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The Pension Risk Management Framework

Journal 33: Technical Finance

Robert Gardner, Dawid Konotey-Ahulu, Ivan Soto-Wright

In recent years, the economic landscape for defined benefit (DB) pension schemes has evolved dramatically for the worse. Among the ongoing challenges are the continued weaknesses in equity markets, falling interest rates, inflation levels that persist despite a drop in economic activity, and ever-increasing life expectancy due to improving medical care, all of which have left pension schemes with large deficits. It is vital that pension schemes develop a framework to examine the assets and liabilities holistically and evaluate all of the risks that a scheme is facing, both together and separately. This paper will present Redington’s Pension Risk Management Framework (PRMF), an effective framework for trustees and sponsors to identify, measure, and understand risk and to respond to them effectively. The PRMF requires stakeholders to agree key objectives and constraints, ensures that these are realistic in light of the scheme’s risk budget, and provides clear “calls to action” when actual outcomes diverge from the planned path to full-funding.

If a man does not know what port he is steering for, no wind is favorable to him” – Seneca

Current climate for DB schemes
In a DB scheme the employer is legally required to pay the employee a pension as outlined by their contract. The amount is usually determined by the earnings of the individual, their length of service at the firm, and the age at which they retire. The majority of pensions are also linked to inflation [Demptser et al. (2009)]. This set-up renders the scheme’s sponsoring employer as the risk bearer, as they must absorb any difference between the value of the pension fund assets and pension entitlements. Liabilities that are significantly greater than assets not only endanger pensioners’ benefits but can also put a sponsor’s commercial viability and growth at risk.

In recent years, the fair market value of DB deficits has grown particularly quickly. This has come about as a result of several factors:

  • Falling equity markets, with the FTSE 100 and MSCI World indices down by 18.74 percent and 26.11 percent (as of September 30th, 2011), respectively since the beginning of 2007. In addition to the long-term downward trend, volatility has also increased sharply over the same period.
  • Declining long-term interest rates, with the 30-year U.K. gilt yield down to 3.55 percent (as of September 30th, 2011) from 4.21 percent at the start of 2007.
  • Resilient inflation expectations, with 30-year swap breakeven inflation at 3.54 percent (as of September 30th, 2011), up from 3.04 percent at the beginning of 2007.
  • Increasing longevity, with male (female) life expectancy at 65 up from 15.9 (19.0) years in 2000 to 17.6 (20.2) years in 2009.

As Figures 1 and 2, in this article, show, this has had a dramatic impact on the funding position of U.K. defined benefit schemes. Firstly, on an s179 basis,2 the aggregate funding ratio of the approximately 6500 schemes in the PPF universe has plunged from 121 percent in June 2007 to 83.1 percent in September 2011.3 Secondly, the recent equity market downturn and sharp decline in gilt yields has been particularly damaging. Between February 2011 and September 2011, the aggregate balance of PPF schemes has deteriorated from a surplus of £48.4bln to a deficit of £196.4bln. Finally, between July 2007 and September 2011, the aggregate balance of all FTSE100 company pension schemes has deteriorated from a surplus of around £30bln to a deficit of £36.3bln (measured on an accounting basis).

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