Extreme Events – Specimen Answer A.8.2(e)
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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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