Survey on pension risk management and impact of funding gap.

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There are currently over 1,200 pension schemes in Nigeria managed by 19 pension fund management firms registered with Retirement Benefits Authority. These firms usually receive pension fund contributions from their corporate and individual clients and invest these funds on their behalf as pooled or segregated funds as agreed. The firms declare different interest rates annually from their investment returns and this attracts more pension schemes to the funds that can offer greater returns. Further, the RBA Act specifies how investment risk can be managed by placing caps on the maximum that can be invested in various portfolios. Therefore, how well a pension fund management firm is able to manage the risks may be an important ingredient to better financial performance. This is the challenge to the pension fund management firms in Nigeria. The study sought to determine the level of implementation of RISK MANAGEMENT by pension fund management firms in Nigeria and to assess the effect of RISK MANAGEMENT on the firm’s financial performance. This study adopted a descriptive study design. The population for this study was the 19 registered pension fund management firms in Nigeria by July 2014 from which 11 agreed to take part in the survey giving a response rate of 58%. Both primary and secondary data were used. Primary data was collected using questionnaires structured based on the objectives of the study. This specifically collected data on the practice and implementation of RISK MANAGEMENT by fund managers. The research instrument was administered through mail and drop and pick later methods. The respondents were the risk and compliance managers in each of the selected f. Secondary data was collected for purposes of identifying performance indices and other control variable such as size of the firms, growth, and leverage from the financial statements of each of these pension fund management firms. Data was analysed using both descriptive and linear regression analysis. The regression results revealed that the model accounted for 99.3% of the variance in financial performance as shown by the R2 value. The F-statistic of 38.3 was significant at 5% level, suggesting that the model was fit to explain the relationship between RISK MANAGEMENT and financial performance. The coefficient results showed that event identification, risk assessment, objective setting, and information communication had negative effects on the financial performance of fund management firms while risk response, internal environment, and control activities had positive effects on the financial performance of pension fund management firms in Nigeria. However, the effects of even identification and risk response on financial performance were insignificant at 5% level. Thus, the study concludes that RISK MANAGEMENT practices influence the financial performance of pension fund management firms in Nigeria to a very large extent. The study recommends that the pension fund management firms in Nigeria should employ robust RISK MANAGEMENT practices, improve on internal environment assessment procedures and control activities as these are likely to influence their financial performance in one way or another. Retirement Benefits Authority should regularly evaluate RM practices of pension fund management firms and reward those with excellent practices.



1.1            Background of the Study


Risk is an intrinsic part of doing business in banking and financial services, as firms must be willing to take on a fair amount of risk in order to provide the most value to shareholders. To successfully do so, one must strike an optimal balance between growth and return objectives and the associated risks and apply resources efficiently and effectively in pursuit of those goals (Sobel and Reding, 2004). That is where Risk Management comes in.

Risk Management has emerged as a new paradigm for managing the portfolio of risks that face organizations, and policy makers continue to focus on mechanisms to improve corporate governance and Risk Management. Despite these developments, there is little research on factors associated with the implementation of Risk Management. Research is needed to provide insights as to why some organizations  are responding to changing risk profiles by embracing Risk Management and others are not (Beasley, et al., 2005). RISK MANAGEMENT (RM) encompasses aligning risk appetite and strategy, enhancing risk response decisions, reducing operational surprises and losses, identifying and managing multiple and cross- enterprise risks, seizing opportunities, and improving deployment of capital (Beasley, et al.,2005).

Risk Management strategies are the actions that firms take in order to respond to the identified risks. Liebenberg and Hoyt (2003) stated that RISK MANAGEMENT has captured the attention of Risk Management professionals and academics worldwide. Unlike the traditional silo-based approach to corporate Risk Management, RM enables firms to benefit from an integrated approach to managing risk thatshiftsthe focus of the Risk Management function from primarily defensive to increasingly offensive and strategic (Liebenberg and Hoyt, 2003).



