Pension funds face threats relating to inflation, interest rates and longevity - all of which can be mitigated in new ways
It goes without saying that managing a complex financial venture such as a pension fund carries with it significant risks - primarily, that the fund is unable to meet its commitment to pay its contributors. Consequently, fund managers have become adept at understanding investment risk, particularly equity risk, and managing it through diversifying asset portfolios and hedging strategies.
However, the assets held to pay for future pension benefits represent only one half of the pensions equation. Funds remain at risk from volatility in pension scheme liabilities caused by inflation, interest rates and increased longevity.
In recent years, funds have been addressing the risks posed by the costs arising from unforeseen liability movements. This includes the longevity improvements, which have been consistently higher than expected and have accelerated in the past 20 years. Consequently, a renewed appetite for liability-driven investment has emerged, which often makes use of interest rate and inflation hedging to manage risk.
This has been closely followed by the emergence of a growing market in liability risk mitigation and removal products – for example, pension scheme buy-outs, whereby liabilities and responsibilities for paying pensions are transferred to a third party (typically an insurer).
Pension scheme buy-ins operate in a similar fashion in that they insure the fund against liability volatility, but the fund retains its obligations to the members. Deals of this nature ran to over £10bn in 2008, and while they lost popularity during the economic downturn, activity has started to rise again.
In the private sector, the financial risks associated with pension funds place immense financial pressure on the scheme sponsor. Many employers have responded to these risks by closing schemes to protect existing members. Others have taken steps to de-risk through scheme design: reducing benefit accrual rates; increasing members’ contributions; increasing retirement ages; and capping pensionable pay increases.
In addition, some schemes have sought to remove risk by offering financial inducements to scheme members to transfer their accrued benefits out of the pension scheme, or by buying out rights to annual pension increases in return for lump sum payments or one-off increases in pension.
A more recent development has been the emergence of products designed to mitigate longevity risk. Longevity swaps operate in much the same way as other swap deals, with a stream of fixed payments (fixed leg) being swapped for a stream of variable payments (floating leg).
Public sector pension funds also face the problems of liability risk. This was recognised in the last round of scheme changes, where the major public sector schemes introduced ‘cap and share’ arrangements. These seek to limit the employers’ exposure to longevity risk by sharing the costs of longevity improvements with employees.
In the Local Government Pension Scheme, individual funds are also taking steps to manage risk. Research by the Royal Bank of Scotland, which was presented to an audience of CIPFA Pensions Network members in March, revealed that longevity risk ranked fourth within the risk profile of the LGPS. It is perhaps not surprising therefore to see an LGPS fund enter the longevity swap market, as the Berkshire fund did last year.
That said, no one approach should be regarded as a panacea for pension fund risk. Instead, the approach to risk management should be seen as a series of steps within an overall risk reduction strategy. And, of course, not all of the risk removal or reduction tools discussed above are appropriate or permissible in a local authority context. However, funds should understand their risk profile and consider how they might address liability risk.
Nigel Keogh is technical manager, pensions and central government, at CIPFA. Managing liability risks in the LGPS will form part of ‘Investing for the future’ – the pensions and treasury management strand of the 2010 CIPFA annual conference
