Defined Benefit Pension Schemes Research Articles

Effects of scheme default insurance on decisions and financial outcomes in defined benefit pension schemes

AbstractA simulation investigation of the effect of default insurance on the optimal equity allocation and deficit spread period of a model defined benefit pension scheme is performed, using the old and new frameworks of the Pension Protection Fund in the U.K. as a starting point. The old default insurance levy framework encourages an increase in the allocation to equities, creating an indirect effect of increased deficits. The new framework reverses the effect to a reduction in the allocation to equities, thus reducing deficits. In addition the gaming element of default insurance is investigated and found to significantly increase optimal equity allocation and deficit spread period, leading to a significant increase in deficits.

Feedback Effects of Default Insurance for Defined Benefit Schemes

A simulation investigation of the effect of default insurance on the optimal equity allocation and deficit spread period of a model defined benefit pension scheme is performed, using the old and new frameworks of the Pension Protection Fund in the U.K. as a starting point. The old default insurance levy framework encourages an increase in the allocation to equities, creating an indirect effect of increased deficits. The new framework reverses the effect to a reduction in the allocation to equities, thus reducing deficits. In addition the gaming element of default insurance is investigated and found to significantly increase optimal equity allocation and deficit spread period, leading to a significant increase in deficits.

A Value-at-Risk framework for longevity trend risk

AbstractLongevity risk faced by annuity portfolios and defined-benefit pension schemes is typically long-term, i.e. the risk is of an adverse trend which unfolds over a long period of time. However, there are circumstances when it is useful to know by how much expectations of future mortality rates might change over a single year. Such an approach lies at the heart of the one-year, value-at-risk view of reserves, and also for the pending Solvency II regime for insurers in the European Union. This paper describes a framework for determining how much a longevity liability might change based on new information over the course of one year. It is a general framework and can accommodate a wide choice of stochastic projection models, thus allowing the user to explore the importance of model risk. A further benefit of the framework is that it also provides a robustness test for projection models, which is useful in selecting an internal model for management purposes.

Financial Management of the UK Pension Protection Fund

AbstractThe UK Pension Protection Fund (PPF) was established in April 2005 to protect the pensions of members of UK private sector defined benefit pension schemes which have insufficient assets and whose corporate sponsor fails. The Fund takes over the pension scheme assets and assumes responsibility for the payment of compensation to the former members of the scheme. The PPF is funded by a levy on the population of eligible schemes. This paper discusses the application of Enterprise Risk Management principles and techniques to the unique situation of the PPF. The elements of the financial management of the Fund have been developed by reference to practice within proprietary insurance institutions and within pension funds. The paper will be of interest and, we hope, of some value to students, researchers and analysts and also to the PPF's own stakeholder groups that have a stake in an effective pension protection regime.

The Effect of Objective Functions on Investment and Contribution Decisions for Defined Benefit Pension Schemes

This paper examines the effect of objective function structures on the optimal management decisions (in particular, asset allocation and surplus/deficit spread period) for a model defined benefit superannuation scheme. The objectives of employer-sponsors, members and trustees are identified, with three risks being quantified and incorporated into different objective functions as used in previous studies. These are contribution rate risk, excess contribution rate risk and funding level risk. Simulation of a model scheme which is closed to new entrants is carried out to generate numerical values for the risks and consequently a single value from the range of different objective functions observed in the literature. Investigation of whether consistency exists between various objective functions in terms of optimal strategies is undertaken. It is found that there are considerable variations in the optimal decisions derived from each objective function, based on the same set of simulated outcomes. These variations are up to 87% in equity allocation and 14 years of surplus/deficit spread period. Such variations can be explained by either the risks that are considered or the way that the risks are measured. Further analysis is then undertaken of the impact of weighting parameter values on the optimal decisions with this analysis discovering that some of the objective functions tested are not appropriate for the investigation being undertaken. An overall outcome of the paper is the confirmation that it is vital to choose the most appropriate objective function based on the function’s characteristics and on the particular circumstances of the defined benefit scheme, in order to ensure that the optimal decisions are made for the scheme.

Meeting defined benefit pension obligations: measurement, risk and flight paths

AbstractThe UK defined benefit pension scheme landscape has changed dramatically over the last few decades. During this period of change, conflicting views regarding the measurement of both assets and liabilities has made communication challenging. In turn, this has led to an under appreciation of risk and often suboptimal decision making. This paper seeks to draw together a variety of contrasting views to provide a coherent framework for stakeholders to meet pension scheme obligations over time.The proposed framework encourages agreement between both scheme sponsors and trustees towards a common target through a well articulated plan or “flight path”. In addition, the proposed flight path structure provides a common basis underpinning the measurement of both pension obligations and the risks inherent in any plan to meet those obligations.

