Pension fund trustees are increasingly grappling with the question of risk. How, for instance, to judge whether a scheme is running too much risk (whatever that means), embracing risk with insufficient enthusiasm or, maybe, judging it to sweet perfection. It’s a fiendishly difficult question and there is no generic answer. But how exactly do you measure risk within a pension scheme? No single method is sufficient for the task. This is a brief summary of three complementary approaches.
First, microscopic changes in certain market factors impact the pension scheme. Measuring these potent sources of risk is an important first step. A tiny rise (or fall) in inflation for instance, ripples through the future liability cash flows and changes their value by a defined amount. A minute adjustment to the rate used to discount the cash flows due to tomorrow’s pensioners measurably alters the present value of the liabilities. And if the deferred pensioners live only slightly longer than actuarial mortality tables predict, the liabilities rise. So the first step in a basic risk analysis is to use an asset/liability “microscope” to determine the scheme’s sensitivity to micro-factors - which should be considered separately, then together. The results are usually of great interest. 100x magnification of the scheme shows up potentially deadly microbe-like risks invisible to the naked eye.
Value at risk
A second risk measure used by banks, insurance companies and asset managers is known as Value-at-Risk. VaR is far from perfect – there are some “slow burn” adverse market moves it doesn’t properly capture - but it is widely used and easily understood. It provides a single amount (the value) which one might expect to lose (at risk) in a reasonable “worst case” scenario, one year, say, from now. So, if the scheme’s liabilities are £1bn, its assets are £950m and its 1-year VaR95 is £200m, then, simply, there is a 1-in-20 (i.e. reasonable worst case) risk of the deficit increasing from £50m today to more than £250m in a year’s time. This lens analyses and “brings near” a distant galaxy of tomorrow’s risks – a “risk telescope”, if you will. There are several sub-lenses and filters which may be fitted to the risk telescope to great effect, all building a deeper, richer picture of where the scheme could find itself in the future, given what we have learnt from the past.
But, for all its ability to unlock the secrets of future night skies, even the risk telescope only takes the trustees so far. The images it produces are, after all, based upon the likelihood of certain future events whereas in today’s world, as everyone knows, stuff happens (in the adapted words of Forrest Gump). So trustees need yet a third perspective from which to view the scheme - a kaleidoscope of unexpected, but definitely possible, dark scenarios re-created from yesteryear: Black Monday 1987; the Russian Crisis of 1998; September 11 2001; the credit crunch of 2007/2008. This comprehensive collection of simulated bleak and dismal scenarios is designed to measure just how well equipped (or not) the pension scheme is to withstand sudden and severe jolts or sustained market dislocations.
Trustees can, and should, simulate their own bespoke kaleidoscope of rising inflation, falling interest rates, plunging equities, falling property and weakening credit – in other words, a brutally tough obstacle course to test the real-time robustness of the scheme and its current investment strategy.
As a matter of routine, trustees need to use these powerful lenses, each providing highly pixillated images of the pension scheme’s risk profile and, together, making sense of its behavioural complexities. The Sensitivity Microscope (magnifying the scheme’s reaction to the slightest change in certain market or demographic factors); the Risk Telescope (calculating the chance of the scheme finding itself with a serious shortfall problem in the future); and the Scenario Kaleidoscope (evaluating the scheme’s susceptibility to the unpredictable).
Flight plan
After the diagnostic imaging, the flight plan. Once the trustees have a truly clear 3-D picture of the pension scheme they are in a promising position to map out an investment strategy to take the scheme to its ultimate destination - full funding. To illustrate – the Boeing 747 captain is unlikely to take off from London Heathrow flying roughly west in the vague hope of reaching JFK seven hours later. More usually, the crew pre-agrees a flight path, flight levels, fuel burn rates and navigation aided routing. As each Navaid is passed and logged, the crew knows with increasing certainty that the flight will arrive in New York on time. True, there may be unanticipated severe weather problems en route, but these are readily dealt with in flight and it is therefore no great surprise when, on cue, JFK finally materialises below the aircraft.
Managing a modern day pension scheme is much like flying a sophisticated aircraft. It requires careful advance planning, an optimised risk burn rate, meticulous attention to a flight deck of crucial information, ruthless elimination of unrewarded risk, constant monitoring of progress against a specific route and an ability to navigate around the unexpected. Anything short of that is, well, optimistic.
Dawid Konotey-Ahulu, partner & co-principal, Redington Partners LLP.
