Pension funds: understanding funding ratio risk better (part 1)

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Understanding the factors that support or weaken a pension fund’s funding ratio is important since it forms the basis of crucial policy decisions including the allocation to risk sources in the investment portfolio. In part 1, we argue that funding ratio risk is an important metric and can produce valuable insights. In part 2, we will argue that a more detailed grasp of the sources of economic risk can help the portfolio manager adjust the allocation as and when required.

Funding ratio risk is the relevant metric

Previous work in this area has been focused on surplus risk, which in our view is not a useful risk measure. Instead, we believe risk management is better served by a focus on funding ratio risk and accordingly, we are proposing a framework for decomposing the funding ratio risk, which we view as the pertinent risk metric for defined benefit (DB) pension funds.

The funding ratio is a core indicator of a pension fund’s financial health and risk management is an important driver. Signalling the need for improved risk management, the ratio has shown wide swings since 2007. There are differences in starting points and impact sizes, but the trends have been clear. In just one year, from year-end 2007 to year-end 2008, funding ratios fell rapidly and heavily, by about 20% in the UK and 30% in the US and the Netherlands. At their worst since 2007, funding ratios had plunged by an average of about 35% and initial overfunding turned into serious underfunding. Funding ratios recovered, but in 2014 were still well below the end-2007 levels.

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In response, many plan sponsors are opting to close their traditional DB plans. Admittedly, deteriorating funding ratios have not been the only reason. Others include tougher regulations, a more difficult business climate and eroded financial health. The very real chance of shortfalls in such plans and thus the possibility of sponsors having to make additional contributions to repair underfunding is spurring them to rethink the nature of their pension offering. Increasingly, this is leading to interest in defined contribution (DC) and/or hybrid DB/DC schemes since these effectively involve a transfer of investment decisions and consequently investment risk from employers to employees and retirees. In our view, improved risk management could also have helped to bolster pension schemes. It is in this context that we want to stress the importance of liability-driven investment approaches to managing pension funds since this involves effective risk management.

For us, pension funds can make significant progress in this area, as was also underscored by a recent survey of pension funds and sponsor companies, most of them European pension funds, by the EDHEC-Risk Institute. One of the survey’s main findings was that, although participants were generally familiar with the LDI paradigm, the rate of adoption remained rather limited.

In concrete terms, many pension funds are more concerned with standalone performance than with risk management. For example, many respondents had not yet translated regulatory minimum funding requirements into strategies to protect the funding ratio by imposing a floor.

It is precisely in the area of improved risk management that our new paper seeks to make a contribution.

Decomposing funding ratio risk: the advantages

There are our two primary objectives.

A) To demonstrate to DB plan sponsors the advantages of measuring funding ratio risk over surplus risk. Surplus risk offers a less complete view of the health of the pension fund and, at times, can be misleading. In fact, an increase in surplus can be accompanied by a fall in the funding ratio. This leaves no doubt about a deterioration of a pension fund’s financial health. Therefore, it is logical that the funding ratio, not surplus, tends to be the focus of regulators.

B) To propose a framework for decomposing funding ratio risk. This is based on a standard linear factor model that we customised.

We see two reasons why such a factor model needs to be tailor-made:

1) Customisation is needed since pension fund investments are driven by liabilities.

2) Pension funds invest in many asset classes, which has repercussions for the choice of which factors to include. In particular, macroeconomic factors rather than many asset class-specific style factors could prove enough to capture the lion’s share of risk exposures.

Our decomposition methodology is a first

To our knowledge, we are the first to propose a decomposition methodology for funding ratio risk.

As said, it is based on a factor model and it is flexible with regards to the choice of risk factors.

In a case study based on a real DB pension fund, we have decomposed its funding ratio risk into macroeconomic factor risks such as real rates risk, inflation risk and two economic growth risks, namely, credit risk and equity risk. We have included a risk factor to measure accurately the risk impact of not hedging away fully the interest-rate sensitivity of the liabilities.

The study took into account forward-looking simulations rather than historical regression. We believe that this information is more powerful and useful for DB pension funds and that our decomposition methodology can deliver valuable insights into important key portfolio risk exposures.

For more details on our methodology, read part 2 of ‘Pension funds: understanding funding ratio risk better

For more on our tailored solutions that meet the needs of pension schemes, insurance companies, corporates and other institutional investors, go to http://institutional.bnpparibas-ip.com > our-capabilities > multi-asset-solutions > customised-solutions

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Anton Wouters

Head of Customised and Fiduciary Solutions, Multi-Asset Solutions

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