Skip to main content
The Actuary: The magazine of the Institute and Faculty of Actuaries - return to the homepage Logo of The Actuary website
  • Search
  • Visit The Actuary Magazine on Facebook
  • Visit The Actuary Magazine on LinkedIn
  • Visit @TheActuaryMag on Twitter
Visit the website of the Institute and Faculty of Actuaries Logo of the Institute and Faculty of Actuaries

Main navigation

  • News
  • Features
    • General Features
    • Interviews
    • Students
    • Opinion
  • Topics
  • Knowledge
    • Business Skills
    • Careers
    • Events
    • Predictions by The Actuary
    • Whitepapers
    • Moody's - Climate Risk Insurers series
    • Webinars
    • Podcasts
  • Jobs
  • IFoA
    • CEO Comment
    • IFoA News
    • People & Social News
    • President Comment
  • Archive
Quick links:
  • Home
  • The Actuary Issues
  • May 2016
05

Taming pension risk

Open-access content Tuesday 3rd May 2016 — updated 2.44pm, Friday 15th May 2020

Dan Mikulskis examines how changes in asset allocation have affected risk levels in UK pension schemes over the past decade and suggests what needs to be done in the future

2

—


The past 10 years have been a uniquely challenging, volatile and uncertain period for UK defined benefit pension schemes. How well have they weathered the storm? We found out by analysing data published by the Pension Protection Fund (PPF) in its annual Pensions Universe Risk Profile or 'Purple Book', plus other industry-wide data from leading sources.

The asset side of the story, viewed in isolation, seems positive. Total assets have grown from £770bn in 2006 to £1,254bn in 2015, an average increase of around 5% per year, albeit a very significant proportion, possibly 25-45% of the increase, has come from contributions. Over a period that includes several crises, the asset value has had a relatively low volatility (or standard deviation) of about 5% per year.

Total liabilities have grown even faster though, at an average rate of around 7% per year. The increase is from £790bn in 2006 to £1,516bn in 2015 on the PPF's measure (which, for most schemes, caps benefits and pension increases), or from around £1trn to just under £2trn based on full benefits.
Furthermore, the volatility has been about 14% per year, almost three times that of the assets - largely a consequence of plunging yields on British government bonds or 'gilts', which are used as a benchmark for valuing the liabilities.

Asset allocation has changed in two main respects. Firstly, there has been a move away from equities - from 61% in 2006 to 33% in 2015 (see Figure 1 below) - in particular, a reduction
in UK equities. A slightly different dataset published by UBS shows allocations to equities of over 80% in the 1990s, so the past decade is part of a continuing trend.

As discussed later, this has reduced the level of risk, but it has also reduced the expected future investment returns in excess of the liabilities, by around one-third over the decade. The second trend is an increase in the amount of liability hedging.

When long dated interest rates fall or inflation rises, the value of liabilities increases relative to the assets. This can be hedged by investing in matching bonds, but also by entering into derivative transactions with similar economic properties to bonds.

From a risk perspective, the key statistic is the hedge ratio, which estimates the proportion of liabilities that are effectively hedged (or immunised) against movements in interest rates or inflation. Using data published by KPMG in its annual Liability Driven Investment (LDI) Survey, we estimate that the average hedge ratio has increased over the past 10 years from 15% to around 33%.

At an aggregate level, there have been small second-order changes in asset allocation relating to a greater use of hedge funds and other assets, albeit a more pronounced feature in some individual schemes, and fluctuating levels of cash. Holdings in property of around 5% in aggregate are a fairly constant feature.

Figure 1

 
Risk change - a conflicting story
To gain insight into the de-risking effect of these asset allocation changes, we ran the data through our pension risk model. Figure 2 (below) measures risk in relative terms, showing the possible change in funding ratio of assets to liabilities at a given confidence level, often called funding ratio at risk (FRaR) and measured in percentage terms, which is useful to trustees in quantifying how benefit coverage could be affected in an adverse period.

In 2006/07, pension schemes were running an average FRaR of 20%, meaning they had a
one in 20 probability of suffering a funding ratio fall of 20% or more over one year.

As expected, it can be seen that the asset allocation changes implied by the aggregate data (a reduction in equities and an increase in liability hedging) have been risk-reducing, with the FRaR having decreased to about 10% by 2015.