Myth busting: Defined contribution Clearing up common misperceptions about defined contribution pension schemes

Many factors play a part when comparing different pension schemes. Myths and misperceptions cloud the discussion whether employers or employees are better off with a defined benefit (DB), defined contribution (DC) or a hybrid scheme. We notice that, especially among proponents of DB schemes, some persistent misconceptions about DC schemes persist. In this article, we aim to clear up five of these myths: (i) DC schemes generate lower pensions than DB schemes, (ii) Individuals in DC schemes take poor investment decisions, (iii) Management fees in DC schemes are too high, (iv) Collectivity is lost in DC schemes, (v) Participants in DC schemes run big interest rate risks. DC pension schemes might not be a panacea to all retirement problems, but we feel a fair comparison with DB pension schemes is required.

On the Application of Stochastic Optimal Control to Pension Fund Management

In this paper, we apply the stochastic optimal control theory to the pension fund management before and after retirement in the defined contribution and defined benefit pension schemes, where benefits are paid as investment returns for a period or duration of time. The goal of the management problem is to optimize the long-term growth of expected utility of returns. We consider different types of power law utility function of the form U(X)=γ-1Xγ, γ<1, γ≠0 to examine the different investment schemes. Our result shows the advantage of the defined contribution scheme over the defined benefit scheme before and after retirement.

Economic capital for defined benefit pension schemes: An application to the UK Universities Superannuation Scheme

AbstractThis article considers the amount of economic capital that defined benefit (DB) pension schemes potentially need to cover the risks they are running. A real open scheme, the Universities Superannuation Scheme, is modelled and used to illustrate our results and, as expected, economic capital requirements are large. We discuss the appropriateness of these results and what they mean for the DB pension scheme industry and their sponsors. The article is particularly pertinent following the recent European Commission Green Paper on the future of European pensions systems, its call for advice on reviewing the Institutions for Occupational Retirement Provision Directive and the introduction of the Basel 2 and Solvency 2 risk-based regulatory regimes for banking and insurance, respectively.

Risk-Based Approach for the Management of a Defined Benefit Pension Scheme

We apply a risk-based analysis to study the optimal investment-contribution-new venture strategy of a defined-benefit pension (DB) scheme. This problem is formulated as a zero-sum stochastic differential game (SDG) with jump-diffusion between the sponsor and the fictitious market. The scheme selects an optimal investment-contribution-new venture strategy that minimizes the risk described by a convex risk measure of the scheme’s terminal wealth while the market selects a probability measure index analogous to the worst-case scenario where the risk is maximal. We apply the backward stochastic differential equation (BSDE) approach to solve the game problem. This allows us to obtain a simple and natural approach for the existence and uniqueness of an optimal strategy of the SDG without imposing any Markov assumptions.

An inconvenient truth: Pensions in the UK have priority ranking

Defined benefit pension schemes in deficit have long been a matter of concern. The outcome in October 2011 of linked appeals by the administrators of the groups of both Nortel and Lehman Brothers were a notable triumph for the UK Pensions Regulator and scheme trustees. However, the adverse consequences of these cases on lenders and insolvency practitioners, created by the ‘oddities, anomalies and inconveniences’ of a ‘legislative mess’ are also likely to generate important knock-on effects for corporates and scheme trustees.

The determinants of hiring older workers in Britain revisited: an analysis using WERS 2004

This article reexamines the role of specific human capital and back loading of compensation as deterrents to hiring older workers. We utilize the framework initially suggested by Hutchens (1986) and more recently implemented by Daniel and Heywood (2007). This approach identifies the extent to which firms hire older workers at a rate less than full replacement would imply. Using the 2004 British Workplace Employment Relations Survey, we examine whether a more favourable climate including a much tighter UK labour market combined with the abandonment of defined benefit pension schemes has increased the tendency to hire older workers. We also examine the impact of private health insurance.

The Sustainability of Pension Schemes

Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.

Informed Intermediation of Longevity Exposures

We examine pension buyout transactions and longevity risk securitization in a common framework, emphasizing the role played by asymmetries in capital requirements and mortality forecasting technology. The results are used to develop a coherent model of intermediation of longevity exposures, between defined benefit pension schemes and capital market investors, through insurers operating in the pension buyout market. We derive several predictions consistent with the recent empirical evidence on pension buyouts, and offer insights on the role of buyout firms and regulation in the emerging market for longevity-linked securities. A multi-period version of the model is used to explore the effects of longevity risk securitization on the capacity of the pension buyout market.

