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JournalThe Capco Institute Journal of Financial Transformation
#33
Technical Finance
Recipient of the Apex Awards for Publication Excellence 2002-2011
12.2011
Journal
Article
Journal 33
Robert Gardner
Dawid Konotey-Ahulu
van Soto-Wright
The Pension Risk
Management Framework
2
Layout, production and coordination: Cypres – Daniel Brandt, Kris Van de Vijver and
Pieter Vereertbrugghen
Graphic design: Buro Proper – Bob Goor
Photographs: Bart Heynen
© 2011 The Capital Markets Company, N.V.
All rights reserved. This journal may not be duplicated in any way without the express
written consent of the publisher except in the form of brief excerpts or quotations
for review purposes. Making copies of this journal or any portion there of for any
purpose other than your own is a violation of copyright law.
Editor
Shahin Shojai, Global Head of Strategic Research, Capco
Advisory Editors
Cornel Bender, Partner, Capco
Christopher Hamilton, Partner, Capco
Nick Jackson, Partner, Capco
Editorial Board
Franklin Allen, Nippon Life Professor of Finance, The Wharton School,
University of Pennsylvania
Joe Anastasio, Partner, Capco
Philippe d’Arvisenet, Group Chief Economist, BNP Paribas
Rudi Bogni, former Chief Executive Officer, UBS Private Banking
Bruno Bonati, Strategic Consultant, Bruno Bonati Consulting
David Clark, NED on the board of financial institutions and a former senior
advisor to the FSA
Géry Daeninck, former CEO, Robeco
Stephen C. Daffron, Global Head, Operations, Institutional Trading & Investment
Banking, Morgan Stanley
Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance,
Graduate School of Business, University of Chicago
Elroy Dimson, BGI Professor of Investment Management, London Business School
Nicholas Economides, Professor of Economics, Leonard N. Stern School of
Business, New York University
Michael Enthoven, Former Chief Executive Officer, NIBC Bank N.V.
José Luis Escrivá, Group Chief Economist, Grupo BBVA
George Feiger, Executive Vice President and Head of Wealth Management,
Zions Bancorporation
Gregorio de Felice, Group Chief Economist, Banca Intesa
Hans Geiger, Professor of Banking, Swiss Banking Institute, University of Zurich
Peter Gomber, Full Professor, Chair of e-Finance, Goethe University Frankfurt
Wilfried Hauck, Chief Executive Officer, Allianz Dresdner Asset Management
International GmbH
Michael D. Hayford, Corporate Executive Vice President, Chief Financial Officer, FIS
Pierre Hillion, de Picciotto Chaired Professor of Alternative Investments and
Shell Professor of Finance, INSEAD
Thomas Kloet, Chief Executive Officer, TMX Group Inc.
Mitchel Lenson, former Group Head of IT and Operations, Deutsche Bank Group
Donald A. Marchand, Professor of Strategy and Information Management,
IMD and Chairman and President of enterpriseIQ®
Colin Mayer, Peter Moores Dean, Saïd Business School, Oxford University
John Owen, Chief Operating Officer, Matrix Group
Steve Perry, Executive Vice President, Visa Europe
Derek Sach, Managing Director, Specialized Lending Services, The Royal Bank
of Scotland
ManMohan S. Sodhi, Professor in Operations & Supply Chain Management,
Cass Business School, City University London
John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund
Graham Vickery, Head of Information Economy Unit, OECD
Individual Selected Article from Journal 32
JournalThe Capco Institute Journal of Financial Transformation
157
PART 2
The Pension Risk
Management
Framework
Abstract
In recent years, the economic landscape for defined ben-
efit (DB) pension schemes has evolved dramatically for the
worse. Among the ongoing challenges are the continued
weaknesses in equity markets, falling interest rates, infla-
tion levels that persist despite a drop in economic activity,
and ever-increasing life expectancy due to improving medi-
cal 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 under-
stand risk and to respond to them effectively. The PRMF re-
quires 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 out-
comes diverge from the planned path to full-funding.
Robert Gardner — Co-CEO, Redington
Dawid Konotey-Ahulu — Co-CEO, Redington
Ivan Soto-Wright — Analyst, Redington
158
“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 em-
ployer 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 show, this has had a dramatic impact on the fund-
ing 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 Feb-
ruary 2011 and September 2011, the aggregate balance of PPF schemes
has deteriorated from a surplus of £48.4bln to a deficit of £196.4bln. Fi-
nally, 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).4
Renewed importance for risk management
In this environment, effective risk management is ever more important
for trustees and sponsors. Those responsible for managing assets and li-
abilities of pension schemes need to use the most robust and informative
analytic models and the most effective risk management strategies to
cope with volatile financial markets, address rising deficits, and take ad-
vantage of investment opportunities.
In DB pension schemes, risk management involves the measurement and
assessment of pension fund risks and the design, monitoring, and revi-
sion of the fund’s investment strategy, asset allocation, and performance
benchmarks to meet the requirements of both pension scheme members
and sponsor. A risk management framework should seek to minimize
sponsor contributions as far as this is possible as well as minimizing
the risk of benefit cuts to beneficiaries. These goals require trade-offs to
be made between contributions, asset allocation, and risk as the objec-
tives of different stakeholders vary. Risk management also needs to take
into account the sponsor covenant which ultimately supports the deficit.
However, if the scheme becomes materially underfunded and starts to
divert cash this in turn could undermine the sponsor covenant.
The Pension Risk Management Framework (PRMF)
Most sponsors and trustees were not prepared for the recent financial
market turmoil both in 2008 and more recently in August and Septem-
ber 2011. They have differing and sometimes conflicting concerns and
1 An index of all U.K. pension schemes required to pay the PPF levy. In return, the PPF
provides compensation to scheme members should the sponsor become insolvent.
2 A pension liability valuation methodology used for calculating the PPF levy, it uses highly
conservative assumptions regarding yields, inflation, and longevity.
3 Pension Protection Fund. PPF7800 Index. http://www.pensionprotectionfund.org.uk/
DocumentLibrary/Documents/PPF_7800_september_11.pdf.
4 AON Hewitt Pension Risk Tracker. https://rfmtools.hewitt.com/PensionRiskTracker/.
70
80
90
100
110
120
130
-250
-200
-150
-100
-50
0
50
100
150
200
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
%
£ billion
Aggregate Balance (LHS) Funding Ratio (RHS)
Source: Pension Protection Fund 7800 Index
1
, Redington
Figure 1 – Estimated aggregate balance (assets less liabilities) and
funding ratio of PPF-eligible schemes
159
The Capco Institute Journal of Financial Transformation
The Pension Risk Management Framework
objectives. The board of trustees is responsible for “ensuring that the
pension scheme is run properly and that the members’ benefits are se-
cure.” They are also required to “act in the best interest of the scheme
beneficiaries” [The Pensions Regulator (2011)]. Trustees must ensure that
the pension fund is able to make payments on time and in full to mem-
bers who reach retirement age, and ensure that there is a strong covenant
backing the scheme. Additionally, scheme sponsors are obliged to make
contributions as necessary to ensure that schemes have sufficient assets
to meet their liabilities. The scheme sponsor, however, faces a dilemma
as diverting funds to the pension scheme that could have been used
to invest in and expand the business has potential consequences for
the long-term growth and profitability of the company. Consequently, the
scheme sponsor generally seeks to minimize the contributions it makes
to the pension scheme. The scheme sponsor must collaborate with the
board of trustees to determine an acceptable level of contributions over
an acceptable timeline.
