Who cares about pension scheme risk? All members of defined benefit pension schemes should care. Ris...
Who cares about pension scheme risk? All members of defined benefit pension schemes should care. Risk control is there for their benefit and there is currently a vigorous debate by pension practitioners as to how much focus should be placed on the management of risk.
It is certainly a complex area, but the key points can be clearly illustrated by considering a hypothetical gambling game.
You are given 20 lots of £100 with which to bet. You have two choices on betting your £100 but your choice must be the same for all lots.
The first option is betting £100 and receive £120 with absolute certainty or bet £100 and roll a dice. If the dice lands on anything but a six then you receive £180, but if it lands on a six then you win nothing. What will you choose?
For the second option your expected win is £150 (180 x 5/6 + 0 x1/6), greater than the £120 of the first option but you are taking a risk. If you were offered only one £100 bet then you may well prefer to take the £120 of the first option rather than risk losing your money in the second option.
Given you have 20 rolls of the dice then you should make more money from the second option than the first. Most people would go for the second option which involves some risk but an investor is receiving a reward of additional return on average.
Now let us make the game more interesting. You have £1000 with which you must make 10 £100 bets with, with the same betting options as above. Again your choice must be the same for all lots. This time, though, at the end of each bet you must give away £120.
For the first option, you know that by betting a £100 you will receive £120 back, which will match the money you are giving away.
At the end of your 10 bets you will have given away 10 lots of £120 and have no money left. For the second option, on average you would expect to make £1500 (10 x £150) from your 10 bets, more than enough to meet the necessary payments. However, you are told that should you be unfortunate with your bets and run out of money, you will be expected to make the £120 payments from your own pocket.
Which option will you choose? The second option should produce more money but you do not want to fork out of your own pocket should you be unlucky. If these figures above were in millions rather just single pounds most people would undoubtedly choose the first option.
The lesson? Here, the choice depended upon a situation more complex than merely a direct comparison between the two options. To put it another way, the risk control conditioned the betting selection. Now consider two broad categories of defined benefit pension schemes - young and mature schemes. A young scheme is one in which the members contributions plus investment income exceed all outgoing payments to the fund. A mature scheme is one in which outgoing payments exceed the sum of investment income and contributions. Should these schemes have the same investment policy?
A young scheme is analogous to the first half of the game (once all outgoings are met there is money to invest). In the game the choice would be the higher returning, higher risk option. In real life this behaviour is mirrored in a pension scheme investment policy where a high proportion of assets is invested in equities.
In the second half, payments had to be made out of the fund, similar to the cash flow dynamics of a mature pension scheme. In the game the for the lower returning, lower risk option was chosen but is this behaviour reflected in real life ?
The answer again is yes, although the real world is a lot more complex. Defined benefit schemes are becoming more mature; they are influenced by the closure of schemes to new entrants (who are instead being put into defined contribution arrangements).
Pension schemes are moving assets from higher risk equities to lower risk fixed interest, driven both by actuaries, asset-liability management models and by regulatory collars such as the Minimum Funding Requirement (MFR).
Whether pension schemes should have to be fully matched in terms of their asset-liability position, thus restricting the fund from benefiting from the expected higher returns of equities over fixed interest assets is debatable. There is general agreement that pension scheme assets should better reflect the underlying liability profile as it matures, but there is no consensus over the degree to which a pension scheme should match assets and liabilities.
Let us re-examine the second half of the game. We have £1000, selected the first option and made the first bet - £100 is paid and £120 received which in turn is paid out and the amount of money left is £900. No problem.
But what if the second option was selected, the £100 bet made and the dice landed on six? Nothing is received and £120 still has to be paid out. The fund is £220 poorer and the balance is £780. The long term view is that by rolling the dice the payments will be made and have money will be left over, but what happens if you roll another six?
Rolling four sixes would result in you having to dip into your own pocket. By selecting the first option, the chance of a surplus is foregone but you have peace of mind in that you will be able to make the payments without dipping into your own pocket.
Now consider a pension scheme that has more of its assets invested in equities and less in fixed interest than its underlying liabilities would suggest.
The mismatch extends the opportunity to benefit from the expected extra returns that equities provide over fixed interest assets, a benefit which would help reduce the cost of the scheme to the employer. Many would argue that investment experience of the past twenty years lends strong support to this view.
But what if equities perform poorly for a sustained period of time, like those of Japan throughout the 1990s? We are effectively betting that we will not endure a bea
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