London Briefing: Risk management is a term much in vogue in the British fund management industry these days, for fairly obvious reasons, writes Chris Johns

The results of risk management errors are plain for all to see.

Endowment mortgages that fail to cover the underlying mortgage, a struggling insurance industry and the closure of defined-benefit pension plans are all symptoms of an industry desperately trying to come to terms with investment returns that have failed to live up to expectations.

The government is trying to persuade individuals to take more responsibility for their own pensions, so far with very little success.

Such efforts, with similar results, can be seen in many other countries.

The standard industry response has been to try to develop better methods of measuring and controlling risk.

At the heart of all of this is an attempt to match much more closely the liabilities of the investment industry with the underlying assets.

This is a fiercely complex area, which even the experts admit is fraught with uncertainties and there exists only a partial understanding of the underlying problem.

Take the simple endowment mortgage. The underlying liability is the debt that must be paid at the end of the life of the mortgage.

The only truly risk-free way of saving to pay off this debt - the only perfect asset/liability match - is to save, in a secure bank vault, a sufficient pile of cash such that the mortgage is ultimately cleared by the accumulated savings.

Even then, there is a small risk that the bank will fail. If the savings are placed on deposit, there is a risk that changes in interest rates will not permit sufficient accumulation of capital. A slightly riskier place for the savings is in government bonds. Unless our saver buys bonds that mature on the same date as the mortgage there is a similar risk that fluctuations in interest rates (bond yields) will cause a capital shortfall.

There is also a tiny risk that a government could default on its bonds (a rare but not unknown occurrence). If either of these two routes, bank deposits or bonds, is chosen, the rate at which we save is actually rather high.

To reduce the amount that our saver puts in every month the manager of the savings puts some of the cash into assets, such as property and equities, which historically pay higher returns than deposits or bonds.

As soon as we start putting our cash into stocks, real estate or other "risk" assets, we are into a whole new ball game.

The fund manager projects returns on those assets and works out the required saving rates (the amounts that we have to put in every month). This is the business of risk.

The higher those projected returns, the lower the required rate of saving. If the achieved returns are lower than projected there will be disappointment and a funding shortfall.

It could be that all of this involves concepts and arithmetic that are too difficult for some people to comprehend. This might seem fairly patronising but I was struck by a comment from someone at the heart of a recent major fraud trial in London, which ended with the jury unable to reach a verdict: the assertion was that most people in Britain don't understand percentages, let alone the complex accountancy that lies at the heart of major frauds.

This general comment about the numeracy of the average UK citizen was an appeal to abolish juries in complicated cases of fraud. But if it is true, then the chances of explaining risk to many investors remain low. In one sense, risk management is just sophisticated arithmetic.

A friend of mine, who should know better, recently remarked that they were looking forward to a comfortable and imminent retirement since they had accumulated around £500,000 (€724,000) in their retirement fund. When I told him that this would, under current rules and after withdrawing his lump-sum, buy him a £20,000 pension he was less than pleased. The arithmetic of pensions is relentless and full of paradoxes.

To stand any chance of a decent pension we have to save a lot and take risk. The inventor of the benchmark age of retirement, 65, knew a thing or two about risk. In the last century, Bismarck introduced this to Germany when relatively few people lived beyond the age of 50.

No matter how it is dressed up, risk is about taking a punt. And the basic rules of the casino apply. In particular, don't play with money that you can't afford to lose.

That is at the heart of the pension paradox: who can afford to take a risk with their retirement income?