managing risks under the contributory pension scheme2

National Pension National Pension CommissionCommission

Managing Risks Under A Managing Risks Under A Contributory Pension SchemeContributory Pension Scheme

May 19th & 20th , 2009

Presented by B.J RewaneFINANCIAL DERIVATIVES COMPANY LIMITED

OutlineOutline►BackgroundBackground►The Pension Reform ActThe Pension Reform Act►Global Crisis and Pension Funds-Global Crisis and Pension Funds-

Are there Linkages?Are there Linkages?

► Impact of Crisis On Pension AssetsImpact of Crisis On Pension Assets►Challenges Facing Pension ManagersChallenges Facing Pension Managers►Managing Risks Associated With Managing Risks Associated With

Pension AssetsPension Assets►Limitations To Effective Risk Limitations To Effective Risk

ManagementManagement

BackgroundBackground► The 2004 pension reform act saw the birth The 2004 pension reform act saw the birth

of a contributory pension scheme in Nigeriaof a contributory pension scheme in Nigeria► A brief history of the Nigerian pension A brief history of the Nigerian pension

scheme is as follows;scheme is as follows;

Type of Scheme Year

Non-Contributory Defined Benefit Scheme Pre-IndependeceDefined Contribution Scheme (National Provident Fund;NPF) 1961Defined Benefit Scheme (NSITF) 1994Contributory Pension Scheme (Pension Reform Act) 2004

The Pension Reform ActThe Pension Reform Act► The primary objective of the scheme is to The primary objective of the scheme is to

ensure safety of the fundensure safety of the fund► Features of the scheme are;Features of the scheme are;

Transfer of risk from employer to employeeTransfer of risk from employer to employee Employer makes a commitment and employee Employer makes a commitment and employee

makes compulsory contributions as belowmakes compulsory contributions as below Fund is invested in market securities and Fund is invested in market securities and

exposed to risksexposed to risks

Sector Employee Employer

Private 7.5% 7.5%

Military 2.5% 12.5%

Public 7.5% 7.5%

The Pension Reform ActThe Pension Reform Act►Risks associated with the scheme Risks associated with the scheme

include the following;include the following;

Market/ systemic risksMarket/ systemic risks

Investment risksInvestment risks

Operational risks:Operational risks:

►Systems, processes and peopleSystems, processes and people

Regulatory risksRegulatory risks

Global Crisis and Pension Funds-Global Crisis and Pension Funds-Are there Linkages?Are there Linkages?

► The global economy has witnessed a huge The global economy has witnessed a huge diminution in value in asset pricesdiminution in value in asset prices

► Pension funds have come under limited Pension funds have come under limited pressure owing to;pressure owing to; Robustness of their prior reformsRobustness of their prior reforms Most importantly; diversification of their Most importantly; diversification of their

portfolios across sectors and continentsportfolios across sectors and continents

► In the US, pension funds have lost an In the US, pension funds have lost an average of 20% of their values when average of 20% of their values when compared to hedge funds and mutual compared to hedge funds and mutual fundsfunds

Global Crisis and Pension Funds-Global Crisis and Pension Funds-Are there Linkages?Are there Linkages?

►There may be a link between the crisis There may be a link between the crisis

and pension fund performanceand pension fund performance

►The problems of the Nigerian pension The problems of the Nigerian pension

scheme could be attributed to scheme could be attributed to

structural weaknesses within the structural weaknesses within the

Nigerian Capital and financial marketsNigerian Capital and financial markets

Impact of Crisis On Pension Impact of Crisis On Pension AssetsAssets

►The Nigerian financial crisis has The Nigerian financial crisis has manifested as follows;manifested as follows; Increased volatility of all asset classesIncreased volatility of all asset classes A burst of the asset price bubble in the A burst of the asset price bubble in the

Nigerian stock marketNigerian stock market►Losing 80% cumulatively (at its peak) and Losing 80% cumulatively (at its peak) and

21.16% year to date21.16% year to date Higher returns in fixed income and Higher returns in fixed income and

government securities and portfolios are government securities and portfolios are now skewed in favour these securitiesnow skewed in favour these securities

General fear and pessimism which has General fear and pessimism which has questioned the safety of the Nigerian questioned the safety of the Nigerian banking systembanking system


► It’s true that only a maximum of 25% of It’s true that only a maximum of 25% of pension funds should be affected by stock pension funds should be affected by stock market downturn as the regulation limited market downturn as the regulation limited PFAs investment to this percentage.PFAs investment to this percentage.

