The Risks of De-Risking
DB regulatory focus is based on the view that schemes are carrying too much investment risk relative to the employer's ability to repair deficits.
The Pension Regulator’s standard response to a weaker covenant is to require de-risking of investments, with the objective being to minimise investment risk, reduce funding level volatility and reduce the severity of the impact of future downside events.
As a consequence, de-risking is now a key item on trustees’ agendas, with trustees’ wanting to ensure that the employer has the ability to support any investment risk (which typically means making sure the employer can make good a VaR loss over a relatively short time period).
Against this background, the purpose of most strategic investment reviews is to choose between asset allocations that minimise VaR and reduce interest-rate and inflation risks. No consideration is given to actual outcomes for members and the impact that de-risking has on pensions.
The Impact of De-Risking on Member Pensions
De-risking will mean that an underfunded scheme is expected to remain in deficit for longer. As the scheme is in deficit for longer, it is more exposed to the risk of employer insolvency. By de-risking, the trustees may only have exchanged investment risk for covenant risk, and it’s not clear if the position for members has actually been improved.
To assess the impact of de-risking on DB pension benefits, we carry out a stochastic IRM modelling exercise that allows for covenant, investment strategy, funding, market conditions and market volatility, the interplays between all these items and the proportion of full pensions paid under each simulation.
We consider covenant risk in a similar way to the default risk for corporate bonds of different ratings. In the event of employer insolvency, we assume that the trustees’ secure pensions with an insurer. No allowance is made for any recoveries from employer after insolvency.
The results of our modelling is set out in the table below, which shows the allocation to growth that maximises the proportion of full pension paid to members.
- As expected, a scheme that is fully funded could guarantee pensions by investing in a portfolio of gilts that cash-flow match future pensions
- If a scheme is backed by a very strong employer, then benefits are secure with all investment strategies and whatever the funding position. It’s not that there isn’t investment risk, there is, but this risk is borne by the employer who is strong enough to ensure pensions are paid in full in all circumstances
- Benefit security is poor in schemes that are poorly funded with weaker covenants. However premature de-risking reduces benefit security further. This is because premature de-risking transfers investment risk to a weaker covenant with poorer outcomes for members
- A large allocation to growth should be associated with lower funding levels and weaker covenants
- In general, benefit security is optimised with a larger allocation to growth, with de-risking only happening later and after the funding position has recovered
Incorporating covenant risk into traditional asset-liability modelling challenges the conventional view that the best outcomes for DB members are achieved by having a higher funding target, de-risked investments and shorter recovery plans. This is especially the case for schemes with weaker covenants.
The exact impact of investment and covenant risks on benefit security for a particular scheme is very scheme specific. It depends on scheme specific factors such as maturity and how the covenant may change with changes to market and economic conditions.
However, IRM modelling suggests that, in many cases, a larger allocation to growth assets makes sense. That is, instead of increasing the future reliance of the scheme on a (possibly weakened) employer, better outcomes for DB members can be achieved by meeting pension promises from a diversified pool of growth investments alongside the employer covenant.
Please contact us if you would like to discuss this