analysis to aggregate portfolio exposures. With respect to individual security pricing, models can be useful in aiding in purchase and hold decisions. Systems are powerful in their ability to model and stress test securities under a range of scenarios, including best and worst cases. However, managers should not use such analytics in a "black box" framework, as systems should serve as tools to aid in investment decision-making, not to drive decisions. In addition, the evaluation should not end after a security is purchased. Managers should regularly reevaluate portfolio holdings, as the decision to hold is as critical as the initial decision to purchase.

Room for Improvement

The industry's risk exposure and management have certainly improved from the days when we could only invest in insurance company GICs. Yet there remain many areas in need of improvement.

Here's a list of questions to help any plan clarify and improve its risk management process:

Security and Portfolio Risks

• Do you measure investment risks at the security level and consolidate them at the fund level?
• What are your fund's average duration and credit quality? Do you control these characteristics with clear investment guidelines?
• Is your portfolio managed with the help of sophisticated and flexible systems that allow for stress testing?
• For marketable securities, does your manager obtain unbiased analytical evaluations and risk measures that are not affected by its own market views?
• Does your manager provide accurate and timely reporting which gives insight into the strategies being applied as well as the opportunities and risks they represent?

Portfolio Management and Operational Risks

• Does your manager have a well-defined investment philosophy?
• What controls enforce the investment process?
• What is your manager's organization and incentive structure?
• Does your manager have clear lines of reporting and segregation of non-compatible functions (such as trading, settlement and accounting)?
• Does your manager have a dedicated and independent compliance group, and procedures for resolving compliance issues?

Performance Risks

• Do your investment guidelines appropriately balance the conflict of this "conservative" vehicle that also has long-term retirement investment objectives?
• What is your fund's management benchmark?
• Can you precisely measure and evaluate your fund's performance?
• Can you determine sources of value-added?
• What sources of tracking error does your fund have versus money market funds -- which is your participants' de facto benchmark?

Cash Flow Risks

• When and to what degree does your fund self-insure withdrawal risk, such as by withdrawing from participating contracts or using natural fund cash flows to cover withdrawal needs?
• When and to what degree does your fund pass withdrawal risk to a third party, by directly tapping GICs or non-participating wrap contracts?
• What is the financial impact on your fund of its withdrawal risk?
• Can you determine when withdrawal risk will be profitable to your participants and when it will be detrimental?

Contractual, Legal or Accounting Risks

• What events in your portfolio or plan could generate market value adjustments to your fund?
• Do you know the exit provisions in your contracts?
• Are ERISA and other regulatory requirements satisfied completely in your Fund?

In sum, effective risk management requires focus by both the plan sponsor in designing and monitoring the fund, and by the investment manager in developing sophisticated measurement tools and in communicating with clients. It is important that advanced risk management processes lead the way in the stable value industry's continuous evolution.

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