National Pension Commission
Managing Risks Under A
Contributory Pension Scheme
May 19th & 20th , 2009
Presented by B.J Rewane
FINANCIAL DERIVATIVES COMPANY LIMITED
Outline
► Background
► The
Pension Reform Act
► Global Crisis and Pension FundsAre there Linkages?
► Impact
of Crisis On Pension Assets
► Challenges Facing Pension Managers
► Managing Risks Associated With Pension
Assets
► Limitations To Effective Risk Management
Background
► The
2004 pension reform act saw the birth of
a contributory pension scheme in Nigeria
► A brief history of the Nigerian pension scheme
is as follows;
Type of Scheme
Year
Non-Contributory Defined Benefit Scheme Pre-Independece
Defined Contribution Scheme (National
Provident Fund;NPF)
1961
Defined Benefit Scheme (NSITF)
1994
Contributory Pension Scheme (Pension
Reform Act)
2004
The Pension Reform Act
► The
primary objective of the scheme is to
ensure safety of the fund
► Features of the scheme are;
 Transfer of risk from employer to employee
 Employer makes a commitment and employee makes
compulsory contributions as below
 Fund is invested in market securities and exposed to
risks
Se ctor
Em ploye e
Em ploye r
Private
7.5%
7.5%
Military
2.5%
12.5%
Public
7.5%
7.5%
The Pension Reform Act
► Risks
associated with the scheme include
the following;
 Market/ systemic risks
 Investment risks
 Operational risks:
►Systems,
processes and people
 Regulatory risks
Global Crisis and Pension FundsAre there Linkages?
► The
global economy has witnessed a huge
diminution in value in asset prices
► Pension funds have come under limited pressure
owing to;
 Robustness of their prior reforms
 Most importantly; diversification of their portfolios
across sectors and continents
► In
the US, pension funds have lost an average
of 20% of their values when compared to hedge
funds and mutual funds
Global Crisis and Pension FundsAre there Linkages?
► There
may be a link between the crisis and
pension fund performance
► The
problems of the Nigerian pension
scheme could be attributed to structural
weaknesses within the Nigerian Capital and
financial markets
Impact of Crisis On Pension Assets
► The
Nigerian financial crisis has manifested
as follows;
 Increased volatility of all asset classes
 A burst of the asset price bubble in the Nigerian
stock market
►Losing
80% cumulatively (at its peak) and 21.16%
year to date
 Higher returns in fixed income and government
securities and portfolios are now skewed in
favour these securities
 General fear and pessimism which has
questioned the safety of the Nigerian banking
system
Impact of Crisis On Pension Assets
► It’s
true that only a maximum of 25% of pension
funds should be affected by stock market
downturn as the regulation limited PFAs
investment to this percentage.
► PFAs actually complied with this limit. They
actually took a “flight from equity” before year
end 2008 which reduced the actual exposure of
RSA funds to about 12%
► Growth from additional contribution should not
be affected by the crisis as unemployment rate
has been modest
Impact of Crisis On Pension Assets
► This
is not the case because;
 Only 30% of Nigerian workforce are in
compliance with the act
 Returns from equity investments accounts for
approx. 50% of total returns
► Thus
a decline in the Nigerian stock
market had more than a profound impact
on pension assets
Impact of Crisis On Pension Assets
►
RSA funds recorded unrealized losses of about
N33.21billion (approx. 7% of the RSA portfolio) as
at 31/12/08.
►
Compares favorably to the entire Nigerian stock
market loss of 45.77% loss in NSE ASI and 31.66%
loss in market capitalization as at 31/12/08.
►
Total value of pension assets is about N1.1trn
►
A diminution in pension assets has both
 Moral impact: deter prospective companies to the scheme
 Economic impact: loss in value of assets
Challenges Facing Pension Managers
► How
to meet redemptions based on a
mark to market approach which
crystallizes the risks associated with
market securities?
► How
do we manage the investment,
operational and regulatory risks?
► What
strategies should be adopted in
ensuring compliance and safety of the
assets?
Challenges Facing Pension Managers
► Prior
to now studies were carried out by the
commission to establish the risk inherent
with pension investments in the capital
market
► A summary of the findings were that
 The Nigerian capital market was over-valued
 The guidelines were adequate but must be
refined to extend the asset classes to include
real estate investments
 It also called for liberalization of the fee
structure of PFAs
Challenges Facing Pension Managers
► That
exercise was carried out in the context
that the variables were known and could be
measured
► Current events show that the variables are
no longer confined to domestic
imponderables
► The impact of exogenous shocks must be
part of the risk equation
Challenges Facing Pension Managers
► Fund
managers and the commission must
not confine themselves only to domestic
risks and must play out the scenarios and
their possible outcomes i.e.