The PRMF provides a framework for stakeholders to understand and
agree key objectives and constraints, and helps put in place the right
governance structure so that trustees can make quick and effective
decisions in response to both market turbulence and opportunities. The
PRMF ensures that the objectives chosen are realistic and provides con-
sistent metrics to assess progress towards these goals. By measuring
liabilities in a market consistent manner, the scheme is better placed to
exploit opportunities to achieve these goals. Moreover, the PRMF pro-
vides stakeholders with clear “calls to action” when actual outcomes
diverge from the scheme’s objectives. In tandem, these features enable
the scheme to chart the most efficient path to its ultimate objective of
full-funding.
Formally, the PRMF serves three purposes: to identify and set objectives
and constraints; to monitor the pension scheme’s progress towards ob-
jectives; and to respond to changes.
Setting and defining objectives
The first step of the framework is to establish clear objectives. It is vital
for stakeholders to identify and define a set of objectives which are tai-
lored to the specific funding, contribution schedule, and recovery period
of the scheme. The PRMF should encompass an overall objective, risk
targets, aspirations, and constraints.
-80
-60
-40
-20
0
20
40
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
1
3
4
2
Source: Aon Hewitt Pension Risk Tracker, Redington
Points on the chart refer to
1 15/09/2008 Lehman Brothers collapse FTSE 100
30yr gilt
30yr inflation
5,204
4.44%
3.87%
2 03/03/2009 FTSE reaches 4-year low FTSE 100
30yr gilt
30yr inflation
3,512
4.32%
3.55%
3 27/08/2010 Bernanke alludes to QE2 FTSE 100
30yr gilt
30yr inflation
5,201
3.87%
3.50%
4 30/09/2011 Where we are today FTSE 100
30yr gilt
30yr inflation
5,102
3.55%
3.54%
Source: Bloomberg, Redington
Figure 2 – Cumulative surplus/deficit (£ Billions) of all FTSE 100 pension
schemes on accounting basis
Overall objective Risk targets
Aspirational
targets
Scheme
constraints
Objective Trigger Performance indicators
What is the overall
objective?
Full funding on self-
sufficiency basis
By 2020 on a swaps
+ [50]bps basis with
contributions of £[25]m p.a.
How will we measure the
objective?
Required return on the
scheme’s assets
Required return of assets is
swaps + [160]bps
What are the primary risk
targets?
Required return at risk
(RRaR)
Contributions at risk (CaR)
RRaR < swaps +[200]bps
CaR should be kept below
£[50]m
What is the secondary
risk target?
Value at Risk (VaR) VaR should not exceed
[20]% of the liabilities
What are the primary
aspirational targets?
To be fully inflation and
interest rate hedged
Hedge ratios should be
equal to [100%]
What are the secondary
aspirational targets?
Increase efficiency of
hedges by earning more
return for same risk
Regular monitoring of
relative value of swaps
vs. gilts
What is the primary
scheme constraint?
Liquidity Sufficient liquidity to make
pension payments
What is the secondary
scheme constraint?
Collateral requirements Enough available collateral
to cover the 1-year
derivative [VaR95]
Source: Redington
Figure 3 – Example PRMF
160
The overall objective5
shared by most trustees and sponsors is “a fully
funded scheme.” However, the funding basis used to determine liabili-
ties and time horizon over which to achieve fully-funded status will differ
based on the respective interests and limitations of trustees and sponsor.
Covenant strength and pension entitlements will determine the capacity
for the sponsor to allocate contributions and, consequently, the funding
basis and time horizon. Articulating an overall goal clearly and succinctly
before an investment strategy is implemented significantly improves the
probability of a favorable outcome. The subsequent section on measuring
risk provides an overview of the key risk metrics that might be employed
for understanding and reviewing risk targets and the scheme’s perfor-
mance against them. Setting these parameters ensures that a pension
scheme has an overall funding and investment benchmark by which to
gauge the risk associated with different asset allocations and to identify
and the ability and agility to take advantage of investment opportunities.
Aspirational objectives are those that the scheme would like to achieve
but which are secondary to its primary goals. However, the PRMF pro-
vides a framework for achieving these should market opportunities make
this possible. Aspirational objectives take into consideration the impact of
volatile market conditions that could increase deficits and thereby affect
the required returns to reach full funding. These conditions might include
an instantaneous shock to interest rates, inflation expectations, or equity
market valuations. For example, an aspirational target might be to increase
the interest rate and inflation hedge ratio to equal the funding ratio, as this
stabilizes funding level volatility with respect to interest rates and inflation.
The constraints are limits that a scheme cannot breach whilst pursuing its
path to full funding. A primary constraint that a scheme faces is liquidity.
The pension fund must hold cash and readily realizable assets in order
to pay out members of the scheme. A secondary scheme constraint is
the collateral requirement. A pension fund must also hold sufficient and
eligible collateral to meet potential collateral calls on derivative contracts,
such as interest rate and inflation swaps. This constraint will require
greater focus with the introduction of central clearing and CRDIV in 2013.
Ultimately, the PRMF enables pension scheme stakeholders to act with
the agility, control, and transparency to realize their objectives.
The “Flight Plan”
Once the trustees and sponsor have outlined and defined the overall
objective, risk targets, aspirations, and constraints, they can begin with
designing their scheme’s “Flight Plan.” The Flight Plan projects the future
path of the assets and liabilities needed to achieve the long-term funding
objective (Figure 4). Building a Flight Plan requires three key variables: (i)
the cash contribution schedule, (ii) the target date to reach full funding,
and (iii) the required rate of return needed by the assets. Note that the
Flight Plan is constrained by both the trustee and sponsor’s risk appe-
tite, which might be expressed as funding ratio at risk, or contributions
at risk. An earlier target date for full funding (and thus higher required
return) might mean taking more risk than the scheme feels comfortable
with. Ultimately, the Flight Plan assumes that the deficit will be funded
through a combination of investment returns and sponsor contributions.
Note the length of the recovery plan is limited by the long-term viability
of the sponsor.
