Amy Kessler explains how pension schemes can determine the ‘correct’ level of risk through risk budgeting

A key challenge has emerged for DB schemes in the post-crisis era. Many have lost confidence in the conventional wisdom of taking asset risk to minimise the overall contributions to the scheme in the long term. The key issues associated with this include: 1) the lack of focus on the liability and its risks; 2) the volatility; and 3) the risk of loss that can’t be overcome in the medium term.

Pension schemes need not walk today’s tightrope of too much risk. Risk budgeting is the first step on the way back to solid footing.

In managing the total risk exposure of a pension fund, potential losses can be budgeted so that their impact on required pension contri-butions in the medium term is affordable for the plan sponsor.

To bring our objective forward into risk practice, it is important to be specific and define each element.

• ‘Potential losses’ refer to the loss in funded status in a reasonable worst case (95th percentile) scenario that takes into consideration asset risks, liability risks and diversification benefits. We are focused on funded status at risk because this is the amount the plan sponsor would need to contribute in cash to overcome these potential losses.

• ‘Budgeting the impact on required pension contributions’ refers to managing the pension fund’s asset and liability risks to try to keep potential losses below a specific level. Again, the plan sponsor may have to make contributions of cash to overcome these potential losses and it is the potential cash contributions that need to be budgeted and affordable in order to ensure sustainability.

• ‘Medium term’ refers to the plan sponsor’s reasonable time horizon for recovery from market disruption. In some circumstances, the reasonable time horizon will be driven by regulation.

•‘Affordable for the plan sponsor’ will have a different meaning for every sponsor. In tailoring the definition of ‘affordability’ to each unique obligor, we recognise that public pension plans will need to control the impact of potential losses to ensure the loss is affordable in terms of the sponsor’s debt burden or future tax burden. In contrast, corporate plan sponsors will need to control the impact of potential losses to ensure the loss is affordable in terms of their debt burden, considered alongside such other factors as shareholders’ equity and free cash flow.

Credit and equity analysts are increasingly aware of the super-senior nature of unfunded pension liabilities, which are debt of the plan sponsor and which come ahead of any other debt or equity.

For corporate plans, losses in the pension fund that increase the company’s debt burden also reduce its shareholders’ equity because the increase in net effective debt does not create any investment in the enterprise nor any earning power for the firm. To the extent that pension losses trigger a requirement to contribute cash to the pension fund, a corporation’s free cash flow can also be severely impacted by pension risk. As a result, we see companies with limited free cash flow taking the lead in pension de-risking to minimise potential cash calls and ensure more consistent financial results within their industry peer groups.

For public plans, losses in the pension fund may increase the sponsor’s required contributions and create pressure on tax revenues or, where tax revenues can’t be raised, the pension contributions may displace needed public services. Would the potential losses and resulting contributions cause tax rates to rise substantially? Would tax revenues need to be diverted from public services? Would the municipal entity be downgraded?

On the path to a more stable future, risk budgeting is the first step. The financial health of many plan sponsors and the retirement security of many real people depends on it!

Amy Kessler is Senior Vice President, Head of Longevity Reinsurance, Prudential Retirement, Prudential Financial, Inc

Prudential Financial, Inc. of the United States is not affiliated with Prudential plc which is headquartered in the United Kingdom.

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