RISK MANAGEMENT is defined as the process, effected by an entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives (COSO, 2004). There are a number of risks that financial firms deal with. These are credit risks, market risks, liquidity risks and operational risks (Nocco and Stulz, 2006). Credit risk is the potential that a borrower/counterparty fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank. These losses could take the form of outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default (Nocco and Stulz, 2006). The management of credit risk includes: measurement through credit rating/ scoring, quantification through estimate of expected loan losses, pricing on a scientific basis and controlling through effective loan review mechanism and portfolio management (Nocco and Stulz, 2006).

Liquidity risk is the potential for loss to an institution arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable cost or losses. Theoretically, deposits or contributions generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficientlyaccommodatedepositandalsoreductioninliabilitiesandtofundtheloan


growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time budgets based on future likely behaviour of assets, liabilities and off-balance sheet items (Al-Tamini and Al-Mazrooei, 2007). Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc. A firm should track the impact of pre- payment of loans & premature closure of deposits so as to realistically estimate the cash flow profile (Nocco and Stulz,2006).

Market risk is the risk that the value of on and off-balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and capital (Nocco and Stulz, 2006). Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institution’s financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability off- balance sheet items and cash flow (Sensarma and Jayadev, 2009). Hence, the objective of interest rate Risk Management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off. Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective (Sensarma and Jayadev,2009).

Foreign exchange risk is the risk that a firm may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward


transactions may produce mismatches (Al-Tamimi, 2002). There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one centre and the settlement of another currency in another time zone. Pension fund management firms are also exposed to interest rate risk, which arises from the maturity mismatch of foreign currency position (Al-Tamimi, 2002).

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events (Nocco and Stulz, 2006). According to Dorfman (2007), once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories: risk avoidance, risk abatement, risk allocation, and risk retention. Risk avoidance involves not performing an activity that could carry risk. (Eliminate, withdraw from or not become involved in the activity). Avoidance may seem the answer to all risks but avoiding risks also means losing out on the potential gain that accepting the risk may have allowed. Risk abatement is the process of combining loss prevention or loss control to minimize a risk. It is also called risk reduction or risk optimization. Risk allocation is the sharing of the risk burden with other parties for example asset allocation to various asset classes i.e. equity, bonds, real estate, private equity, hedge funds, etc. Risk retention is a good strategy but it is impossible to transfer the risk. Defined benefit pension schemes are a good example of risk retention.

There are however a number of risks that are specific to retirement benefits scheme, which the pension fund management firms are supposed to consider in their RM activities. These are sponsor insolvency risk (risk of the employer becoming insolvent or being unable to meet obligations to the scheme), counter-party default risk (risk of loss from the failures of a counterparty e.g. Service provider to meet its obligations), market risk (risk of losses due to movements in asset prices or interest rates),


operational risk (risk of losses resulting from inadequate internal processes, people and systems), liquidity risk (risk that the scheme will not be able to meet its payment obligations as they fall due without excessive cost), legal and regulatory risk (the likelihood of adverse consequences arising from the failure to comply with all relevant laws and regulations), strategic risk (risks to the continued viability of the scheme as a result of change in the operating environment), contagion and related party risk (risk to a scheme’s operations as a result of close association with another entity), and actuarial risk (risk that assumptions made in predicting liabilities, for example life expectancy, prove to be incorrect resulting in higher than planned for liabilities) (Mutuku,2011).

In general, companies hardly publish any comprehensive information about their existing Risk Management system or plans. Hence, the empirical literature is faced with the challenge of gathering information about whether or not an RM system has been adopted and to what degree. Information about the current corporate Risk Management system can either be collected by using surveys or by scanning public sources. Surveys are typically used to study the level or stage of the RM implementation. Beasley, Clune, and Hermanson (2005), for instance, conduct a survey and introduce a classification of five stages to analyse the determinants of RM. Further studies make use of external databases such as Standard & Poor’s (S&P) RM rating (McShane, Nair, and Rustambekov, 2011) and the Osiris database (Razali, Yazid, and Tahir, 2011; Tahir and Razali, 2011) or develop their own index for the firm’s RM (Gordon, Loeb, and Tseng,2009).