► PFAs actually complied with this limit. PFAs actually complied with this limit. They actually took a “flight from equity” They actually took a “flight from equity” before year end 2008 which reduced the before year end 2008 which reduced the actual exposure of RSA funds to about actual exposure of RSA funds to about 12%12%

► Growth from additional contribution should Growth from additional contribution should not be affected by the crisis as not be affected by the crisis as unemployment rate has been modestunemployment rate has been modest


►This is not the case because;This is not the case because; Only 30% of Nigerian workforce are in Only 30% of Nigerian workforce are in

compliance with the actcompliance with the act Returns from equity investments Returns from equity investments

accounts for approx. 50% of total accounts for approx. 50% of total returnsreturns

►Thus a decline in the Nigerian stock Thus a decline in the Nigerian stock market had more than a profound market had more than a profound impact on pension assetsimpact on pension assets


► RSA funds recorded unrealized losses of about RSA funds recorded unrealized losses of about

N33.21billion (approx. 7% of the RSA portfolio) as N33.21billion (approx. 7% of the RSA portfolio) as

at 31/12/08.at 31/12/08.

► Compares favorably to the entire Nigerian stock Compares favorably to the entire Nigerian stock

market loss of 45.77% loss in NSE ASI and 31.66% market loss of 45.77% loss in NSE ASI and 31.66%

loss in market capitalization as at 31/12/08.loss in market capitalization as at 31/12/08.

► Total value of pension assets is about N1.1trnTotal value of pension assets is about N1.1trn

► A diminution in pension assets has both A diminution in pension assets has both Moral impact: deter prospective companies to the Moral impact: deter prospective companies to the

schemescheme

Economic impact: loss in value of assetsEconomic impact: loss in value of assets

Challenges Facing Pension ManagersChallenges Facing Pension Managers

►How to meet redemptions based on a How to meet redemptions based on a mark to market approach which mark to market approach which crystallizes the risks associated with crystallizes the risks associated with market securities?market securities?

►How do we manage the investment, How do we manage the investment, operational and regulatory risks?operational and regulatory risks?

►What strategies should be adopted in What strategies should be adopted in ensuring compliance and safety of ensuring compliance and safety of the assets?the assets?

Challenges Facing Pension Challenges Facing Pension ManagersManagers

►Prior to now studies were carried out Prior to now studies were carried out by the commission to establish the risk by the commission to establish the risk inherent with pension investments in inherent with pension investments in the capital marketthe capital market

►A summary of the findings were thatA summary of the findings were that The Nigerian capital market was over-The Nigerian capital market was over-

valuedvalued The guidelines were adequate but must The guidelines were adequate but must

be refined to extend the asset classes to be refined to extend the asset classes to include real estate investmentsinclude real estate investments

It also called for liberalization of the fee It also called for liberalization of the fee structure of PFAsstructure of PFAs


►That exercise was carried out in the That exercise was carried out in the context that the variables were known context that the variables were known and could be measuredand could be measured

►Current events show that the variables Current events show that the variables are no longer confined to domestic are no longer confined to domestic imponderablesimponderables

►The impact of exogenous shocks must The impact of exogenous shocks must be part of the risk equationbe part of the risk equation


►Fund managers and the commission Fund managers and the commission

must not confine themselves only to must not confine themselves only to

domestic risks and must play out the domestic risks and must play out the

scenarios and their possible outcomes scenarios and their possible outcomes

i.e.i.e. Domestic Stability and A Global CrisisDomestic Stability and A Global Crisis