Both sponsors and trustees have a mutual interest in managing the abso-
lute deficit volatility and/or funding ratio and reducing the long-term de-
pendence on the sponsor. Trustees wish to minimize covenant risk and
to ensure benefit payments to the scheme’s members. Consequently,
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
GBP millions
Liabilities path Actual liabilities Assets path Actual assets
Source: Redington
Figure 4 – Example “Flight Plan”
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
2009
2010
2011
2012
2013
2013
2014
2015
2016
2017
2018
2018
2019
2020
2021
2022
2023
2023
2024
2025
2026
2027
2028
2028
Assets/liabilities in £bln
Assets Liabilities (technical provisions)
Liabilities (accounting basis) Liabilities (self sufficiency basis)
Liabilities (buyout basis)
Source: Redington
Figure 5 – Flight Plan against different funding bases
5 The scheme’s overall objective is illustrated by its “Flight Plan.” The Flight Plan maps out
the path of the scheme’s asset and liabilities, using market consistent yield curves, from
their current position to the funding goal under a given investment strategy (see below).
161
The Capco Institute Journal of Financial Transformation
The Pension Risk Management Framework
trustees will generally adopt self-sufficiency and/or buyout as targets for
full funding. On the other hand, the sponsor wishes to reduce accounting
volatility from the deficit and cash flow by minimizing future contributions.
The different funding objectives are formulated and illustrated using the
Flight Plan. There are several differing funding bases to establish the level
of liabilities against which to measure the overall objective. As Figure 5 il-
lustrates, the choice of discount rate has a significant impact on the value
of liabilities and, hence, on whether the chosen objective in the PRMF is
realistic.
The primary purpose of the PRMF is to set realistic goals and objectives
and to manage risk effectively. The Flight Plan can be used to monitor
through time whether a scheme is on track to achieve its funding objec-
tives. The Flight Plan also highlights the opportunity costs of investment
strategy decisions. For example, a higher allocation to equity may shorten
the time period required to reach full funding, but it could simultaneously
increase volatility, making it more likely the funding target will be missed.
Consequently, the PRMF allows the scheme to assess how realistic and
achievable its chosen Flight Plan is within its risk budget and constraints.
This helps the scheme to be proactive about reacting to new develop-
ments and thus to increase its probability of travelling along its desired
path. Together with the parameters set out in the PRMF, the Flight Plan,
therefore, produces “calls to action” whenever the scheme diverges too
far from its objectives (Figure 7). The framework will signal to the scheme
that it will have to take action, i.e., hedge risks or potentially re-risk if it
wants to achieve its desired funding objectives. See case study below to
understand how this has been implemented in practice.
Flight Plan Consistent Assets (FPCA)
One effective way of flying the Flight Plan and achieving the objectives
laid out in the PRMF are FPCA. These are assets that provide a good
proxy match for pension liabilities. They provide secure, long-dated, in-
flation-linked cash flows. Moreover, their illiquid nature means that they
tend to deliver higher real returns than traditional matching assets, such
as government bonds (the “illiquidity premium”). They, therefore, reduce
risks by matching interest rate and inflation risk in the liabilities and en-
able schemes to achieve their required rate of return to reach full funding.
Examples of FPCAs include secured leases, social housing, and infra-
structure investments. Given their combination of higher real returns and
liability-matching properties, these assets can be thought of as lying on
the spectrum between traditional return seeking (growth) and matching
asset classes. As a result, they have tended to be overlooked by many
pension schemes. Investments in FPCAs also tend to be more complex
to access, with a wide variety of investment structures and risk/return
profiles available to the investor. It is, therefore, imperative that schemes
have a transparent and actionable framework in place to make informed
investment decisions and access FPCAs in a way tailored to their specific
objectives and risk budget.
Measuring risk
The PRMF highlights the risks that schemes will be blown off their cho-
sen path to full funding. It is thus important to develop the right method-
ology to monitor progress towards risk targets.
The “three lenses approach”
To properly understand a scheme’s exposure, it is not sufficient to look at
just one risk metric. Consequently, we employ three different but comple-
mentary analytical methods to assess risks in order to gain a comprehen-
sive picture of a scheme’s exposure. Each metric highlights different risks
and hence a different aspect of a scheme’s exposure.
The risk telescope
The first lens, the “risk telescope,” uses value-at-risk (VaR) to measure
the total amount of risk for a variety of confidence intervals over various
Funding level
Time
PRMF
Without PRMF
PRMF constraints
Source: Redington
Figure 7 – Development of funding level over time
Funding Basis
Accounting basis Liabilities discounted at a corporate bond “AA” rate.
Technical provisions basis Actuarial basis that takes into account the expected
return on the assets. May often be a dual discount rate.
For example, pensioners at gilts + 50bps, and actives
and deferred members at gilts + 200bps.
Self-sufficiency basis The basis on which the scheme has sufficient assets
to run the scheme on a low-risk basis without further
support from the sponsor, i.e., gilts flat.
Buyout basis The conservative basis on which an insurance company
would be willing to assume legal responsibility for the
pension scheme (note: insurance companies are required
to hold capital). Typically closer to Libor flat or gilts
-50bps.
Source: Redington
Figure 6 – Different funding bases
162
time horizons. Formally, VaR represents the single minimum amount the
scheme might expect to lose over a one-year horizon in a worst case
scenario (typically at a 95 percent confidence level). VaR is a useful mea-
surement for pension fund trustees as it provides a single number that
allows them to intuitively compare the effects that changes to their asset
allocation have on the total risk of their portfolios. The risk telescope is
probabilistic in the sense it shows what could happen – the minimum
5 percent worst-case loss – with a reasonable degree of probability. The
“risk attribution” chart shows both the total risk as determined by VaR –
which is reported both in absolute £ terms and as a percentage of liabili-
ties to allow for comparisons across schemes and time – and the main
components of this risk.
In addition to VAR, a number of complementary variables can be em-
ployed to measure total risk. The four main risk metrics used by pension
schemes in their PRMF are summarized in Figure 9.
The “sensitivity microscope”
In contrast to the “risk telescope,” the “sensitivity microscope” is de-
terministic. PV01 (present value of one basis point) analyses how the
scheme will be affected by a single basis point change in inflation and/or
interest rates across different liability maturity buckets (Figure 10). Sen-
sitivity testing also shows the size and shape of the swap overlay neces-
sary to fully hedge the risk in each duration bucket. As interest rate and
inflation risks are often unrewarded and can impact scheme funding po-
sitions far more severely than equities, PV01 analysis can be particularly
useful in putting these risks into perspective.
The “scenario kaleidoscope”
Complementary to the previous two lenses, the “scenario kaleidoscope”
assesses the impact of extreme scenarios on the pension scheme. This
is done via stress tests – simulations that subject the portfolio to extreme
market conditions – which allows the scheme to estimate the magnitude
(though not the probability) of the loss associated with highly adverse
events. Stress testing can be used to analyze the impact of a single fac-
tor, such as a significant fall in equity values, or of multi-factor economic
scenarios, such as a repeat of the 2007-2008 financial crisis (Figure 11).
