I just returned from my son’s hockey game. It was a nail-biter that ended with the opposing team pulling their goalie in the last minute. Somehow, my son’s team managed to survive the onslaught of frantic last minute shots to preserve a one goal victory. For the winners, 2 points in the standings. For the losers, no points.
Notably, no one really focused on the actual score. Was it 3-2 or 2-1? Who really cares? They won the game, right? And they won by one slim goal. Defensive players in any sport need to remember that it’s not the number of goals a team scores, but the margin of victory (indeed, the simple fact they won) that matters. In other words, an opposing goal prevented is just as good as another goal for your own team.
Pension funds should operate on much the same basis. Portfolio returns – no matter how high – don’t mean much if the opponent (pension fund liabilities) puts up more points on the scoreboard. And that’s why many pensions prefer to measure their success against a liability benchmark, not just a return benchmark. A 10% pension fund return won’t do you much good if your liabilities just increased by 12% (for example, due to changes in the interest rate used to discount future liabilities to the present).
An interesting survey by Toronto-based consultant CEM Benchmarking and published in the Fall Edition of the Rotman International Journal of Pension Management (see AAA posts on two previous studies that use CEM’s proprietary data: one, two) shows that a lot of pensions actually prefer to count goals instead of worrying about the size of their (or their opponent’s) lead.
The article’s authors Sandy Halim, Terrie Miller and David Dupont divide risk into several categories. One category is “active management risk” (a.k.a. tracking error, or standard deviation of the “value-added” by the fund over its benchmark); another is “absolute risk” (a.k.a. “total risk” that includes passive, market risk and active risk); and a third is “surplus risk”, defined as the gap between asset returns and liability growth.
Hockey players might view these three risks as performance beyond the expected (active risk), the total goals scored (absolute risk) and the margin of victory or loss (the surplus risk).
As you can see from the table below in the article, many pension funds (88%) had a good feeling for when they outperform expectations (a tie against a superior team can sometimes be as good as a win after all). Nearly half (48%) kept a close eye on their lead (or margin of loss) and about a quarter (28%) focused mainly on the number of goals they scored. Curiously, 7% didn’t care who won or how many goals they scored. These respondents appear to be playing a game of pick-up hockey for fun only.
Even those pension funds that focus on their surplus (or deficit) of goals reported varying degrees of focus. As you can see in the chart below, only 42% of respondents put a high priority on surplus risk. Conversely, nearly two-thirds (63%) of respondents focused on active risk. This is like an old-timers hockey league where participants focus on beating their personal best instead of actually getting more points that the opponent – great for adult recreational hockey, but not for pension management.
The authors of this article then wondered if this focus on either performance (active risk) or goal differential (surplus risk) actually influenced the outcome of the game. They found that pension funds with a focus on their own performance only (not on their total goals or even their margin of victory/loss), actually performed better that you would otherwise expect. Those with a high focus on active risk had a median “value-added” of 0.48% per annum.
By contrast, those with a low focus on active risk had a median “value added” of -0.13%. Apparently a good coach can make his players exceed their expectations…
Unfortunately, the same could not be said for surplus risk. No matter how hard pension funds tried, they could not will the other team into scoring less – and the other team (pension liabilities) always seemed to rally and match their opponent. Average annual surplus was around -3% for funds with both a high and a low focus on surplus risk. However, as you can sort of see from the chart below in the report, at least the surplus volatility is lower for those pension funds that focus on surplus risk.
There are a bunch of other interesting factoids in this article so we recommend you have a look. (For example, guess which country’s pension funds have the most staff dedicated to risk management? Think: home of the black swan…)
The bottom line is that goal differential matters. Otherwise, the scoreboard wouldn’t contain the scores for both teams. In fact, if the absolute number of goals were all that mattered, teams wouldn’t put anyone on defense and all the players would be forwards. Sure, they’d score a lot. But in the end, they’d still end up losing.