An alternative to surveys are public sources, where, e.g., business libraries or annual reports are scanned for key words, their acronyms or individual words within the sameparagraphthatindicateanimplementedRMsystem(RMkeywords).Many


studies thereby revert to the appointment of a Chief Risk Officer (CRO) as a signal of an RM system (CRO key words) (Pagach and Warr, 2011; Golshan and Rasid, 2012). This assumption may lead to biased results in cases where the existence of a CRO does not correspond to an implemented RM system or in cases where the title or person changes (Grace et al., 2013). Furthermore, it allows for no differentiation with respect to the level of the RM implementation. However, there are several strong arguments for using a CRO appointment as a signal. For instance, an RM implementation process should typically be overseen and led by a senior executive due to the considerable impact of RM and its complexity (Pagach and Warr, 2011). In addition, Beasley, Clune, and Hermanson (2005) empirically show that there is a significant positive relationship between the presence of a CRO and the RM implementation stage, thus providing support for the proxy used in the empirical studies. More recently, indices have been introduced as methods of measuring how firms manage risks. For instance, Pooser (2012) uses a modified HHI to measure diversification as a method of managing operational risk, portfolio variance to measure financial risk, re-insurance use to measure hazard risk, and aspiration to measure strategicrisk.

1.1.2    Financial Performance


Performance encompasses three specific areas of firm outcomes namely financial performance (profits, return on assets, return on investment); market performance (sales, market share); and shareholder return (total shareholder return, economic value added) (Divenney et al., 2008). Performance is the ultimate dependent variable of interest for those concerned with just about any area of management: accounting is concerned with measuring performance; marketing with customer satisfaction and market share; operations management with productivity and cost of operations,


organizational behaviour with employee satisfaction and structural efficiency; and finance with capital market response to all of the above.

Performance is so common in organizational research that it is rarely explicitly considered or justified; instead it is treated as a seemingly unquestionable assumption (Devinney et al., 2005). The multidimensionality of performance covers the many ways in which organizations can be successful; the domain of which is arguably as large as the many ways in which organizations operate and interact with their environment.

Meulbroek (2002) and Hoyt et al, (2008) study the value of RM in the US insurance Industry by measuring the effect of RM implementation on the value of the firm as measured by Tobin Q (ratio of company’s market value to its replacement cost of assets). Tobin suggested that the combined market value of all the companies on the stock market should be equal to their replacement costs, Tobin (1969) and Hayashi (1982). The Q ratio is theoretically defined as the market value of a company’s assets divided by the replacement value of the company’s assets. Then, when the assets are priced properly in the capital market, the Q ratio should be equal to one. In their survey of evidence of whether Risk Management adds value to companies, Smithson et al (2005) found that 9 studies on Risk Management and the value of the firm also used Tobin’s Q to proxy firm value.

This study uses the natural logarithm of Tobin’s Q as a proxy for firm value because it dominates other performance measures. Unlike other measures, Tobin’s Q does not require risk adjustment or normalization. Lindenberg and Ross (1981) also find Tobin’s Q to reflect market expectations and as being relatively free from managerial manipulation. This study defines Tobin’s Q as: – (market value of equity + book


value of liabilities) / (book value of assets) (Cummins, Lewis & Wei 2006; Chung and Pruitt, 1994).

Another measure of performance is Return on Assets (ROA) which is an indicator of how profitable a company is relative to its total assets. It gives an idea as to how efficient management is at using its assets to generate earnings. Related to this measure is Return on Equity (ROE) which is the amount of net income as a percentage of shareholders equity. It measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested (Pagach and Warr,2010).

