A broader perspective on risk for defined benefit schemes
"Trustees should... put in place appropriate policies to mitigate and manage all the key risks [schemes face]... The risks broadly fall into three categories: employer covenant related, investment related [and] funding related risks"
Source: TPR’s new DB funding code.
The above quote is one of the asks for UK defined benefit pension schemes as set out in the Pension Regulator's new Code of Practice.
But with improved funding levels, less reliance on employer contributions, and generally lower levels of investment risk being targeted, outcomes will no longer be dominated by the asset side of the equation. Instead, the liability side and funding-related risks will now need to play a more prominent role in decision-making, risk management, and thus scheme outcomes than they generally have in the past.
As such, these risks need to be integrated and managed by trustees and their advisors, and neglecting to take them into account could lead to:
Higher returns with lower risk is the dream for many making decisions on how to invest assets — and, in the main, is not an achievable goal (without other sacrifices, or a material change in approach).
However, defined benefit pension schemes differ from those simply looking to maximise return, and minimise investment risk, as they are also exposed to funding-related risks as set out above. Critically, this means their overall risk is not solely a function of how much risk is taken in their investment portfolio.
In isolation, targeting a lower investment return has a diminishing marginal impact in reducing overall risk — as funding-related risks become a bigger contributor to overall risk. This is shown in Figure 1.
Many of the risks faced by pension schemes cannot be reduced by targeting a lower investment return alone – for example, the risk that a new government will change the tax rules, that positive medical advancements increase life expectancy, or that deflation plays havoc with liability hedging programmes interacting with a 0% inflation floor in scheme benefit structures.
The impact of this is that, over the long term, running a very low level of investment return significantly increases the chance of a pension scheme underperforming its liabilities — as shown in Figure 2.
Instead, targeting a more meaningful level of return builds a buffer to help protect against negative funding risk outcomes — and increases the chances of pensions being paid in full. Insurers learned this lesson a long time ago and bulk-annuity providers typically target returns in the Gilts+1%-to-Gilts+2% pa range, both to generate a buffer and earn a profit.
Risk can be reduced further with sensible strategies for mitigating/managing these funding-related risks — further reducing the chance of underperformance.
For example: The risk of scheme members living longer can be effectively managed with longevity swaps; member options can be managed by appropriate alignment between the investment strategy and the terms set for these options; mismatches between liabilities and inflation hedging strategies can be reduced with good governance.
Running a well-funded pension scheme can be very ‘low risk’ but, somewhat counterintuitively, to achieve this it should avoid being very ‘low return’. However, many pension schemes, including those looking to run-on, will have reduced return in a meaningful way over recent years. That means the overall level of returns targeted may be too low to adequately achieve their aims while supporting the effective management of funding-related risks. This presents the opportunity for pension schemes to simultaneously ‘re-return’ and 'derisk’. However, to do this successfully needs true integrated risk management and partnership with advisors who have the experience, and know how, to effectively bring Investment and funding-related risks together.