These risk levels may seem large, but, to put them into perspective, over the decade funding levels have twice fallen by more than 20% in a one-year period (according to the PPF's data) - once in the year to April 2009 at the lows of the financial crisis, and once in the year to May 2012 as bond yields fell.

Figure 3 (below) measures risk in another way, in absolute monetary terms, showing the possible change in funding deficit or surplus at a given confidence level, often referred to as value at risk or VaR.
This is often helpful to corporate sponsors in indicating how much the pension scheme could affect their balance sheets.

In 2006, the aggregate VaR was around £300bn, meaning they had a one in 20 probability of suffering a combined increase in funding deficit of £300bn or more over one year (this is based on full benefits rather than the lower PPF measure).

While the VaR is influenced by similar factors to the FRaR, it is also affected by the size of the pension schemes. The overall increase in size of the assets and liabilities overwhelms the de-risking described earlier, resulting in an increase in VaR to £450bn in 2015. Again, putting these figures into perspective, there was one annual period (the year to May 2012) where the combined deficit increased by more than £300bn.

Figure 2
Figure 3 NEW


Efficient risk reduction
Will the current asset allocation deliver the returns that pension schemes need to be fully funded? We cannot tell from the aggregate data, as each individual pension scheme has its own specific circumstances, such as funding and investment strategy. We can say that, on average, while funding ratio risks are lower today than in 2006, so are the expected future investment returns.

Many pension schemes want to continue to reduce risk. After all, the risk to the funding ratio described earlier, of 10% over one year, is still substantial in the eyes of the majority of schemes and corporate sponsors. However, they need to generate the same, or increased, investment returns to close their deficits over the next 15 or 20 years.

The solution is to stop viewing investments in terms of fixed buckets of 'growth' or 'matching' assets and embrace modern-day liability management techniques. This includes the use of derivatives to reduce liability-related risks without needing to invest the majority of the portfolio in bonds, thereby enabling the scheme to invest the remainder in a range of return-seeking assets.
Using the principles of diversification, risk control and downside protection, schemes can generate returns more efficiently - that is, for less risk - than has been achieved previously.


Dan Mikulskis is managing director and co-head of asset liability management and investment strategy at Redington Ltd
This article appeared in our May 2016 issue of The Actuary .
Click here to view this issue

You may also be interested in...

2

Pension freedom - is it enough?

Derek Steeden, Sally Rayment and Francis Chua suggest that inclusive projections will help people understand how their actions and ‘non-pension’ income streams will affect their standard of retirement
Tuesday 3rd May 2016
Open-access content
2

Women less engaged with pension planning

Women are far less likely to review their pension investments or even know their expected income at retirement, according to research.
Friday 6th May 2016
Open-access content
ta filler

Four in 10 employers to consider lifetime ISAs

Some 42% of UK employers are considering introducing a lifetime ISA (LISA) into their remuneration package, according to research by Sackers.
Monday 9th May 2016
Open-access content
2

UK government launches website to help track £400m lost pensions

The Department for Work and Pensions (DWP) has launched a new website to help people locate their lost retirement savings.
Wednesday 11th May 2016
Open-access content
2

Master trusts a 'potential risk' for auto-enrolment, MPs warn

Master trusts pension schemes could undermine the success of auto-enrolment, according to the Work and Pensions Committee.
Monday 16th May 2016
Open-access content
2

Marks & Spencer to close defined benefit scheme for future service accruals

Retailer Marks & Spencer is to close its UK defined benefit pension scheme for future service accrual, it has said in its 2015-16 annual results. The scheme has been closed to new members since 2002.
Friday 27th May 2016
Open-access content

Latest from Pensions

ers

By halves

Reducing the pensions gap between men and women is a work in progress – and there’s still a long way to go, with women retiring on 50% less than men, says Alexandra Miles
Thursday 2nd March 2023
Open-access content
rdth

Make My Money Matter's Tony Burdon on the practical power of sustainable pensions

Years working in international development showed Tony Burdon, head of Make My Money Matter, that sustainable pensions can harness trillions of pounds to build a better world – at a scale governments and charities can’t. He talks to Travis Elsum
Wednesday 1st March 2023
Open-access content
KV

Liability-driven investments: new landscape

What now for liability-driven investments, after last year’s crash in the market? Pensions experts Rakesh Girdharlal and Moiz Khan say it should lead to a more balanced approach
Wednesday 1st February 2023
Open-access content