Domestic Crisis and Global StabilityDomestic Crisis and Global Stability

Domestic Crisis and A Global CrisisDomestic Crisis and A Global Crisis

Managing Investment Risks Managing Investment Risks Associated With Pension AssetsAssociated With Pension Assets

► In order to optimise the risk reward trade In order to optimise the risk reward trade off of pension funds, off of pension funds,

► managers and custodians must be able to managers and custodians must be able to identify and measure the risksidentify and measure the risks

► Managing the risk elements go beyond Managing the risk elements go beyond identifying them identifying them

► It begins by It begins by formulating a risk strategy that will help in formulating a risk strategy that will help in

preserving pension funds. preserving pension funds. Taking a proactive stand in relation to changes Taking a proactive stand in relation to changes

in the business environment in the business environment integration of the risk management framework integration of the risk management framework

with the strategy. with the strategy.

Managing Investment Risks Managing Investment Risks Associated With Pension AssetsAssociated With Pension Assets

► It also involves It also involves improving the risk awareness to all improving the risk awareness to all

stakeholders, stakeholders, clearly defining roles and responsibilities,clearly defining roles and responsibilities, building risks and simulating stress testing building risks and simulating stress testing

scenarios, scenarios, and effective portfolio management that and effective portfolio management that

avoids concentration risk.avoids concentration risk.

► using leading economic indicators helps using leading economic indicators helps managers to pre-empt the risks that may managers to pre-empt the risks that may occur or that are about to crystallize.occur or that are about to crystallize.

Managing Operational Risks Managing Operational Risks Associated With Pension AssetsAssociated With Pension Assets

► The due diligence of the fund manager must The due diligence of the fund manager must include building a proper business structure include building a proper business structure i.e. staffing – experience level, organisation i.e. staffing – experience level, organisation size, e.t.c. size, e.t.c.

► Clear articulation and documentation of the Clear articulation and documentation of the risk policies or contingency plans does not risk policies or contingency plans does not only aid a proactive risk management only aid a proactive risk management framework but institutionalises the processframework but institutionalises the process

► Decentralizing the risk process has proven Decentralizing the risk process has proven to be the most effective in developing a to be the most effective in developing a proactive risk framework proactive risk framework

Managing Operational Risks Managing Operational Risks Associated With Pension AssetsAssociated With Pension Assets

► It helps put in place multiple points where red It helps put in place multiple points where red

flags could be raised in the risk management flags could be raised in the risk management

process. process.

► Contingency planning will aid the development Contingency planning will aid the development

of an effective risk management framework.of an effective risk management framework.

► Seeking expert opinion, embracing the use of Seeking expert opinion, embracing the use of

technology to deploy risk mitigants are some technology to deploy risk mitigants are some

of the concepts used in developing an of the concepts used in developing an

enterprise risk management framework. enterprise risk management framework.

Managing Regulatory Risks Managing Regulatory Risks Associated With Pension AssetsAssociated With Pension Assets

► The regulatory framework must seek to The regulatory framework must seek to reduce the level of subjective uncertainty in reduce the level of subjective uncertainty in relating to pension fund management. relating to pension fund management.

► The Knightian theory of uncertainty states The Knightian theory of uncertainty states that when subjective uncertainty is greater that when subjective uncertainty is greater that objective uncertainty, it leads to that objective uncertainty, it leads to extreme risk aversion and economic extreme risk aversion and economic paralysis. paralysis.

► Fund managers and the pension commission Fund managers and the pension commission have been extremely risk adverse owing to have been extremely risk adverse owing to the increased volatility in asset prices. the increased volatility in asset prices.


► There must be a clear delineation between There must be a clear delineation between the supervisory and regulatory roles of the the supervisory and regulatory roles of the commission. commission.

► The regulatory role of the commission must The regulatory role of the commission must be able to address the issue of compliance be able to address the issue of compliance to the investment guidelines by PFAs and to to the investment guidelines by PFAs and to the act by companiesthe act by companies

► A periodic review of the guidelines, A periodic review of the guidelines, collaborating with other regulatory bodies collaborating with other regulatory bodies and the enactment of laws that will enforce and the enactment of laws that will enforce strict compliance and sanctions may be strict compliance and sanctions may be considered as an objective means of considered as an objective means of tackling the problem.tackling the problem.


