Huw Davies discusses the risk bow tie, a simple integrated risk management tool for UK defined benefit pension schemes
The UK Pensions Regulator (TPR) expects defined benefit (DB) pension schemes to adopt an integrated risk management (IRM) approach, taking into account the key areas of risk: funding, investment and the strength of the sponsoring employer's covenant. In this article I present the 'risk bow tie', a simple tool that can be used to help implement IRM. It could promote a more standardised approach to IRM across the UK pensions industry and, being easy to prepare, may be especially useful for many small schemes, which typically have limited governance budgets.
Taking control
The risk bowtie is a controls-based risk management model that was first popularised by Shell and is illustrated below in the context of a DB pension scheme. It takes its name from the shape of the diagram, and is read from left to right. It shows how the impact of external events on benefit security is managed, firstly using preventative controls to protect the level of financial support (funding level and covenant), and then using corrective controls (or contingency plans) to protect the level of benefit security from changes to the level of financial support. This approach mirrors the guidance from the Pensions Regulator.
In this simplified example below (Figure 1) I have shown six preventative controls and four corrective controls, but more can be added as necessary. Preventative controls for a risk involve one of the following actions: retain; mitigate or reduce; transfer or insure; or avoid. Retained risks might include those that are rewarded (such as equity or credit risk), or cannot be dealt with cost effectively in any other way. They are managed by means of an appropriate prudence (contingency) margin - a key theme in TPR's guidance.
Actions to mitigate or reduce risk might include adopting a lower risk investment strategy, or applying transfer value reductions, in order to protect the scheme from a large number of transfer requests at a time when the level of financial support was low.
An example of insured or transferred risk is the purchase of annuities through a buy-in or the use of longevity swaps. Another example is a liability management exercise such as pension increase exchange, where members give up future pension increases for an immediate increase in pension; the inflation risk is thereby passed from the scheme to the member. An investment example is the use of derivatives, such as to protect the scheme against a fall in equity markets over a particular period.
There are also some limited circumstances in which it is possible to avoid risks. An example would be to ensure that the scheme does not invest directly or indirectly in the sponsoring employer, and to avoid assets that are correlated with the fortunes of the employer.
In Figure 1, the employer covenant is judged as moderate and deemed sufficient to permit a low level of prudence in the calculation of the liabilities. The funding deficit is being paid off over a long recovery period, hence the low level of control. The investment strategy has a high allocation to non-matching assets and a low hedging ratio, so the level of control for both is rated as low. Finally, there is no liability insurance or contingent asset.
When triggered, corrective controls vary the existing preventative controls to reduce the impact of the change in financial support on member's benefit security. These controls might include the employer providing additional contributions or contingent assets, or adopting a lower risk investment strategy, perhaps for a limited period. In Figure 1, there are no agreed corrective controls, and so the default position is that the funding arrangements would be reviewed at the next actuarial valuation.
External events can, of course, improve the level of financial support for a scheme, and so different preventative controls would be appropriate, depending on whether financial support was improving or deteriorating. Where it was improving, the controls might provide for a reduction in employer contributions, or a reduction in investment risk in order to 'protect' the gains.
Dealing with change
Taking the same example, suppose that the funding level at the next actuarial valuation had deteriorated from 67% to 61% and the covenant changed from moderate to weak. The trustees might press the employer for an increase in deficit contributions, but the employer may be unwilling to do so in its weakened financial position. In order to maintain an adequate level of benefit security, the trustees and the employer have agreed the revised set of controls seen above in Figure 2.
Deficit funding contributions are no greater than before, but there is now a higher level of prudence in the calculation of the liabilities and more investment hedging (in both cases low becomes moderate), and a low level contingent asset has been provided by the employer to bolster the covenant.
In addition, corrective controls have been introduced whereby the employer agrees to provide a low level of increase in contributions should the financial support deteriorate by a specified amount. A further low level control has been introduced, whereby the investment strategy is de-risked if the financial support improves.
The risk bow tie is a methodology that is widely used in the risk management community, and provides a simple visual summary of the risk management controls of a pension scheme. If widely adopted, it can facilitate discussions between trustees, employers, advisers and regulators and so help promote a common understanding of these complex issues. Maybe the time has come for the pensions industry to smarten up its act on IRM, and start wearing its bow ties!
Huw Davies is a senior associate at Mercer Limited