Sustaining DB schemes

Amy Kessler explains how risk budgeting and longevity insurance are strategies that help to create sustainable defined benefit pension funds

In the aftermath of the financial crisis, the conventional approach to managing defined benefit pension schemes has been placed under the microscope.

In the face of extreme losses, many schemes have closed and stopped accruing benefits for new or existing members. Closing a scheme, however, only stems the growth in the pension risk – it does nothing to manage the risk the scheme already has. As such, in the wake of unprecedented losses and with a new appreciation for longevity risk, open and closed defined benefit pension plans in the UK, the Netherlands, the US, Canada, Switzerland and other countries continue to search for a new paradigm that manages some key areas of risk.

• Investment risk is the risk that asset performance falls short of expected returns. Twice in the last 12 years, plans that maintain a high allocation to risky assets have incurred losses severe enough to overwhelm the financial wherewithal of many scheme sponsors.

• Longevity risk is the risk that scheme participants and eligible dependants live longer than expected. While longer life is a welcome development, it is also a significant financial obligation for pension scheme sponsors, particularly in instances where the retirement age has remained the same for decades.

• Inter-generational risk is the risk that current employees contributing to a pension scheme will support current retirees at the expense of securing their own future retirement benefits. In most open schemes, the number of retired participants is rising much more quickly than the number of working age people contributing to the scheme, raising questions about sustainability and fairness, particularly where pension deficits are acute, the credit quality of the scheme sponsor is weak and life expectancy is underestimated.

Current employees who contribute to such schemes are exposed to the risk that the scheme sponsor can’t fulfill its future obligations to them.

In today’s low rate and low growth environment, these risks are particularly daunting and the failure to manage them is behind today’s growing funding gap for defined benefit pension schemes. Going forward, the key question is how to develop the strategies and solutions that will help pension funds regain and maintain a path toward a stable and sustainable future.

This ‘DB pension sustainability model’ may involve combining techniques that already exist to achieve more predictable outcomes and manage risk within the plan sponsor’s financial wherewithal to absorb losses. Thought leaders in the pension industry are working to develop approaches to a DB pension sustainability model, which must address investment risk, longevity risk and intergenerational risk.

The goal is to create a new paradigm for defined benefit pension risk that draws from the best available practices in risk budgeting, asset management and insurance. One possible approach would include the following components.

• Risk budgeting involves measuring the key sources of risk that a pension scheme has in order to quantify potential losses, identify areas where risks compound each other and establish a targeted level of potential risk of loss from which the plan and its sponsor could recover over the medium term.

• A sustainable asset management approach is the next step. With its risk budget in place, a pension scheme can chart a course for a lower risk future, shedding the risks it views as unrewarded (such as interest rate risk) and creating opportunity to take risk it views as rewarded risk (such as credit and exposure to equities) all within a prudent risk budget. The overall goal is a lower risk, lower volatility portfolio that creates a stable base for risk management. As asset management choices are made, a key paradigm shift must take place, bringing the liabilities squarely into the equation.

• Toward that end, longevity insurance can be used to cover the pension fund’s most significant demographic risk and achieve three key objectives:

1. to create a known and knowable future obligation and ease the challenge of managing assets against unknown future cash flows;

2. to protect the solvency of the pension fund, the sponsor and the promises made to plan participants in the event of unexpected longevity; and

3. to addresses the impact of inter-generational risk on current employees in the event of increasing obligations to retirees.

These strategies must go hand in hand with the ability to increase retirement age as healthy life expectancy extends. We believe that this approach could put pension funds on a path to a more sustainable future.

The key challenge for pension funds today lies in rethinking their risk. As long-term investors, the conventional wisdom was always that pension funds should take asset risk and so investing in equities, private equity, real estate, hedge funds, commodities and other asset classes has become the norm. However, for most scheme sponsors, the value of the risky assets fluctuates in ways that bear no relation to the liabilities. The conventional strategy was designed to minimise overall contributions to the pension scheme by investing to retain liquidity premiums, earn risk premiums and maximise diversification benefit. In carrying out this strategy, most pension funds have hoped to earn enough return to outrun increasing life expectancy and offer generous pension benefits with affordable contributions.

Today, the challenge is to modify the conventional strategy to mode-rate the role of risk. In the new paradigm, the role of risk must be more carefully harnessed.

• Potential losses must be budgeted so that their impact on required pension contributions in the medium term is affordable for the scheme sponsor.
• Within the overall risk budget, pension schemes should still retain liquidity premiums, earn risk premia, maximise diversification benefit and seek to minimise overall contributions.

The key change is that all of these activities would be limited and controlled within a risk budget that is made to measure for each pension fund and that takes into consideration the credit quality and financial wherewithal of the plan sponsor to absorb potential losses.

To succeed, the DB pension sustainability model must enhance retirement security for scheme participants, include a safety net for disabled workers to retire early and be flexible enough to adapt to the risk tolerance of scheme sponsors of varied size, credit quality and sophistication.

We look forward to a vibrant discussion of these ideas as the pension industry helps individuals and institutions prepare for a longer retirement.

Amy Kessler is a Senior Vice President and the Head of Longevity Reinsurance at Prudential Retirement in the United States

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

©2013 Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc., and its related entities, registered in many jurisdictions worldwide. 0243946-00001-00

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