► Adoption of a conservative investment Adoption of a conservative investment strategy is a key determinant in preserving strategy is a key determinant in preserving the value of pension funds. the value of pension funds.

► The fund manager must be seen as a counter The fund manager must be seen as a counter party in the entire risk management process. party in the entire risk management process.

► Several closed pension funds which have Several closed pension funds which have adopted a conservative investment strategy adopted a conservative investment strategy i.e. limited investment in equities and mutual i.e. limited investment in equities and mutual funds which account for less than 25% of total funds which account for less than 25% of total funds have performed optimally amidst the funds have performed optimally amidst the crisis.crisis.

Managing Risks Associated With Managing Risks Associated With Pension AssetsPension Assets

► Specific measures that can be taken to Specific measures that can be taken to ensure safety of pension fund assets are;ensure safety of pension fund assets are; Evaluating fund performance on a mark to Evaluating fund performance on a mark to

market basis.market basis. Measuring PFA’s by returns only leads to Measuring PFA’s by returns only leads to

reacting after the deed has been done.reacting after the deed has been done. Strict sanctions should be put in place to Strict sanctions should be put in place to

ensure compliance to investment guidelinesensure compliance to investment guidelines Increasing the placement limits on some Increasing the placement limits on some

permissible asset classes reduces the permissible asset classes reduces the possibility to going above limits e.g. possibility to going above limits e.g. participation in corporate and state bondsparticipation in corporate and state bonds

Managing Risks Associated With Managing Risks Associated With Pension AssetsPension Assets

Collaborating with SEC and NSE to ensure Collaborating with SEC and NSE to ensure disclosure of pension contribution in the annual disclosure of pension contribution in the annual reports may encourage participation.reports may encourage participation.

The risk management process must seek The risk management process must seek innovative ways of raising red flags when there innovative ways of raising red flags when there is a breach of the guidelines.is a breach of the guidelines.

Increase awareness campaign on safety rather Increase awareness campaign on safety rather than on returns.than on returns.

Rating the security is only part of the risk Rating the security is only part of the risk management process.management process.

Risk management should not be confined to Risk management should not be confined to professionals.professionals.

Limitations To Effective Risk Limitations To Effective Risk ManagementManagement

► Some of these arise from regulatory Some of these arise from regulatory imperfections but misconceptions about imperfections but misconceptions about risk management have even greater risk management have even greater implications. implications.

► The lessons from the global financial crisis The lessons from the global financial crisis points to the fact that there are linkages points to the fact that there are linkages between the meltdown and improper risk between the meltdown and improper risk management. management.

► Some of these misconceptions are; Some of these misconceptions are; ““the size of the commitment is a sufficient the size of the commitment is a sufficient

measure of risk, an approved rating by an measure of risk, an approved rating by an agency bestows the risk quality.agency bestows the risk quality.

Limitations To Effective Risk Limitations To Effective Risk ManagementManagement

► Remember that the adequacy of risk rating Remember that the adequacy of risk rating in the management of investment risks is a in the management of investment risks is a necessary but an insufficient tool. necessary but an insufficient tool.

► Risk ratings are done with historical data Risk ratings are done with historical data which may be inadequate in quality or which may be inadequate in quality or quantity, quantity,

► And the fundamentals used in determining And the fundamentals used in determining the rating may change at any time. the rating may change at any time.

► Institutions and funds with investment grade Institutions and funds with investment grade ratings have failed in recent times.ratings have failed in recent times.

Mark Haynes DanielMark Haynes Daniel

►““Looking ahead, these risks that we Looking ahead, these risks that we

face are increasing in scale and face are increasing in scale and

complexity. Unfortunately our ability complexity. Unfortunately our ability

to respond has not kept pace” to respond has not kept pace”

►Lesson: We must strive to be ahead of Lesson: We must strive to be ahead of

the pack.the pack.

Thank YouThank You

managing risks under the contributory pension scheme2

Documents

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