Responding to changes
Once the objectives, constraints, and risk targets are in place, the PRMF
enables the scheme to quickly adapt if specific parameters are breached
and opportunities arise to secure improvements in the funding level. “Dy-
namic de-risking” is one strategy made possible by implementing a ro-
bust PRMF and Flight Plan monitoring.
Case study in practice: scheme ABC with dynamic
de-risking
Scheme ABC had £100m of assets and a high allocation to equities. The
scheme was well-funded in early 2008 and was in the position where
11.4%
16.9%
0.7%
8.8% 14.4%
23.3%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Equity risk Interest rates Credit risk Inflation Diversification Total
Percentage
Risk attribution by risk type
0
0.05
0.1
0.15
0.2
0.25
0 2 4 6 8 10 12 14 16 18 20
Tail event:
worst 5% of
outcomes
95th percentile
Normal distribution - one-sided VAR 95%
Source: Redington
Figure 8 – VaR and VaR risk attribution
Risk parameter Definition (for given confidence level)
Value at risk The likely worst-case single minimum amount the scheme
might expect to lose over a one-year horizon.
Required return at risk The worst case increase in the return assets must earn to
reach full-funding over a one-year horizon. The measure is
most useful for understanding the impact of a deteriorating
funding level on the return required to reach full funding.
Funding ratio at risk The worst case decrease in the scheme’s funding ratio over
a one-year horizon.
Contributions at risk The worst case increase in contributions over a one-year
horizon to reach full funding by the target date. A popular
measure for sponsors wishing to assess risk’s potential
impact on their contribution future schedules.
Figure 9 – Measures of risk
163
The Capco Institute Journal of Financial Transformation
The Pension Risk Management Framework
it could consider the possibility of a buy-out. However, the absence of
a PRMF and ongoing monitoring meant that the scheme missed the
opportunity to reduce risk in response to improved funding conditions.
Consequently, the volatile financial markets of 2008/2009 resulted in a
significant deterioration in its funding level. Seeking to avoid a repeat of
this scenario, the scheme decided to implement a PRMF and dynamic
de-Risking strategy:
■■ The scheme’s primary objective under the PRMF was to achieve full
funding in 2022 on a self-sufficiency basis of gilts + 25 bps assuming
contributions until 2022.
■■ The scheme put in place a “dynamic de-risking” framework whereby
equity exposure and the associated risk would be reduced as the
scheme’s funding ratio improved. Trigger levels for these actions were
established based on the funding level, which would be monitored
daily by the scheme’s investment consultants.
■■ The investment committee initially implemented the process on a
recourse basis (the trustees wished to be consulted before a decision
was taken).
■■ Between September 2010 and September 2011, the scheme was able
to capture improvements in its funding ratio whilst at the same time
significantly reducing the risk it is exposed to – as Figure 12 shows.
The success of this strategy followed directly from the three features
-7 -5 -3 -1 1 3 5 7
0 - 11Y
11Y - 21Y
21Y - 31Y
31Y - 41Y
41Y+
PV01 (in £ millions)
Nominal PV01 (unhedged)
-7 -5 -3 -1 1 3 5 7
0 - 11Y
11Y - 21Y
21Y - 31Y
31Y - 41Y
41Y+
PV01 (in £ millions)
Inflation PV01 (unhedged)
Assets
Liabilities
11.4%
16.9%
0.7%
8.8% 14.4%
23.3%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Equity risk Interest
rates
Credit
risk
Inflation Diversification Total
Percentage
Risk attribution by risk type
Source: Redington
Figure 10 – Interest rate and inflation PV01
-400
-350
-300
-250
-200
-150
-100
-50
0
50
100
Lehman bankruptcy Credit crunch `Jan 06 Black Monday
Historical stress tests
-300
-250
-200
-150
-100
-50
0
50
25% fall in
equities
1% fall in
interest rates
1% increase in
inflation rates
1% increase in
the credit spreads
Single factor stress tests
Unhedged 20% hedged 100% hedged
Unhedged 20% hedged 100% hedged
Source: Redington
Figure 11 – Example stress tests
0.6
0.7
0.7
0.8
0.8
0.9
0.9
1.0 Original strategy
(annual vol. 19%)
PRMF strategy without
derisking (annual vol. 17%)
PRMF strategy
(annual vol. 15%)
Source: Redington
Figure 12: ABC funding level comparison (1-Oct-2010 to 30-Sep-2011)
Original New without de-risking New with de-risking
Funding level
1-Oct-2010
78.4% 79.2% 79.2%
Funding level
30-Sep-2011
65.7% 66.8% 71.6%
Volatility of funding
level
17.5% 15.9% 13.3%
Source: Redington
Figure 13 – Comparisons of ABC funding levels with different strategies
164
References
• Barr, N. and P. Diamond, 2006, “The economics of pensions,” Oxford Review of Economic
Policy, 22:1, 15-39
• Blome, S., K. Fachinger, D. Franzen, G. Scheuenstuhl, and J. Yermo, 2007, “Pension fund
regulation and risk management: results from an ALM optimisation exercise,” OECD working
papers on insurance and private pensions, No. 8, OECD Publishing
• Burgess, K., 2005, “Companies facing £130bn pension gap,” Financial Times, 7 December,
page 3
• Demptser, M. A. H., M. Germano, E. A. Medova, J. K. Murphy, D. Ryan, and F. Sadrini, F., 2009,
“Risk profiling defined benefit pension schemes,” Journal of Portfolio Management, 35:4, 76-93
• Fox, A. M., 2010, “An exploration of the governance and accountability of UK defined benefit
pension schemes,” University of Dundee School of Accounting and Finance Theses
• Gardner, R., 2008, “Liability driven investment (LDI): pension risk management in the 21st
century,” Redington Partners: Pension Management Institute Newsletter, March
• Konotey-Ahulu, D., 2011, “Hedging investment risk,” Redington limited
• Pension Protection Fund, 2010, “Purple book 2010,” 10 September
• Professional Pensions, 2009, “Half of DB future accrual to cease by 2012,” 7 September
• The Pensions Regulator, 2011, “Guidance for trustees,” 10 October
of the PRMF: a clear set of long-term objectives, a system to regularly
monitor progress towards these goals, and “calls for action” as market
opportunities arise and conditions deviate from the expected path to full
funding.
Conclusion
The Pension Risk Management Framework performs three vital tasks for
any pension scheme with strategic funding and risk objectives. First, a
PRMF identifies and defines objectives that relate to achieving a speci-
fied funding level by a certain date. Second, the PRMF measures the
objectives in relation to key risk factors of interest rates, inflation, equi-
ties, credit, etc. By reducing these risks, a trustee or sponsor increases
the certainty of achieving its objectives. Finally, the PRMF is most effec-
tive when efficient governance structures facilitate focused and proac-
tive decision-making. Regular monitoring of market and scheme condi-
tions, and of the effectiveness of any actions taken, is key to ensuring
responses are timely and appropriate. We see this as having the ability
to act through agility to respond to rapidly changing market conditions,
control through the PRMF, and transparency through daily monitoring of
the Flight Plan.
