Defined benefit pension funds: Identifying, quantifying and managing asset-liability risks

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This paper looks at issues relating to defined benefit pension plans. The paper presents a risk management framework for the identification, measurement and management of the asset-liability risks inherent in defined benefit pension plans. This is a flexible and transparent platform that can provide immediate insights into the key risk drivers of a defined benefit (DB) pension plan, and how these risks interact. Some of these insights are obvious — if a pension plan holds equity assets to back liability cashflows that are, at best, indirectly related to equity returns, the pension plan will be exposed to falls in equity values. However, the case study discussed in this report provides some more subtle insights into the quantification and interaction of the risks being run by a ‘typical’ DB pension plan: Diversification of risk across assets and liabilities is hugely important when the risk/reward management of DB pension plans is considered. Historically, this factor has been neglected by many — opting for equities as the sole ‘return’ generator. Typical DB pension plans are exposed to falls in equity values and falls in interest rates. Standard assumptions about the relationship between changes in equities and interest rates imply that these two exposures provide a limited amount of natural offset. That is, when equities fall, interest rates tend to rise, providing some relief in the form of a reduction in the liability value. This has some interesting implications from a risk management perspective. The consequence is that hedging interest rate risk without managing equity risk will have little effect on the total risk facing the pensions plan — even where the liability duration risk is very significant. Given the size of asset/liability mismatches typically present in a DB pension plan, the marginal contribution to risk of mortality risk is very low. This is not because significant mortality uncertainty does not exist. Rather, it is because it is uncorrelated with the large asset/liability risks that are typically present in a DB pension plan. If and when the asset/liability mismatches are mitigated, the impact of mortality risk will be significantly greater. This undermines the principle that risks can be totally removed from pension fund management.