Risk budget analysis is conducted to better understand the level of investment risk being taken and how it could be managed, and to determine an appropriate strategic asset allocation considering the risk budget established (as covered in Guideline 7).
Spending the risk budget enables the investing institution to determine an appropriate strategic asset allocation considering the available risk budget, investment assumptions, restrictions on investments and liabilities, and funding policy.
The use of the risk budget as outlined here should be distinguished from dynamic investing (Guideline 12). For example, dynamic investing may lead to a decision to purchase equities based on a view that their price is currently advantageous; such a decision may be at odds with a long-term view to reduce equity exposure due to a maturing of liabilities. These decisions should be taken in consideration of strategies to rebalance risk levels (covered in Guideline 13).
- The management or investment committee should conduct, and the board should approve, the risk budget analysis and the strategic asset allocation. This should be done regularly; best practice for institutional investors is typically on an annual basis.
- The management or investment committee should propose, and the board should approve, the risks to be considered. Scenario analysis should be used as a way of identifying such risks. The investment strategy can then be managed to provide the level of protection deemed necessary.
- Risk budget analysis should be conducted to determine an appropriate strategic asset allocation that is efficient in terms of the investing institution’s return target and risk budget; the risk budget should be allocated efficiently.
- Risk budget analysis should be conducted to understand the level of investment risk being taken and where the concentrations of risks lie. Changes can then be identified within the portfolio which can help improve efficiency through diversification, active management, hedging or other actions.
- The management or investment committee should sufficiently diversify the portfolio using frameworks such as asset class, geographic region, risk premia and thematic investments as methodologies to assess diversity.
- Where risks are deemed to be “unrewarded”, the management or investment committee should consider how to manage (or “hedge”) such risks. Board decisions, liquidity considerations, the governance budget and the cost and effectiveness of hedging strategies should be considered when determining whether the use of derivatives to hedge risk is appropriate.
- Compliance with the risk management structures set in place to govern the use of derivatives for hedging should be carefully monitored.
- Where the board, management or investment committee lacks sufficient resource, expertise or governance budget to conduct risk budget analysis, the board, or the management or investment committee with board authorization, should seek expert advice or appoint external professionals to carry out these functions.
- Risk budget analysis should be conducted to diversify investment risk where possible.
- The management (or “hedging”) or removal of unrewarded risk should be considered.
- Risks that may be specific to the social security institution should be identified, and possibly hedged or removed.
- Appropriate risk management structures should be set in place to govern the use of derivatives for hedging.
- Risk budget analysis should, where required, reflect decrees or decisions issued by relevant national authorities or establishing legislation.