In recent years, U.K. schemes have reduced investment risk by shifting
towards gilts and fixed interest assets and away from equities [Pension
Protection Fund (2010)]. However, the sharp decline in funding ratios over
the past six months suggests that there remains significant scope for
schemes to implement more effective risk management frameworks. As
market volatility persists, a clear and powerful guide to investment strat-
egy and asset allocation like the PRMF is essential to ensure pension
schemes remain firmly on the path to full funding.
3
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Journal- The Pension Risk Management Framework

  • 1. JournalThe Capco Institute Journal of Financial Transformation #33 Technical Finance Recipient of the Apex Awards for Publication Excellence 2002-2011 12.2011 Journal Article Journal 33 Robert Gardner Dawid Konotey-Ahulu van Soto-Wright The Pension Risk Management Framework
  • 2. 2 Layout, production and coordination: Cypres – Daniel Brandt, Kris Van de Vijver and Pieter Vereertbrugghen Graphic design: Buro Proper – Bob Goor Photographs: Bart Heynen © 2011 The Capital Markets Company, N.V. All rights reserved. This journal may not be duplicated in any way without the express written consent of the publisher except in the form of brief excerpts or quotations for review purposes. Making copies of this journal or any portion there of for any purpose other than your own is a violation of copyright law. Editor Shahin Shojai, Global Head of Strategic Research, Capco Advisory Editors Cornel Bender, Partner, Capco Christopher Hamilton, Partner, Capco Nick Jackson, Partner, Capco Editorial Board Franklin Allen, Nippon Life Professor of Finance, The Wharton School, University of Pennsylvania Joe Anastasio, Partner, Capco Philippe d’Arvisenet, Group Chief Economist, BNP Paribas Rudi Bogni, former Chief Executive Officer, UBS Private Banking Bruno Bonati, Strategic Consultant, Bruno Bonati Consulting David Clark, NED on the board of financial institutions and a former senior advisor to the FSA Géry Daeninck, former CEO, Robeco Stephen C. Daffron, Global Head, Operations, Institutional Trading & Investment Banking, Morgan Stanley Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago Elroy Dimson, BGI Professor of Investment Management, London Business School Nicholas Economides, Professor of Economics, Leonard N. Stern School of Business, New York University Michael Enthoven, Former Chief Executive Officer, NIBC Bank N.V. José Luis Escrivá, Group Chief Economist, Grupo BBVA George Feiger, Executive Vice President and Head of Wealth Management, Zions Bancorporation Gregorio de Felice, Group Chief Economist, Banca Intesa Hans Geiger, Professor of Banking, Swiss Banking Institute, University of Zurich Peter Gomber, Full Professor, Chair of e-Finance, Goethe University Frankfurt Wilfried Hauck, Chief Executive Officer, Allianz Dresdner Asset Management International GmbH Michael D. Hayford, Corporate Executive Vice President, Chief Financial Officer, FIS Pierre Hillion, de Picciotto Chaired Professor of Alternative Investments and Shell Professor of Finance, INSEAD Thomas Kloet, Chief Executive Officer, TMX Group Inc. Mitchel Lenson, former Group Head of IT and Operations, Deutsche Bank Group Donald A. Marchand, Professor of Strategy and Information Management, IMD and Chairman and President of enterpriseIQ® Colin Mayer, Peter Moores Dean, Saïd Business School, Oxford University John Owen, Chief Operating Officer, Matrix Group Steve Perry, Executive Vice President, Visa Europe Derek Sach, Managing Director, Specialized Lending Services, The Royal Bank of Scotland ManMohan S. Sodhi, Professor in Operations & Supply Chain Management, Cass Business School, City University London John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund Graham Vickery, Head of Information Economy Unit, OECD Individual Selected Article from Journal 32 JournalThe Capco Institute Journal of Financial Transformation
  • 3. 157 PART 2 The Pension Risk Management Framework Abstract In recent years, the economic landscape for defined ben- efit (DB) pension schemes has evolved dramatically for the worse. Among the ongoing challenges are the continued weaknesses in equity markets, falling interest rates, infla- tion levels that persist despite a drop in economic activity, and ever-increasing life expectancy due to improving medi- cal 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 under- stand risk and to respond to them effectively. The PRMF re- quires 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 out- comes diverge from the planned path to full-funding. Robert Gardner — Co-CEO, Redington Dawid Konotey-Ahulu — Co-CEO, Redington Ivan Soto-Wright — Analyst, Redington
  • 4. 158 “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 em- ployer 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 show, this has had a dramatic impact on the fund- ing 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 Feb- ruary 2011 and September 2011, the aggregate balance of PPF schemes has deteriorated from a surplus of £48.4bln to a deficit of £196.4bln. Fi- nally, 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).4 Renewed importance for risk management In this environment, effective risk management is ever more important for trustees and sponsors. Those responsible for managing assets and li- abilities of pension schemes need to use the most robust and informative analytic models and the most effective risk management strategies to cope with volatile financial markets, address rising deficits, and take ad- vantage of investment opportunities. In DB pension schemes, risk management involves the measurement and assessment of pension fund risks and the design, monitoring, and revi- sion of the fund’s investment strategy, asset allocation, and performance benchmarks to meet the requirements of both pension scheme members and sponsor. A risk management framework should seek to minimize sponsor contributions as far as this is possible as well as minimizing the risk of benefit cuts to beneficiaries. These goals require trade-offs to be made between contributions, asset allocation, and risk as the objec- tives of different stakeholders vary. Risk management also needs to take into account the sponsor covenant which ultimately supports the deficit. However, if the scheme becomes materially underfunded and starts to divert cash this in turn could undermine the sponsor covenant. The Pension Risk Management Framework (PRMF) Most sponsors and trustees were not prepared for the recent financial market turmoil both in 2008 and more recently in August and Septem- ber 2011. They have differing and sometimes conflicting concerns and 1 An index of all U.K. pension schemes required to pay the PPF levy. In return, the PPF provides compensation to scheme members should the sponsor become insolvent. 2 A pension liability valuation methodology used for calculating the PPF levy, it uses highly conservative assumptions regarding yields, inflation, and longevity. 3 Pension Protection Fund. PPF7800 Index. http://www.pensionprotectionfund.org.uk/ DocumentLibrary/Documents/PPF_7800_september_11.pdf. 4 AON Hewitt Pension Risk Tracker. https://rfmtools.hewitt.com/PensionRiskTracker/. 70 80 90 100 110 120 130 -250 -200 -150 -100 -50 0 50 100 150 200 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 % £ billion Aggregate Balance (LHS) Funding Ratio (RHS) Source: Pension Protection Fund 7800 Index 1 , Redington Figure 1 – Estimated aggregate balance (assets less liabilities) and funding ratio of PPF-eligible schemes