 Domestic Stability and A Global Crisis
 Domestic Crisis and Global Stability
 Domestic Crisis and A Global Crisis
Managing Investment Risks Associated With
Pension Assets
► In
order to optimise the risk reward trade off of
pension funds,
► managers and custodians must be able to
identify and measure the risks
► Managing the risk elements go beyond
identifying them
► It begins by
 formulating a risk strategy that will help in preserving
pension funds.
 Taking a proactive stand in relation to changes in the
business environment
 integration of the risk management framework with
the strategy.
Managing Investment Risks Associated With
Pension Assets
► It
also involves
 improving the risk awareness to all stakeholders,
 clearly defining roles and responsibilities,
 building risks and simulating stress testing
scenarios,
 and effective portfolio management that avoids
concentration risk.
► using
leading economic indicators helps
managers to pre-empt the risks that may occur
or that are about to crystallize.
Managing Operational Risks Associated
With Pension Assets
► The
due diligence of the fund manager must
include building a proper business structure i.e.
staffing – experience level, organisation size, e.t.c.
► Clear
articulation and documentation of the risk
policies or contingency plans does not only aid a
proactive risk management framework but
institutionalises the process
► Decentralizing
the risk process has proven to be
the most effective in developing a proactive risk
framework
Managing Operational Risks Associated
With Pension Assets
► It
helps put in place multiple points where red
flags could be raised in the risk management
process.
► Contingency
planning will aid the development of
an effective risk management framework.
► Seeking
expert opinion, embracing the use of
technology to deploy risk mitigants are some of
the concepts used in developing an enterprise risk
management framework.
Managing Regulatory Risks Associated
With Pension Assets
► The
regulatory framework must seek to reduce
the level of subjective uncertainty in relating to
pension fund management.
► The Knightian theory of uncertainty states that
when subjective uncertainty is greater that
objective uncertainty, it leads to extreme risk
aversion and economic paralysis.
► Fund managers and the pension commission
have been extremely risk adverse owing to the
increased volatility in asset prices.
Managing Regulatory Risks Associated
With Pension Assets
► There
must be a clear delineation between the
supervisory and regulatory roles of the
commission.
► The regulatory role of the commission must be
able to address the issue of compliance to the
investment guidelines by PFAs and to the act by
companies
► A periodic review of the guidelines, collaborating
with other regulatory bodies and the enactment
of laws that will enforce strict compliance and
sanctions may be considered as an objective
means of tackling the problem.
Managing Regulatory Risks Associated
With Pension Assets
► Adoption
of a conservative investment strategy
is a key determinant in preserving the value of
pension funds.
► The fund manager must be seen as a counter
party in the entire risk management process.
► Several closed pension funds which have
adopted a conservative investment strategy i.e.
limited investment in equities and mutual funds
which account for less than 25% of total funds
have performed optimally amidst the crisis.
Managing Risks Associated With Pension
Assets
► Specific
measures that can be taken to ensure
safety of pension fund assets are;
 Evaluating fund performance on a mark to market
basis.
 Measuring PFA’s by returns only leads to reacting
after the deed has been done.
 Strict sanctions should be put in place to ensure
compliance to investment guidelines
 Increasing the placement limits on some permissible
asset classes reduces the possibility to going above
limits e.g. participation in corporate and state bonds
Managing Risks Associated With Pension
Assets
 Collaborating with SEC and NSE to ensure disclosure
of pension contribution in the annual reports may
encourage participation.
 The risk management process must seek innovative
ways of raising red flags when there is a breach of the
guidelines.
 Increase awareness campaign on safety rather than
on returns.
 Rating the security is only part of the risk
management process.
 Risk management should not be confined to
professionals.
Limitations To Effective Risk Management
► Some
of these arise from regulatory
imperfections but misconceptions about risk
management have even greater implications.
► The lessons from the global financial crisis points
to the fact that there are linkages between the
meltdown and improper risk management.
► Some of these misconceptions are;
 “the size of the commitment is a sufficient measure of
risk, an approved rating by an agency bestows the
risk quality.
Limitations To Effective Risk Management
► Remember
that the adequacy of risk rating in the
management of investment risks is a necessary
but an insufficient tool.
► Risk ratings are done with historical data which
may be inadequate in quality or quantity,
► And the fundamentals used in determining the
rating may change at any time.
► Institutions and funds with investment grade
ratings have failed in recent times.
Mark Haynes Daniel
► “Looking
ahead, these risks that we face are
increasing in scale and complexity.
Unfortunately our ability to respond has not
kept pace”
► Lesson:
pack.
We must strive to be ahead of the
Thank You