In a number of studies that assess the (financial) performance of RM, the impact is measured by excess stock market returns (Gordon, Loeb, and Tseng, 2009), cost and revenue efficiency including ROA (Grace et al., 2013) measured as net profit divided by total assets or several financial variables, such as financial leverage (measured as total debt divided by total equity), return on equity (ROE) measured as net profit divided by total equity, as well as stock price and cash flow volatility (Pagach and Warr, 2010).

  • Effects of Risk Management on Firm Performance Corporate scandals and diminished confidence in financial reporting among investors and creditors have renewed Corporate Governance as a top-of-mind priority for Boards of Directors, Management, Auditors, and Stakeholders. At the same time, the number of companies trying to manage risk across the entire enterprise is rising sharply. Thus, there is need for companies to effectively integrate RISK MANAGEMENT with Corporate Governance (Sobel and Reding,2004)


These capabilities inherent in RISK MANAGEMENT help management achieve the entity’s performance and profitability targets and prevent loss of resources. RISK MANAGEMENT helps ensure effective reporting and compliance with laws and regulations, and helps avoid damage to the entity’s reputation and associated consequences. It delivers a current, credible understanding of the risks unique to an organization across a broad spectrum that includes all types of risk (credit risk, operational risk, market risk, liquidity risk and trading risk), lines of business and other key dimensions (SAS, 2014). In sum, RISK MANAGEMENT helps an entity get to where it wants to go and avoid pitfalls and surprises along the way (Nocco and Stulz,2006).

For a long time it was believed that corporate Risk Management is irrelevant to the value of the firm and the arguments in favour of the irrelevance were based on the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller, 1958). One of the most important implications of CAPM is that diversified shareholders should care only about the systematic (market risk) component of total risk. On the surface it would appear that this implies that managers of firms who are acting in the best interests of shareholders should be indifferent about hedging of risks that are unsystematic (company or industry specific risks). Miller and Modigliani’s proposition supports CAPM findings.

However, proponents of the value adding effect of RM define RM as a body of knowledge – concepts, methods, and techniques – that enables a firm to understand, measure, and manage its overall risk so as to maximize the company’s value to shareholders and other stakeholders (COSO, 2004). It has been argued that, while traditional Risk Management is largely concerned with protecting the firm against adverse financial effects of risk, RISK MANAGEMENT makes Risk Managementpart of the company’s overall strategy and enables companies to make better risk adjusted decisions that maximizes shareholder value (Lam and Kawamoto, 1997,

1.1.4    Pension Fund Management Firms inNigeria


The retirement benefits industry in Nigeria is composed of four broad schemes namely the Civil Service Pension Scheme (CSPS), the National Social Security Fund (NSSF), Occupational Retirement Schemes (ORS) and Individual Retirement Schemes (IRS) (Odundo, 2008). The CSPS and the NSSF are born out of the Acts of Parliament while the ORS and IRS are born by Trust Deeds. The members of CSPS are all civil servants and teachers, those of NSSF are formal sector workers in companies. The members of ORS are formal sector workers in companies that have schemes while the members of IRS are individuals in formal and informal sectors who join voluntarily. The CSPS is non-funded while the other schemes are funded. Further, apart from the CSPS, the rest of the schemes are subject to regulations by the Retirement Benefits Authority(RBA).

By 2008, the retirement benefits industry in Nigeria had US$ 4bn in total assets with occupational retirement benefit schemes holding 69% of the assets and NSSF holding 30% of industry’s assets. For the financial year ending June 2012, the industry had total assets of NGN 432.8 billion held in various asset classes (RBA, 2012). The  report shows that 34% was held in government securities, 26% in quoted equities, 18% in immovable property and 9% in guaranteedfunds.

These schemes are managed by pension fund management firms registered with RBA. The RBA Act stipulates that every retirement benefit scheme appoint a fund manager. The role of fund managers’ therefore clearly outlined and anchored by RBA regulations. Currently, there are over 1,200 pension schemes in Nigeria and 19 pensionfund management firms (see appendix I) (RBA, 2014). The RBA provides fund managers with investment guidelines (see appendix II) in which the asset classes and the maximum percentage investment in each class is provided (Mutuku, 2007). The guidelines also offer allowance for pension fund management firms to make temporary violations of the maximum caps. These rules therefore guide risk profiles of various asset classes as invested in by pension fund managementfirms.

