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Pension fund regulation should encourage risk management, says Edhec

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Pension fund regulations should encourage risk management by allowing internal models, according to a survey by Edhec-Risk.

The survey of pension funds, advisers, regulators, fiduciary managers and asset managers found that most believe risk management protects minimum funding ratios better than high funding ratios do.

It also found that pension funds should take a long-term approach to investing but they should also manage their short-term constraints.

Dutch pension funds, which have already implemented risk-based regulation with strict minimum funding ratios, are supportive of the idea that minimum funding ratios should be implemented, as these ratios foster risk management.

British pension funds, by contrast, with their chronic underfunding, fear that minimum funding ratios would involve a counterproductive tightening of prudential regulation of pension funds.

Respondents also agree that the funding ratio of the pension fund is not, on its own, a sufficient indicator of the degree of protection afforded pension benefits: the risk to the benefits depends on the combined risk of underfunding and sponsor default.

Respondents argue that the use of modern ALM techniques cannot fully ensure that a pension fund is never underfunded, not only because funding depends on the contribution policy but also because longevity risk has added significantly to liabilities.

As a consequence, a specific measurement of the combined risk of sponsor default and underfunding is required. Contributions must be raised or assets may be pledged by the sponsor when this combined risk arises.

Organisational problems keep pension funds from benefiting from dynamic investment strategies, even though these strategies are viewed with favour by both academics and practitioners: 73.2 per cent of pension funds agree that dynamic strategies ensure that minimum funding constraints are met.

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