  • 5. 159 The Capco Institute Journal of Financial Transformation The Pension Risk Management Framework objectives. The board of trustees is responsible for “ensuring that the pension scheme is run properly and that the members’ benefits are se- cure.” They are also required to “act in the best interest of the scheme beneficiaries” [The Pensions Regulator (2011)]. Trustees must ensure that the pension fund is able to make payments on time and in full to mem- bers who reach retirement age, and ensure that there is a strong covenant backing the scheme. Additionally, scheme sponsors are obliged to make contributions as necessary to ensure that schemes have sufficient assets to meet their liabilities. The scheme sponsor, however, faces a dilemma as diverting funds to the pension scheme that could have been used to invest in and expand the business has potential consequences for the long-term growth and profitability of the company. Consequently, the scheme sponsor generally seeks to minimize the contributions it makes to the pension scheme. The scheme sponsor must collaborate with the board of trustees to determine an acceptable level of contributions over an acceptable timeline. The PRMF provides a framework for stakeholders to understand and agree key objectives and constraints, and helps put in place the right governance structure so that trustees can make quick and effective decisions in response to both market turbulence and opportunities. The PRMF ensures that the objectives chosen are realistic and provides con- sistent metrics to assess progress towards these goals. By measuring liabilities in a market consistent manner, the scheme is better placed to exploit opportunities to achieve these goals. Moreover, the PRMF pro- vides stakeholders with clear “calls to action” when actual outcomes diverge from the scheme’s objectives. In tandem, these features enable the scheme to chart the most efficient path to its ultimate objective of full-funding. Formally, the PRMF serves three purposes: to identify and set objectives and constraints; to monitor the pension scheme’s progress towards ob- jectives; and to respond to changes. Setting and defining objectives The first step of the framework is to establish clear objectives. It is vital for stakeholders to identify and define a set of objectives which are tai- lored to the specific funding, contribution schedule, and recovery period of the scheme. The PRMF should encompass an overall objective, risk targets, aspirations, and constraints. -80 -60 -40 -20 0 20 40 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 1 3 4 2 Source: Aon Hewitt Pension Risk Tracker, Redington Points on the chart refer to 1 15/09/2008 Lehman Brothers collapse FTSE 100 30yr gilt 30yr inflation 5,204 4.44% 3.87% 2 03/03/2009 FTSE reaches 4-year low FTSE 100 30yr gilt 30yr inflation 3,512 4.32% 3.55% 3 27/08/2010 Bernanke alludes to QE2 FTSE 100 30yr gilt 30yr inflation 5,201 3.87% 3.50% 4 30/09/2011 Where we are today FTSE 100 30yr gilt 30yr inflation 5,102 3.55% 3.54% Source: Bloomberg, Redington Figure 2 – Cumulative surplus/deficit (£ Billions) of all FTSE 100 pension schemes on accounting basis Overall objective Risk targets Aspirational targets Scheme constraints Objective Trigger Performance indicators What is the overall objective? Full funding on self- sufficiency basis By 2020 on a swaps + [50]bps basis with contributions of £[25]m p.a. How will we measure the objective? Required return on the scheme’s assets Required return of assets is swaps + [160]bps What are the primary risk targets? Required return at risk (RRaR) Contributions at risk (CaR) RRaR < swaps +[200]bps CaR should be kept below £[50]m What is the secondary risk target? Value at Risk (VaR) VaR should not exceed [20]% of the liabilities What are the primary aspirational targets? To be fully inflation and interest rate hedged Hedge ratios should be equal to [100%] What are the secondary aspirational targets? Increase efficiency of hedges by earning more return for same risk Regular monitoring of relative value of swaps vs. gilts What is the primary scheme constraint? Liquidity Sufficient liquidity to make pension payments What is the secondary scheme constraint? Collateral requirements Enough available collateral to cover the 1-year derivative [VaR95] Source: Redington Figure 3 – Example PRMF
  • 6. 160 The overall objective5 shared by most trustees and sponsors is “a fully funded scheme.” However, the funding basis used to determine liabili- ties and time horizon over which to achieve fully-funded status will differ based on the respective interests and limitations of trustees and sponsor. Covenant strength and pension entitlements will determine the capacity for the sponsor to allocate contributions and, consequently, the funding basis and time horizon. Articulating an overall goal clearly and succinctly before an investment strategy is implemented significantly improves the probability of a favorable outcome. The subsequent section on measuring risk provides an overview of the key risk metrics that might be employed for understanding and reviewing risk targets and the scheme’s perfor- mance against them. Setting these parameters ensures that a pension scheme has an overall funding and investment benchmark by which to gauge the risk associated with different asset allocations and to identify and the ability and agility to take advantage of investment opportunities. Aspirational objectives are those that the scheme would like to achieve but which are secondary to its primary goals. However, the PRMF pro- vides a framework for achieving these should market opportunities make this possible. Aspirational objectives take into consideration the impact of volatile market conditions that could increase deficits and thereby affect the required returns to reach full funding. These conditions might include an instantaneous shock to interest rates, inflation expectations, or equity market valuations. For example, an aspirational target might be to increase the interest rate and inflation hedge ratio to equal the funding ratio, as this stabilizes funding level volatility with respect to interest rates and inflation. The constraints are limits that a scheme cannot breach whilst pursuing its path to full funding. A primary constraint that a scheme faces is liquidity. The pension fund must hold cash and readily realizable assets in order to pay out members of the scheme. A secondary scheme constraint is the collateral requirement. A pension fund must also hold sufficient and eligible collateral to meet potential collateral calls on derivative contracts, such as interest rate and inflation swaps. This constraint will require greater focus with the introduction of central clearing and CRDIV in 2013. Ultimately, the PRMF enables pension scheme stakeholders to act with the agility, control, and transparency to realize their objectives. The “Flight Plan” Once the trustees and sponsor have outlined and defined the overall objective, risk targets, aspirations, and constraints, they can begin with designing their scheme’s “Flight Plan.” The Flight Plan projects the future path of the assets and liabilities needed to achieve the long-term funding objective (Figure 4). Building a Flight Plan requires three key variables: (i) the cash contribution schedule, (ii) the target date to reach full funding, and (iii) the required rate of return needed by the assets. Note that the Flight Plan is constrained by both the trustee and sponsor’s risk appe- tite, which might be expressed as funding ratio at risk, or contributions at risk. An earlier target date for full funding (and thus higher required return) might mean taking more risk than the scheme feels comfortable with. Ultimately, the Flight Plan assumes that the deficit will be funded through a combination of investment returns and sponsor contributions. Note the length of the recovery plan is limited by the long-term viability of the sponsor. Both sponsors and trustees have a mutual interest in managing the abso- lute deficit volatility and/or funding ratio and reducing the long-term de- pendence on the sponsor. Trustees wish to minimize covenant risk and to ensure benefit payments to the scheme’s members. Consequently, 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 GBP millions Liabilities path Actual liabilities Assets path Actual assets Source: Redington Figure 4 – Example “Flight Plan” 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2009 2010 2011 2012 2013 2013 2014 2015 2016 2017 2018 2018 2019 2020 2021 2022 2023 2023 2024 2025 2026 2027 2028 2028 Assets/liabilities in £bln Assets Liabilities (technical provisions) Liabilities (accounting basis) Liabilities (self sufficiency basis) Liabilities (buyout basis) Source: Redington Figure 5 – Flight Plan against different funding bases 5 The scheme’s overall objective is illustrated by its “Flight Plan.” The Flight Plan maps out the path of the scheme’s asset and liabilities, using market consistent yield curves, from their current position to the funding goal under a given investment strategy (see below).