The RBA supervises the investments by pension fund management firms through a specific division whose role is purely to supervise retirement benefit schemes. The supervision of schemes has shifted to risk based supervision (RBS). The RBA has shifted from a compliance based to a more pro-active risk based approach. The approach concentrates on identifying pension risks using defined criteria, monitoring risks and dealing with any identified risk early enough before they become unmanageable and too costly to resolve. The RBS focuses on the aspects of scheme which pose high risk to the security and delivery of benefits (Odundo, 2008).

1.2            Research Problem


Merton (1995) argued that financial systems should be analysed in terms of a functional perspective rather than an institutional perspective. The author suggested that the central function of a financial institution is its ability to distribute risk across different participants. According to Saunders and Cornett (2006), modern financial institutions are in the Risk Management business as they undertake the functions of bearing and managing risks on behalf of their customers through the pooling of risks and the sale of their services as risk specialists.

A lot of people rely on their pension funds as a source of income after retirement. Retirement income accounts for 68% of the total income of retirees in Nigeria


(Kakwani, Sun and Hinz 2006), 45% in Australia, 44% in Austria and 80% in France, while in South Africa 75% of the elderly population rely on pension income (Alliance Global Investors, 2007). In the United States of America 82% of retirees depend on pension income (EBRI, 2007). There are currently over 1200 pension schemes in Nigeria managed by 19 pension fund management firms. These firms usually declare different interest rates annually from their investment returns and this attracts more pension schemes to the funds that can offer greater returns. Further, the RBA Act specifies how risk can be managed by placing caps on the maximum that can be invested in various portfolios. Therefore, how well a pension fund management firm is able to manage the risks may be the important ingredient to better financial performance of the fund manager. This is the challenge to the pension fund management firms inNigeria.

A search on studies on RISK MANAGEMENT in Nigeria yielded studies done on credit Risk Management (Njiru, 2003; Kioko, 2008; Ngare, 2008; Simiyu, 2008; and Wambugu, 2008), information systems Risk Management (Weru, 2008) and foreign exchange Risk Management (Kipchirchir, 2008). The pension fund management firms have not been studied as far as RISK MANAGEMENT is concerned. There is therefore a gap as far as studying the influence of RISK MANAGEMENT practices on financial performance of pension fund management firms is concerned. The research question was therefore: what is the effect of RISK MANAGEMENT on financial performance of pension fund management firms inNigeria?

1.3            Research Objectives


The main objective was to examine the effect of RISK MANAGEMENT on financial performance of pension fund management firms in Nigeria.



The specific objectives of this study were:


  1. To determine the level of implementation of RISK MANAGEMENT by pension fund management firms in Nigeria.
  2. To assess the effect of RISK MANAGEMENT on the financial performance of pension fund management firms in Nigeria.



1.4            Value of the Study


This study will be important to various groups of people. First, the study enriches the theory of RISK MANAGEMENT and how such practices are important in enhancing the performance of organisations.

Secondly, this study is important to pension fund management firms as it shows the value of having and implementing enterprise-wide Risk Management measures in their organisations for purposes of better firm performance.

The study will provide pension schemes sponsors with an insight of extent of RM implementation among the registered pension fund management firms and help in making informed choices of service providers.

The policy makers can obtain knowledge of the pension fund management sector dynamics as regards RISK MANAGEMENT in Nigeria. They can therefore obtain guidance from this study in designing appropriate RISK MANAGEMENT requirements and policies that may regulate the sector.

The study can provide information to potential and current scholars on RISK MANAGEMENT among pension fund management firms or any other firm in Nigeria. They can use the study as a guide and for purposes of furthering future research.

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