Latest from Homepage slider

web_p16_Craig_DSC_7231

Interview: Craig Turnbull

Craig Turnbull has held senior industry positions in global consulting, software and asset management businesses, and has particular interest and experience in risk, capital, valuation and investment.
Wednesday 5th February 2020
Open-access content
2

A fairer outcome

Dr Ian Sharpe discusses the Pensions Advisory Groups guide to good practice in the area of pensions on divorce
Thursday 5th December 2019
Open-access content
Screen Shot 2020-05-07 at 11.40.34.png

For what it's worth

Tiffany Honour of the Current Pensions Review Working Party asks: are cash equivalent transfer values being set at the right level?
Tuesday 5th November 2019
Open-access content

Latest from May 2016

FCA warns over 55s against investment scams

The Financial Conduct Authority (FCA) has warned older people to take care when chasing higher rates of return on their savings through dubious investments.
Friday 27th May 2016
Open-access content
brexit

Brexit could be a game-changer for asset risk

Risk exposures would change radically if the UK were to leave the European Union because larger companies’ earnings from the EU far outweigh those from the UK.That warning has come from Old Mutual Asset Management in its report Brexit: An Analysis of Economic Exposure.
Friday 27th May 2016
Open-access content
2

Survey shows personal investors in favour of Brexit

Independent UK retail stockbroker Share Centre says its customers still favour leaving the European Union but by a narrower margin than they did in February, its latest customer survey found.
Friday 27th May 2016
Open-access content

Latest from small_opening_image

2

COVID-19 forum for actuaries launched

A forum for actuaries has been launched to help the profession come together and learn how best to respond to the deadly coronavirus sweeping the world.
Wednesday 25th March 2020
Open-access content
2

Travel insurers expect record payouts this year

UK travel insurers expect to pay a record £275m to customers this year as coronavirus grounds flights across the world, the Association of British Insurers (ABI) has revealed.
Wednesday 25th March 2020
Open-access content
2

Grim economic forecasts made as countries lockdown

A sharp recession is imminent in the vast majority of developed and emerging economies as the deadly coronavirus forces businesses to shut down across the world.
Tuesday 24th March 2020
Open-access content

Latest from 05

Alternative longevity insurance

Caspar Young explains why longevity insurance transactions using a third-party segregated account cell company are more cost effective for a wider range of pension schemes than traditional approaches
Wednesday 18th May 2016
Open-access content
2

The growth marches on

Is the increasing use of medical underwriting in bulk annuity pricing now inevitable? Costas Yiasoumi examines how MUBAs have affected the pensions industry
Wednesday 4th May 2016
Open-access content
Micro

Hidden complexities

In the context of historically low interest rates and Solvency II, Richard Silveira discusses the challenges in developing ESG software to value liabilities and hedge interest rate exposure
Wednesday 4th May 2016
Open-access content
Share
  • Twitter
  • Facebook
  • Linked in
  • Mail
  • Print

Latest Jobs

Exposure Management Analyst

London, England
£40000 - £50000 per annum
Reference
148639

Pricing - Casualty Actuary

London (Central)
£128K + bonus + benefits
Reference
148638

Reporting Contractor

Negotiable
Reference
148636
See all jobs »
 
 
 
 

Sign up to our newsletter

News, jobs and updates

Sign up

Subscribe to The Actuary

Receive the print edition straight to your door

Subscribe
Spread-iPad-slantB-june.png

Topics

  • Data Science
  • Investment
  • Risk & ERM
  • Pensions
  • Environment
  • Soft skills
  • General Insurance
  • Regulation Standards
  • Health care
  • Technology
  • Reinsurance
  • Global
  • Life insurance
​
FOLLOW US
The Actuary on LinkedIn
@TheActuaryMag on Twitter
Facebook: The Actuary Magazine
CONTACT US
The Actuary
Tel: (+44) 020 7880 6200
​

IFoA

About IFoA
Become an actuary
IFoA Events
About membership

Information

Privacy Policy
Terms & Conditions
Cookie Policy
Think Green

Get in touch

Contact us
Advertise with us
Subscribe to The Actuary Magazine
Contribute

The Actuary Jobs

Actuarial job search
Pensions jobs
General insurance jobs
Solvency II jobs

© 2023 The Actuary. The Actuary is published on behalf of the Institute and Faculty of Actuaries by Redactive Publishing Limited. All rights reserved. Reproduction of any part is not allowed without written permission.

Redactive Media Group Ltd, 71-75 Shelton Street, London WC2H 9JQ