  • 7. 161 The Capco Institute Journal of Financial Transformation The Pension Risk Management Framework trustees will generally adopt self-sufficiency and/or buyout as targets for full funding. On the other hand, the sponsor wishes to reduce accounting volatility from the deficit and cash flow by minimizing future contributions. The different funding objectives are formulated and illustrated using the Flight Plan. There are several differing funding bases to establish the level of liabilities against which to measure the overall objective. As Figure 5 il- lustrates, the choice of discount rate has a significant impact on the value of liabilities and, hence, on whether the chosen objective in the PRMF is realistic. The primary purpose of the PRMF is to set realistic goals and objectives and to manage risk effectively. The Flight Plan can be used to monitor through time whether a scheme is on track to achieve its funding objec- tives. The Flight Plan also highlights the opportunity costs of investment strategy decisions. For example, a higher allocation to equity may shorten the time period required to reach full funding, but it could simultaneously increase volatility, making it more likely the funding target will be missed. Consequently, the PRMF allows the scheme to assess how realistic and achievable its chosen Flight Plan is within its risk budget and constraints. This helps the scheme to be proactive about reacting to new develop- ments and thus to increase its probability of travelling along its desired path. Together with the parameters set out in the PRMF, the Flight Plan, therefore, produces “calls to action” whenever the scheme diverges too far from its objectives (Figure 7). The framework will signal to the scheme that it will have to take action, i.e., hedge risks or potentially re-risk if it wants to achieve its desired funding objectives. See case study below to understand how this has been implemented in practice. Flight Plan Consistent Assets (FPCA) One effective way of flying the Flight Plan and achieving the objectives laid out in the PRMF are FPCA. These are assets that provide a good proxy match for pension liabilities. They provide secure, long-dated, in- flation-linked cash flows. Moreover, their illiquid nature means that they tend to deliver higher real returns than traditional matching assets, such as government bonds (the “illiquidity premium”). They, therefore, reduce risks by matching interest rate and inflation risk in the liabilities and en- able schemes to achieve their required rate of return to reach full funding. Examples of FPCAs include secured leases, social housing, and infra- structure investments. Given their combination of higher real returns and liability-matching properties, these assets can be thought of as lying on the spectrum between traditional return seeking (growth) and matching asset classes. As a result, they have tended to be overlooked by many pension schemes. Investments in FPCAs also tend to be more complex to access, with a wide variety of investment structures and risk/return profiles available to the investor. It is, therefore, imperative that schemes have a transparent and actionable framework in place to make informed investment decisions and access FPCAs in a way tailored to their specific objectives and risk budget. Measuring risk The PRMF highlights the risks that schemes will be blown off their cho- sen path to full funding. It is thus important to develop the right method- ology to monitor progress towards risk targets. The “three lenses approach” To properly understand a scheme’s exposure, it is not sufficient to look at just one risk metric. Consequently, we employ three different but comple- mentary analytical methods to assess risks in order to gain a comprehen- sive picture of a scheme’s exposure. Each metric highlights different risks and hence a different aspect of a scheme’s exposure. The risk telescope The first lens, the “risk telescope,” uses value-at-risk (VaR) to measure the total amount of risk for a variety of confidence intervals over various Funding level Time PRMF Without PRMF PRMF constraints Source: Redington Figure 7 – Development of funding level over time Funding Basis Accounting basis Liabilities discounted at a corporate bond “AA” rate. Technical provisions basis Actuarial basis that takes into account the expected return on the assets. May often be a dual discount rate. For example, pensioners at gilts + 50bps, and actives and deferred members at gilts + 200bps. Self-sufficiency basis The basis on which the scheme has sufficient assets to run the scheme on a low-risk basis without further support from the sponsor, i.e., gilts flat. Buyout basis The conservative basis on which an insurance company would be willing to assume legal responsibility for the pension scheme (note: insurance companies are required to hold capital). Typically closer to Libor flat or gilts -50bps. Source: Redington Figure 6 – Different funding bases
  • 8. 162 time horizons. Formally, VaR represents the single minimum amount the scheme might expect to lose over a one-year horizon in a worst case scenario (typically at a 95 percent confidence level). VaR is a useful mea- surement for pension fund trustees as it provides a single number that allows them to intuitively compare the effects that changes to their asset allocation have on the total risk of their portfolios. The risk telescope is probabilistic in the sense it shows what could happen – the minimum 5 percent worst-case loss – with a reasonable degree of probability. The “risk attribution” chart shows both the total risk as determined by VaR – which is reported both in absolute £ terms and as a percentage of liabili- ties to allow for comparisons across schemes and time – and the main components of this risk. In addition to VAR, a number of complementary variables can be em- ployed to measure total risk. The four main risk metrics used by pension schemes in their PRMF are summarized in Figure 9. The “sensitivity microscope” In contrast to the “risk telescope,” the “sensitivity microscope” is de- terministic. PV01 (present value of one basis point) analyses how the scheme will be affected by a single basis point change in inflation and/or interest rates across different liability maturity buckets (Figure 10). Sen- sitivity testing also shows the size and shape of the swap overlay neces- sary to fully hedge the risk in each duration bucket. As interest rate and inflation risks are often unrewarded and can impact scheme funding po- sitions far more severely than equities, PV01 analysis can be particularly useful in putting these risks into perspective. The “scenario kaleidoscope” Complementary to the previous two lenses, the “scenario kaleidoscope” assesses the impact of extreme scenarios on the pension scheme. This is done via stress tests – simulations that subject the portfolio to extreme market conditions – which allows the scheme to estimate the magnitude (though not the probability) of the loss associated with highly adverse events. Stress testing can be used to analyze the impact of a single fac- tor, such as a significant fall in equity values, or of multi-factor economic scenarios, such as a repeat of the 2007-2008 financial crisis (Figure 11). Responding to changes Once the objectives, constraints, and risk targets are in place, the PRMF enables the scheme to quickly adapt if specific parameters are