Extreme Events – Specimen Answer A.8.2(e) – Answer/Hints

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Q. Summarise the main risks to which the following types of entity might be most exposed (and which it would be prudent to provide stress tests for if you were a risk manager for such an entity): (e) A pension fund


There are significant differences between Defined Benefit (DB) and Defined Contribution (DC) pension funds. With a DB pension fund, the beneficiaries receive pensions calculated according to some defined formula not explicitly linked to the behaviour of the investments in which the fund is invested. In contrast, with a DC pension fund, the beneficiaries receive pensions set by reference to how much pension their accumulated pension “pot” can buy when they retire. So, in broad terms, investment risk is carried by the fund itself in a DB arrangement but by the individual in a DC arrangement.


For a DB scheme, risks it may be appropriate to stress test include:


(i)                  Longevity risk, i.e. the risk that the beneficiaries (on average) live longer than expected, as this makes providing pensions to them more expensive.

(ii)                Inflation risk. Many DB pension benefits have an element of inflation-linking, i.e. the benefits increase through time if inflation is high. In the UK, the exact linkage can be quite complicated, e.g. many DB pension schemes give annual increases to pensions in line with inflation but only up to some previously identified cap (e.g. 5% pa) and also often subject to some predetermined floor (e.g. 0% pa, if pensions are not reduced when inflation is negative).

(iii)               Interest rate risk. The present value of future pension payments will depend on interest rates (more precisely yield curves). Given the prevalence of inflation increases as per (ii), the focus may be in real yields (i.e. interest rates expressed relative to inflation) rather than nominal yields (i.e. interest rates expressed in fixed nominal terms)

(iv)               Operational risk. Like most other entities, pension funds can also be exposed to operational risks, e.g. they might suffer a cyberattack or a fraud.

(v)                Sponsor covenant risk. DB pension schemes are typically financed in part from contributions from the employer(s) who have sponsored the scheme. Historically, sponsors have necessarily not contributed enough to ensure that such schemes are near certain always to have enough money to provide for past promises in full. Instead, they may have contributed lower amounts, with the expectation being that any future shortfall would be made up over time either from excess investment returns or, if necessary, from further contributions from the employer. The ability, if needed, to call on extra contributions from the sponsoring employer is known as the “sponsor covenant” and the risk that the scheme needs more money from the sponsor but the sponsor cannot provide these funds (e.g. because the sponsor has gone bankrupt) is called “sponsor covenant risk”.


DC schemes themselves are typically not exposed to longevity risk, inflation risk, interest rate risk or sponsor covenant risk, at least not during the “accumulation” phase when money is being received from the employee and sponsor and put into the individual’s pension savings “pot” for accumulation prior to retirement. Of course, the members themselves will still typically be exposed to such risks. For example, if inflation increases but asset returns remain the same, all other things being equal the real value of the member’s pension pot will decline and likely so also will its real purchasing power. The DC schemes themselves can still e.g. have fraud committed against them, so are still exposed to operational risk. There are also “hybrid” schemes that share some features of both DB and DC schemes, and hence share some of the risks that each type of scheme faces. In some jurisdictions there are also “Collective DC” (CDC) schemes, which might not carry investment risk themselves but might retain some exposure to longevity risk rather than also passing this risk to their members.


In the UK in late 2022 an additional risk some (mainly DB) pension funds faced came to the fore, namely liquidity risk. Schemes using Liability Driven Investment (LDI) strategies, particularly ones involving investing in leveraged pooled LDI funds, found they had a sudden large need for liquidity, often overwhelming what they had available. Long dated interest rates rose exceptionally rapidly following a very poor market response to government proposals to reduce taxes. The movement was so large that pooled LDI funds required unprecedented amounts of additional funds from their clients (the pension funds investing in them) and/or were being forced to unwind their positions at potentially fire sale prices. This outcome was averted by the Bank of England providing emergency support for parts of the UK government bond (i.e. the gilt) market, the first time it intervened in this market in this manner. This episode has led to (UK) pension funds typically also carrying out stress tests designed to test whether they have sufficient ready cash to be able to meet liquidity calls that might be triggered by e.g. large interest rate movements.


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