Investment - Articles - Managing Pension Scheme Risks

 The last decade has seen a dramatic increase in the amount of time pension schemes are devoting to the subject of risk management. Reasons for this shift include:

 
•   Changes in regulatory and financial reporting;
 
•   The increasing cost of pension provision; and,
 
•   The availability of additional tools for managing risk, such as LDI, buyins/outs, and longevity swaps.

 Increasingly schemes are recognising the need to maintain a pro-active approach to their risk management. Regular monitoring and an enhanced governance structure are enabling schemes to respond promptly to signals from their monitoring.

 Integrating risk management into funding and investment discussions is becoming more important as trustees and sponsors aim to achieve their objectives within their specific constraints.

 This holistic approach to risk management requires the establishment of a framework referred to as Flight Plans, Flight Paths or Dynamic De-Risking. In concept these frameworks are relatively simple:  the actual evolution of a scheme’s funding level is compared to an expected Flight Path, and action is taken when the actual deviates from the expected. This allows improvements to be ‘banked’. There are, however, a couple of areas that tend to create difficulties:

 
•   Determining the parameters to calibrate the framework. In particular, the appropriate discount rate to be applied to the liabilities; and,
 
•   How the framework interacts with the regulatory requirements for Technical Provisions and Recovery Plans.

 Discount Rates

 Most Technical Provisions bases  incorporate allowance for a material amount of risk premium in the discount rate, which means that even if the scheme becomes fully funded , the trustees would need to retain a material amount of risk in the strategy in order that the expected return on assets could keep up with the un-winding of the discount rate.  This would limit the amount of de-risking that can be done.

 An alternative measure that is widely used is the “self sufficiency”.  The notion of self-sufficiency is to target sufficient assets such that trustees are able to meet all accrued liabilities and expenses in the future without any further recourse to their sponsor.  It is therefore typical to assume a very low level of risk premium in the discount rate, leading to a larger liability compared to Technical Provisions.  There is a general consensus in the market about the notion of self-sufficiency, however, the resultant actuarial basis is not uniquely defined and is one for detailed discussion between the trustees, investment advisor and Scheme Actuary.  Pragmatically, whilst trustees might not be willing to take market risk, there are still healthy credit and illiquidity premia in the market that pension schemes can incorporate into the asset allocation and take advantage of when they are fully funded.

 Frameworks and Recovery Plans

 At the core of the risk framework or Flight Plan are projections of how the present value of a scheme’s assets and liabilities are expected to evolve.

 There are different approaches to valuing pension liabilities that lead to different projected future values. These can generate inconsistencies between the Flight Plan and the Recovery Plan.

 For example, liabilities may be valued under the assumption that inflation and interest rates evolve in line with market yield curves, or that these are fixed over time. Some question the need for such an accurate, market-consistent method given that pension liabilities are very long term and will not likely be sold to someone else. Traditional approaches to valuing liabilities therefore tend to adopt a single assumption for inflation and interest rates.  In practice, choosing an “average” inflation assumption and discount rate may give the same present value, but can give markedly different answers when projecting forward the value of the liabilities.  This is because yield curves explicitly result in interest rates that vary over time whilst the single rate approach assumes rates will stay constant.

 A market-consistent method is particularly important when de-risking because most de-risking instruments will be priced on a market-consistent basis, including a reference to the yield curve.

 
•   Technical Provisions bases also apply different approaches for incorporating the risk premia into the discount rate. For example:   
     
  •     A “dual discount rate” uses a higher risk premium for liabilities in the periods before retirement than after;
     
  •     The discount rate can be linked to the financial reporting basis, i.e. some element of corporate bond yields.
    
   

 In both instances, de-risking has the potential to have a direct impact on the Technical Provision as the assets may no longer support the risk premium assumptions. 

 Combining these differences can lead to markedly different results, which, in the extreme, can mean that schemes do not de-risk because of the impact on Technical Provisions and particularly Recovery Plans.

 Considerations for Efficient De-Risking

 The potential for regulatory requirements to impede on schemes trying to de-risk seems counterintuitive, especially given the Pension Regulator’s objectives.

 We conclude that the development of the necessary tools to enable schemes to pro-actively manage their risk gives rise to two major challenges:

 
•   The Pensions Regulator should review and update the triennial actuarial valuation requirements so that they can be more smoothly integrated into a market consistent dynamic de-risking framework.

 
•   The Actuarial Profession should reflect these issues in their current debates on setting discount rates. In particular we feel that classifying Technical Provisions as Budgeting rather than Matching items is not constructive.  We would prefer to see the risk premia included in the Recovery Plans which we feel is a Budgeting item. Furthermore, introducing matching and budgeting categories when the BAS is using valuation and planning in TAS R will only lead to further confusion for users of actuarial reports and fails to achieve the objective of clarity and consistency.