Integral risk management by pension funds in a fair value framework

Abstract

Pension funds worldwide, for instance in the UK and the Netherlands, will increasingly adopt the fair value approach. The aim of this paper is to derive an integral risk management framework for pension funds, based on fair value principles. The point of reference is a typical defined benefit plan with indexed liabilities, where the main sources of risk are the long-term fluctuations in prices driving the value of the plan's assets and the fluctuations in the discount and inflation rates that determine the value of the liabilities. Mismatch risk is identified as the central risk measure for integral risk management. The fair value approach contributes in clarifying the long-term advantages of a pension fund scheme; however, the approach also contributes in revealing its main weakness: a high exposure to mismatch risk and hence a large risk of underfunding in the short term. A typical pension fund usually fails to be explicit on the issue of risk bearing. Therefore, it is not clear which of the stakeholders has to meet up a funding shortage. Three options to handle short-term risk are discussed. First, creating a floor by investing substantially in index-linked bonds. Secondly, holding a high solvency margin to absorb a fall in asset prices. The third option, preferred by the authors, is to state the so-called pension deal so that it is clear which of the stakeholders is participating in the risk of underfunding as well as overfunding, and to what extent. Such a deal will assist in preventing potential conflicts between the stakeholders about the allocation of benefits and costs. The pension fund management and its stakeholders will only obtain good insight into the benefits and costs if the pension fund contract is a transparent and complete contract. Fair value principles contribute to these goals of transparency and completeness.