Next economic crisis to come from pension funds

Unregulated pension fund industry will be a systemic concern

The next financial crisis will stem from pension funds that take on risk to make up for shortfalls in their funding positions, according to Guan Seng Khoo, head of enterprise risk management at Alberta Investment Management Corporation.

Khoo, former senior director of risk management at Singapore's sovereign wealth fund, Temasek, was speaking at the Asia Risk Transition Management forum in Hong Kong last week. He said unregulated pension funds pose significant systemic risks as they struggle to make up a 20–30% shortfall in their liabilities in the current low-yield environment where there is also a shortage of safe assets.

"Because of very low yields a lot of liabilities are now problematic for pension funds and it will affect the whole world. As most pension funds have a deficit in their pension funding ratio, the next crisis will come from the pension fund industry. Some pension funds will blow up while others will do well. A lot of people like to join this sector as it's in the shadow banking system and not regulated," he says.

Khoo says instead Asian pension funds should follow the recent trend from North America to make investments based on strategic risk allocation (SRA), which focuses more on where risks lie in the portfolio than simply diversifying a portfolio across asset classes or products.

"When you invest based on strategic asset allocation you are making a decision according to asset class without looking at the risk-return profile.

"SRA is forward looking based on the investment horizon. It's similar to banks allocating risk capital under the Basel framework. Risk budgeting is coming to the fore and will affect how asset allocation strategies are assessed," he says.

According to Khoo, a lot of real money investors are looking at illiquid assets such as property to make up for the poor risk return across more traditional equity and bond investments and using derivatives to overcome the difficulties of exiting these assets at will.

"Nowadays a lot of sovereigns and pension funds are looking at the illiquid sector. One problem is that you can't get your money out for a while. Total return swaps help in this regard to initially invest in an illiquid sector," he says.

He also warns that asset drift – where a portfolio weighting becomes skewed due to differences in the underlying performance – poses an increasing risk and should be addressed promptly.

"If a client has a 60-40% mandate in equities versus fixed income then over time due to asset drift there might be an equity move to 70% so then you need to rebalance," he says.