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The Actuary The magazine of the Institute & Faculty of Actuaries

Exploring pension risk

Years of high inflation, good investment
returns, and profits from early leavers during the 1970s and 1980s created an illusion that the ‘standard 60th’ defined benefits (DB) pension scheme was easily affordable. Pensions risks have generally been excluded from an organisation’s general risk management process because the surpluses that emerged from cautious funding previously acted as a buffer to absorb any shortfalls. This is combined with the fact that pension risks are rather specialist in nature.

Increased cost
So, what has changed and why should companies be worried? Increasing life expectancy and a steady fall in long-term interest rates have meant that pension costs have grown in recent years. The result is well known many pension schemes now have insufficient assets to fully cover liabilities in the event of a wind-up. Member security has become a real risk factor.

Layers of legislation
The erosion of benefits of pensioners and early leavers led successive governments to improve benefits through layers of legislation, removing the need for discretionary increases and, as a consequence, the ability to divert the assets available for such increases to offset poor experience. The surpluses generated by the excellent investment returns of the 1980s are now largely gone, leaving many schemes without a buffer to weather the storm of adverse experience. Additionally, during the years of high inflation, few companies seriously considered the prospects of a low-inflation environment and many chose to guarantee pensions once in payment at a rate which is several percentage points above today’s inflation levels. The failure of Equitable Life to reserve for the risk of future low inflation is well publicised; the threat to pension scheme security from excessive levels of guaranteed pension increases goes largely unreported. Ironically, the fear of the 1970s was the exposure to index-linked pensions; the real threat is fixed pension increases in a low inflationary environment.

Greater transparency
Against this background is the government’s call for greater transparency, both for scheme funding and within company accounts through FRS17. As a consequence, the company’s risk exposure will be far more visible to investors, analysts, and scheme members.
Negative impact
Pension risk can have a negative impact both on the employer and on the employee, the two being inextricably linked. If the company were to concentrate solely on shareholders’ interests, the optimal strategy would be to terminate the pension scheme and use the money elsewhere in the business. However, most employees expect a decent pension scheme, and not providing one would make it difficult to attract and retain key talent. The value savings from eliminating pension provision have to be set against the attrition of shareholder value if the company is prevented from achieving its business strategy and objectives through poor recruitment and retention. Furthermore, if the company accepts high risk levels within the pension scheme, this decreases member security, ie some of the company risk rubs off on the members. Switching from DB to defined contribution (DC) transfers most of the risks to the member, but it also improves member security; DB schemes continue to be higher risk to members on company sale or scheme wind-up.

Managing pension risk
So, how can these risks be controlled? As with any risk management programme, there are essentially three steps to consider: identification, quantification, and treatment.
To identify and prioritise the main sources of risk, a full pension risk audit can be undertaken. The analysis should cover both employer and member-borne risks.
In terms of quantification, the primary consideration for the main board is likely to be where pensions rank in the hierarchy of business risks and the extent of the potential financial damage. A model has recently been developed to put these risks into the context of the company’s overall finances and measure these against other companies. Least risk analysis compares the investment risk from the schemes investment portfolio against a portfolio of fixed-rate and index-linked gilts constructed to match, as far as possible, the scheme liabilities. A range of stochastic models has also been developed for assessing funding risk, in particular MFR failure. Taken together, these modelling tools provide a valuable insight into the potential risk exposure to the sponsoring company.
Finally, in order to treat pension risk, companies have the option to reduce or transfer the risk. The greatest scope for transfer is to switch from a DB to a DC scheme. Essentially, this is the most extreme solution, resulting in the employee bearing almost all the risk. Switching to DC for new entrants is often chosen as a compromise, but this does nothing for the risk on accrued benefits and reduces future risk slowly, unless there is a strong influx of new joiners.

Negative perception
A quicker solution would be to offer a transfer of past-service benefits to a DC scheme on attractive terms. This transfers the investment and mortality risk on the accrued benefit to the employee. Nevertheless, such an option may still be unwelcomed by members who will probably perceive the switch to DC negatively. A poor DC scheme is likely to have a detrimental effect on recruitment and retention, unless levels of employer contributions are increased to compensate for the heightened risk, and the benefits of the switch are communicated well to members.
Pension scheme design plays a key role in controlling employer risk and those designs that share the risk, like hybrid schemes, are generally preferred.
Changing the investment strategy remains the quickest and most effective method of changing the risk exposure (company risk in a DB arrangement, member risk in a DC account).

Managing the risks
Mortality risk is well known to actuaries and becomes increasingly important as fixed-interest yields fall, because this gives increased weight to payments in the distant future where mortality is least certain. In addition to the risk that longevity increases faster than anticipated, a less publicised risk is the possibility of step changes in expected mortality resulting from medical advances.
Legislative risk has been a major strain over the last 30 years, in particular early leaver revaluation, limited price indexation and ACT removal. While it is tempting to think that there is nothing left to improve, the possibility of adverse tax changes or further non-discrimination legislation cannot be ruled out.
While mortality and legislation are beyond the direct control of employers, organisational risks generally are not. A practical way of reducing pension risk is by looking at the company operations. Systematic failures can generate large E&O (executive and officer) exposures, and failure to observe the numerous requirements of Pensions Act compliance can result in significant fines and a loss of confidence. Data needs to be secure, and the administration system robust.

The response
The issue of risk within pension funds has become far more prominent in recent years and with it has come a knee-jerk reaction to switch from DB to DC. Often this is a response to rising costs, not increasing risk; switching from DB to DC is essentially a risk transfer solution, not one that reduces cost. Nevertheless, it can be, and has been used to disguise a cut in benefit values. Pure DC is only one of a broad range of solutions and, even here, the switch needs to be properly managed and communicated if it is to achieve its objective of reducing risk.
It is vital that scheme sponsors not only understand the nature of risks within their schemes, but are also aware of the tools available to manage them.