Risk measurement and management of defined benefit pension schemes: a stochastic approach

Abstract

The traditional actuarial valuation for defined benefit pension schemes operates on the basis of a set of deterministic calculations combined with actuarial judgment. It has played an important role in guiding decision‐making as far as the level of funding is concerned. The paper argues that stochastic methods can add value in certain crucial areas, in particular the financial risk management of such schemes. The traditional approach to risk is to incorporate margins in the valuation assumptions; however, a stochastic approach allows the user to evaluate specific and quantifiable risk and performance measures in respect of alternative funding and investment strategies. The paper introduces a framework that measures the risks inherent in asset allocation and contribution rate decisions, allowing decisions to be made on a more informed basis. In doing this, we suggest and apply some potential risk and performance measures. This framework provides the means to explore the trade‐offs involved in possible contribution and asset allocation decisions and leads to decision strategies that are expected to give improved outcomes for the same level of risk. A realistic case study is used to illustrate the properties of the methodology and how it might be used.