Charting a course to a lower risk future

Amy Kessler explains how to address longevity risk and market risk within an established budget

As markets recover and interest rates rise, defined benefit pension schemes are experiencing their first sustained recovery in the post-crisis era and their best opportunity in years to make progress toward a lower risk future. Whether a scheme is already on the path to taking risk off the table or still charting a course, best practices are emerging that address longevity risk alongside market risk within an established budget. Here’s how.

• Step 1 - Set a risk budget. Establish an acceptable level of potential loss that would keep pension contributions in the medium term affordable for the plan sponsor.
• Step 2 - Measure the current level of risk. Include both asset and liability risks in the analysis of potential loss. Estimate the increase in the pension deficit that would occur in a reasonable worst-case scenario (often measured at the 95th percentile in a fully stochastic stress of assets and liabilities).
• Step 3 - Chart a course toward a risk profile that matches the risk budget. Within the budget, establish priorities for the risks that are most likely to be rewarded, and trim the risks viewed as unrewarded (often duration, inflation and longevity risk). Many rewarded risks can be retained to the extent they are affordable.

In the US, UK, Canada and elsewhere, these emerging best practices are helping schemes take risk off the table as market conditions improve. This article examines the steps these market leaders are taking.

Step 1 – Set a risk budget.
Every plan sponsor has a different risk tolerance and a different situation with regard to the free cash flow available to make pension contributions. As a result, there are as many risk budgets as there are sponsors. In risk budgeting, potential losses should be limited so that, if a stress scenario emerges, the resulting pension contributions are affordable for the plan sponsor.

Step 2 – Measure the current level of risk…and don’t ignore longevity!

While increasing longevity is a very positive trend for people, longevity risk is a significant financial obligation that sponsors of defined benefit pension funds struggle to afford. Moreover, our gradual awareness of shifting life expectancy can increase pension liabilities very rapidly. For example, in the UK, the life expectancy of a 65 year old male has increased by more than five years in recent decades, while in the US, the same measure shows four years of improvement. With new pensioner mortality tables due to be released in the US this year, more sticker shock is on its way, and pension plan sponsors on both sides of the Atlantic are now coming to grips with the fact that longevity risk is moving their pension liabilities meaningfully higher with every passing year.

Some important changes are needed in the conventional approach to pension risk modelling in order to properly assess the potential financial impact of longevity risk. First, the longevity assumptions used in valuing pension liabilities must be brought current, particularly in the US and Canada, where market-accepted tables are dramatically out of date. Second, the uncertainty around today’s longevity projections must become a standard part of pension risk modelling, because risk managers need to consider how longevity risk interacts with all of their other risks and, in many cases, compounds them.

The fact that longevity risk can have a compound impact on other risks is intuitive. Stated simply, if plan participants live longer than expected, the liability will be larger than expected, and the pension scheme will face more interest rate risk, duration risk, inflation risk and other market risks than currently anticipated.

The fact that liability side risks compound each other leads to some important conclusions about risk modelling and risk management. It suggests that the current standard practice of leaving longevity risk out of pension risk analysis will lead to an underestimation of total risk. This underestimation of risk will be particularly acute for inflation-linked liabilities and deferred liabilities where their longer duration makes them significantly more sensitive to adverse outcomes. It also suggests that hedging and risk-transfer decisions must be made in the context of a fully stochastic analysis of all risks. Hedging and risk-transfer decisions made without a combined stochastic model that brings liability risks into the picture will consistently undervalue the benefits of risk management and risk-transfer strategies.

Step 3 – Allocate the risk budget and prioritise your risks.
Once a pension scheme defines its risk budget and measures the overall level of its potential losses, the focus often turns to the results of a detailed risk assessment and a breakdown of the individual risk exposures to credit, interest rates, equities, property, alternative assets, inflation and longevity, among others. This detailed assessment is a critical step in determining which risks to keep, which risks to manage, and which risks to shed.

From the point of the initial risk assessment, there are some key considerations in determining a risk-reduction strategy. First, the risk assessment clearly identifies the largest sources of risk, where the greatest impact of risk management can be achieved. However, charting a successful course to a lower risk future is never as simple as attacking the largest risks and trimming them back. Second, it is critically important to consider which risks the scheme believes are rewarded risks and which are unrewarded, and in order prioritise rewarded risk taking within the risk budget. Finally, the balance of risks is the key to an optimal outcome so that the scheme makes the most of the diversification benefit available in its portfolio of risks.

In the risk-reduction journey, we have seen several leading pension schemes establish the following core principles: First, before risk reduction, interest rate risk, inflation risk and longevity risk create a substantial amount of risk for the plan, but: a) these risks compound each other; b) each carries with it a lower expectation of returns than equity risk and investments in alternatives; and c) within the overall risk budget, prioritising rewarded over unrewarded risks is fundamental. Second, in reducing the overall level of risk, interest rate risk, inflation risk and longevity risk should be trimmed ahead of equity risk and investments in alternatives. Third, to make the most of the diversification benefit among the risks, no risk should be completely eliminated. Fourth, the liabilities matter, so younger plans with a lot of deferred and active participants will take more risk than mature plans that are primarily comprised of retirees.

For the market leaders pursuing these strategies, many are hedging away a substantial portion of their longevity risk and turning the hedged liability into a known and knowable future obligation. Their hedged liabilities can be managed alongside a lower risk, lower volatility asset portfolio that is often 25 per cent to 30 per cent in risk assets and 70 per cent to 75 per cent fixed income. Within the fixed income allocation, illiquid fixed income (such as private placement loans, commercial mortgages, inflation linked ground leases and other fixed income alternatives) can create yield while closely matching the liability.

Perhaps the most important thing to understand about the emerging best practices in pension risk budgeting and risk management is that they are all focused on creating a pension sustainability model. Pension schemes can create greater certainty that participant benefits can be met through budgeting and moderating risk and through hedging longevity. As markets recover, the time to chart a course to a lower risk future is now. The continued health of many companies and the retirement security of many pension plan participants will depend on it.

Written by Amy Kessler, senior vice president, head of longevity reinsurance, Prudential Financial

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