breached and opportunities arise to secure improvements in the funding level. “Dy- namic de-risking” is one strategy made possible by implementing a ro- bust PRMF and Flight Plan monitoring. Case study in practice: scheme ABC with dynamic de-risking Scheme ABC had £100m of assets and a high allocation to equities. The scheme was well-funded in early 2008 and was in the position where 11.4% 16.9% 0.7% 8.8% 14.4% 23.3% 0% 5% 10% 15% 20% 25% 30% 35% 40% Equity risk Interest rates Credit risk Inflation Diversification Total Percentage Risk attribution by risk type 0 0.05 0.1 0.15 0.2 0.25 0 2 4 6 8 10 12 14 16 18 20 Tail event: worst 5% of outcomes 95th percentile Normal distribution - one-sided VAR 95% Source: Redington Figure 8 – VaR and VaR risk attribution Risk parameter Definition (for given confidence level) Value at risk The likely worst-case single minimum amount the scheme might expect to lose over a one-year horizon. Required return at risk The worst case increase in the return assets must earn to reach full-funding over a one-year horizon. The measure is most useful for understanding the impact of a deteriorating funding level on the return required to reach full funding. Funding ratio at risk The worst case decrease in the scheme’s funding ratio over a one-year horizon. Contributions at risk The worst case increase in contributions over a one-year horizon to reach full funding by the target date. A popular measure for sponsors wishing to assess risk’s potential impact on their contribution future schedules. Figure 9 – Measures of risk
  • 9. 163 The Capco Institute Journal of Financial Transformation The Pension Risk Management Framework it could consider the possibility of a buy-out. However, the absence of a PRMF and ongoing monitoring meant that the scheme missed the opportunity to reduce risk in response to improved funding conditions. Consequently, the volatile financial markets of 2008/2009 resulted in a significant deterioration in its funding level. Seeking to avoid a repeat of this scenario, the scheme decided to implement a PRMF and dynamic de-Risking strategy: ■■ The scheme’s primary objective under the PRMF was to achieve full funding in 2022 on a self-sufficiency basis of gilts + 25 bps assuming contributions until 2022. ■■ The scheme put in place a “dynamic de-risking” framework whereby equity exposure and the associated risk would be reduced as the scheme’s funding ratio improved. Trigger levels for these actions were established based on the funding level, which would be monitored daily by the scheme’s investment consultants. ■■ The investment committee initially implemented the process on a recourse basis (the trustees wished to be consulted before a decision was taken). ■■ Between September 2010 and September 2011, the scheme was able to capture improvements in its funding ratio whilst at the same time significantly reducing the risk it is exposed to – as Figure 12 shows. The success of this strategy followed directly from the three features -7 -5 -3 -1 1 3 5 7 0 - 11Y 11Y - 21Y 21Y - 31Y 31Y - 41Y 41Y+ PV01 (in £ millions) Nominal PV01 (unhedged) -7 -5 -3 -1 1 3 5 7 0 - 11Y 11Y - 21Y 21Y - 31Y 31Y - 41Y 41Y+ PV01 (in £ millions) Inflation PV01 (unhedged) Assets Liabilities 11.4% 16.9% 0.7% 8.8% 14.4% 23.3% 0% 5% 10% 15% 20% 25% 30% 35% 40% Equity risk Interest rates Credit risk Inflation Diversification Total Percentage Risk attribution by risk type Source: Redington Figure 10 – Interest rate and inflation PV01 -400 -350 -300 -250 -200 -150 -100 -50 0 50 100 Lehman bankruptcy Credit crunch `Jan 06 Black Monday Historical stress tests -300 -250 -200 -150 -100 -50 0 50 25% fall in equities 1% fall in interest rates 1% increase in inflation rates 1% increase in the credit spreads Single factor stress tests Unhedged 20% hedged 100% hedged Unhedged 20% hedged 100% hedged Source: Redington Figure 11 – Example stress tests 0.6 0.7 0.7 0.8 0.8 0.9 0.9 1.0 Original strategy (annual vol. 19%) PRMF strategy without derisking (annual vol. 17%) PRMF strategy (annual vol. 15%) Source: Redington Figure 12: ABC funding level comparison (1-Oct-2010 to 30-Sep-2011) Original New without de-risking New with de-risking Funding level 1-Oct-2010 78.4% 79.2% 79.2% Funding level 30-Sep-2011 65.7% 66.8% 71.6% Volatility of funding level 17.5% 15.9% 13.3% Source: Redington Figure 13 – Comparisons of ABC funding levels with different strategies
  • 10. 164 References • Barr, N. and P. Diamond, 2006, “The economics of pensions,” Oxford Review of Economic Policy, 22:1, 15-39 • Blome, S., K. Fachinger, D. Franzen, G. Scheuenstuhl, and J. Yermo, 2007, “Pension fund regulation and risk management: results from an ALM optimisation exercise,” OECD working papers on insurance and private pensions, No. 8, OECD Publishing • Burgess, K., 2005, “Companies facing £130bn pension gap,” Financial Times, 7 December, page 3 • Demptser, M. A. H., M. Germano, E. A. Medova, J. K. Murphy, D. Ryan, and F. Sadrini, F., 2009, “Risk profiling defined benefit pension schemes,” Journal of Portfolio Management, 35:4, 76-93 • Fox, A. M., 2010, “An exploration of the governance and accountability of UK defined benefit pension schemes,” University of Dundee School of Accounting and Finance Theses • Gardner, R., 2008, “Liability driven investment (LDI): pension risk management in the 21st century,” Redington Partners: Pension Management Institute Newsletter, March • Konotey-Ahulu, D., 2011, “Hedging investment risk,” Redington limited • Pension Protection Fund, 2010, “Purple book 2010,” 10 September • Professional Pensions, 2009, “Half of DB future accrual to cease by 2012,” 7 September • The Pensions Regulator, 2011, “Guidance for trustees,” 10 October of the PRMF: a clear set of long-term objectives, a system to regularly monitor progress towards these goals, and “calls for action” as market opportunities arise and conditions deviate from the expected path to full funding. Conclusion The Pension Risk Management Framework performs three vital tasks for any pension scheme with strategic funding and risk objectives. First, a PRMF identifies and defines objectives that relate to achieving a speci- fied funding level by a certain date. Second, the PRMF measures the objectives in relation to key risk factors of interest rates, inflation, equi- ties, credit, etc. By reducing these risks, a trustee or sponsor increases the certainty of achieving its objectives. Finally, the PRMF is most effec- tive when efficient governance structures facilitate focused and proac- tive decision-making. Regular monitoring of market and scheme condi- tions, and of the effectiveness of any actions taken, is key to ensuring responses are timely and appropriate. We see this as having the ability to act through agility to respond to rapidly changing market conditions, control through the PRMF, and transparency through daily monitoring of the Flight Plan. In recent years, U.K. schemes have reduced investment risk by shifting towards gilts and fixed interest assets and away from equities [Pension Protection Fund (2010)]. However, the sharp decline in funding ratios over the past six months suggests that there remains significant scope for schemes to implement more effective risk management frameworks. As market volatility persists, a clear and powerful guide to investment strat- egy and asset allocation like the PRMF is essential to ensure pension schemes remain firmly on the path to full funding.