Pension funds experienced an uncomfortable déjà-vu when financial markets appeared to be heading towards a new abyss last week. Somehow, markets rebounded but experts fear that there might be worse to come. Business leaders and investors increasingly voice their concerns that politicians are mishandling crisis management. Are investors themselves able to effectively deal with financial crises? A number of pension funds seem to be better prepared in recent weeks, some of them seemed at a loss to act. 10 Tips for crisis management, some borrowed from other disciplines, some new.
1. Create a crisis response team in advance. Delegate responsibilities and make clear who is responsible for what in a given crisis. The response team includes the “face” of the fund (usually the chairman), the one who will be in charge of facing the press. The crisis response team will also need to be bolstered with people who have a comprehensive knowledge of the daily operations of your business, such as the CFO and risk manager.
2. Discuss beforehand when the crisis response team should be deployed. A sudden drop in cover ratio, market prices or interest rates, acutely threatening the solvency surely count as valid triggers. The board should determine what constitutes threat as specific as possible.
3. Also, determine beforehand who is in charge: the risk manager or the asset manager. When the crisis is imminent, a number of pension funds held discussions along the following lines. Trustee: we need to derisk to preserve capital. The asset manager: when you derisk now, you will not be able to profit from the recovery imminent after a crisis. Also, you forsake the possibility to buy investments at bargain prices. It’s your loss! Derisking makes perfect sense during a crisis to preserve capital, far more important than hunting for investment opportunities. The risk manager is in charge during a crisis, the asset manager advisor on how the measures might be implemented. Not the other way around.
4. Know thy enemy – develop a thorough understanding of what a crisis is. We cannot predict crises, but in my experience they tend to exhibit the following element
- A sudden drop in cover ratio, more or less downward oscillation, in a very short period of time.
- Markets shift: shortfall in liquidity. Spreads increase. Drop in asset prices. Diversification effects become non-existent.
- Increased uncertainty in a very short time, increased talk of “unprecedented situations”.
- Half expected problems that tend to be followed and worsened by larger, unexpected problems. The fall of LTCM was manageable, but emerged into a widespread crisis with the default of Russia. Bear Stearns was bad enough, but the failure of Lehman created widespread panic. Panic is a classic element of a crisis, taking the shape of bank runs or extreme difficulties for financial organizations or vehicles to raise funding[i].
- Unlimited faith in the healing powers of central bankers, or the deep pockets of politicians, as saviours of last resort.
- Psychological difficulty in group and individual decision making to see a “way out”.
5. Prepare for the obvious problems during a crisis. Pension fund trustees generally face four dangers in any crises which they need to address (and the good news is – prepare for):
- are running behind developments, instead of preparing for upcoming ones, the fear that they might become forced buyer or seller due to the derivatives, outstanding commitments, pension pay-outs, or a stringent application of rebalancing policies
- a decrease in risk appetite, especially if the risk appetite is not formalized in any way.
- a sense of regret that certain measures have not been taken earlier,
- awareness that any risk reducing measure (especially in the derivatives sphere) is too costly to execute, procrastinating sensible actions. The end result is typically a combination of decreasing interest rate exposure somewhat (following the basic paradigm that investors flee to safe havens, lowering interest rates and increasing pension liabilities).
6. Plan in advance. You should already have a written plan in place to be used as soon as the crisis occurs. Try to determine in advance any type of situation that may arise to affect your pension fund. Make sure the organization can cough up a detailed breakdown of the portfolio, by potential risks (credit, market, liquidity, etc.) This need not be a quarterly report, it should be accurate and swiftly delivered. A detailed assessment of potential risks can mean the difference between responding immediately and responding after it is too late. Be as specific in your actions as possible. It requires far less time to update scenario’s then to think of alternatives under (time) pressure. Do not write a elaborate manual. Just the steps and decision to taken, who’s in charge for what. If you’re not convinced, read the Checklist Manifesto, by Gawande[ii]. Concerned about medical mistakes, which Gawande describes in dramatic passages guaranteed to raise your blood pressure, Gawande found that the more complex our lives and work become, the easier it is for us to overlook details and to err, sometimes at great costs. Hence a well-thought-out to-do list.
7. Train well in advance in simulation environment on how, try to fine tune the planning for the following issues:
- Uncover fundamental differences in how trustees approach a crisis. For example, within a board some trustees might make a compelling case to buy more equities after a sudden drop in prices, while other trustees would prefer the opposite
- Challenge the board on its risk appetite. Is it constant throughout, or should it be rescaled when crises occur? This fundamental issue if a board fails to action, or responds swiftly.
8. Communicate what you know, not what you wish for. Refraining from speculation during the earliest stages of the crisis is imperative. If you don’t have solid proof of your facts, don’t release them. Try to step in the shoes of the participant of the fund. Presenting factual updates may not be pleasant news, but is a sign that the trustees are on top of things. Trustees should refrain from forward-looking statements.
9. Refocus the management agenda when things heat up or cool down. The start of the financial crisis is usually too late to start putting together a plan for management and response. Differentiate between normal times, and abnormal times. In abnormal times, correlation is absent, all assets save T-Bills dive downwards. An effective board reallocates time from the “normal times” management, in favor of the “abnormal” times period. Planning in advance, and training are crucial elements here.
10. Conduct brutally honest post mortems. What were the challenges that the fund faced? Set up a chronology. Determine for each event what the reaction was, if it was the right reaction in hindsight, whether it could have been foreseen and prepared, and how the decision process took place. What recommendations can be made? Post them on the fund’s website, to share with participants, signaling that the fund is learning and adapting to new realities.
Whatever you do, avoid phrases like “these are exceptional times” as an excuse to do nothing. We have been forewarned by the publications of Nicholas Taleb, and are now living it: the regularity is not in the risk/return distribution, but in the frequency of occurrence of crisis. In that sense, we are probably heading towards a new management style of pension fund trustees that might be closer to the job descriptions of firemen, ambulances and pilot fighters, and athletes. These groups have in common that they train 95% of the time, to excel in 5%, whether it is on the battlefield or the football field. Pilot fighters train extensively for emergency and safety procedures. Participants should expect no less from their trustees.
[i] See for example Chairman of the Federal Reserve Ben Bernanke’s speech on the 2008-9 crisis, http://www.federalreserve.gov/newsevents/speech/bernanke20090821a.htm
[ii] Atul Gawande. The Checklist Manifesto: How to Get Things Right. 2009, Metropolitan Books