Quantifying mortality risk in small defined-benefit pension schemes

A risk of small defined-benefit pension schemes is that there are too few members to eliminate idiosyncratic mortality risk, that is, there are too few members to effectively pool mortality risk. This means that when there are few members in the scheme, there is an increased risk of the liability value deviating significantly from the expected liability value, as compared to a large scheme. We quantify this risk through examining the coefficient of variation of a scheme's liability value relative to its expected value. We examine how the coefficient of variation varies with the number of members and find that, even with a few hundred members in the scheme, idiosyncratic mortality risk may still be significant. Next we quantify the amount of the mortality risk concentrated in the executive section of the scheme, where the executives receive a benefit that is higher than the non-executive benefit. We use the Euler capital allocation principle to allocate the total standard deviation of the liability value between the executive and non-executive sections. The results suggest that the mortality risk of the scheme should be monitored and managed within the sections of a scheme and not only on a scheme-wide basis.

Causes of defined benefit pension scheme funding ratio volatility and average contribution rates

AbstractSimulations of a model pension scheme are run with stochastic economic and demographic factors, with an aim to investigate the impact of these factors on movements in funding ratio and average contribution rates. These impacts are analysed by running regressions of movements in funding ratio and average contribution rates against the economic and demographic factors. It is found that, for a typical scheme closed to new entrants and a balanced asset allocation including equity investment, the mismatch between discount rate movements and investment returns is by far the biggest predictor of funding ratio movements, with average contribution rates affected more by events in a few individual years rather than averaged over an entire simulation. Where the scheme invests to cash-flow match liabilities, mortality improvement becomes the most significant predictor of funding ratio movements, although mortality improvement still has little impact on average contribution rates.

De-risking and the flightpath to buyout

Trustees and employers are increasingly looking at the various de-risking options available to help manage the £1 trillion liabilities in UK defined benefit pension schemes. This article investigates why there is an increasing appetite for de-risking, including the challenges faced by schemes as a result of increasing costs, longevity trends and accounting practices. De-risking exercises can take many different forms and can be tailored to an individual scheme's de-risking goals, trustee and company budgets, and relevant economic conditions. A number of options available to schemes are highlighted in this article and the concept of ‘flightpath’ (a designated plan that enables a scheme to reach buyout over a period of time) is explored. The ultimate end goal of securing pension scheme benefits for the lifetime of members and their beneficiaries is in the interest of all stakeholders involved. Through good communication and planning, the relevant steps can be taken to reduce risk in a pension scheme, while understanding that any plan needs to be adaptable as inevitably situations will arise that require manual intervention or a change in direction.

Defined Benefit Pension Schemes: A Welfare Analysis of Risk Sharing and Labour Market Distortions

This paper addresses two policy questions with respect to public defined benefit (DB) pension schemes: Firstly, does a funded DB pension scheme increase welfare? In other words: do the gains from intergenerational sharing of capital market risks outweigh the labour market distortions from pension schemes? Secondly, how large is the commitment problem of pension funds after an adverse capital market shock? The answer to the first question depends on the used welfare measure. If we use risk-neutral weights to aggregate the equivalent variations of different generations in different states of nature then a DB pension scheme is welfare increasing. If we use as weights the stochastic discount factors that corresponds to these states of nature, we conclude the opposite: a DB pension scheme reduces welfare. The probability that future households actually experience a welfare gain if the pension scheme is closed can be as large as 38 per cent. So, a pure DB pension scheme has a large commitment problem: continuity will become at risk in case participation in the pension scheme is not mandatory. These results are most sensitive for the values of the labour supply elasticity, the risk aversion parameter and the mean and the standard deviation of the excess return on equity.

A liability-relative drawdown approach to pension asset liability management

Defined benefit pension schemes accumulate assets with the ultimate objective of honoring their obligation to the beneficiaries. Liabilities should be at the center of designing investment policies and serve as the ultimate reference point for evaluating and allocating risks and measuring performance. The goal of the investment policy should be to maximize expected excess returns over liabilities subject to an acceptable level of risk that is expressed relative to liabilities. In this article, we argue for the use of a liability-relative drawdown optimization approach to construct investment portfolios. Asset and liability returns are simulated using a vector autoregressive process with state variables. We find that drawdown optimal portfolios provide better downside protection, are better diversified and tend to be less equity centric while providing higher expected returns compared to surplus variance portfolios.

A critical perspective of pension tax arbitrage

Pension tax arbitrage theory is controversial in that it concludes that defined benefit (DB) pension plans should shift all their assets to bonds. Pension tax arbitrage may occur when a change in asset allocation of a DB pension scheme together with a change in the financing structure of the sponsoring employer firm results in additional tax-based financial returns without increasing the overall financial risk. A share buyback may be financed by an issue of bonds, and the assets of a pension plan (PP) may be shifted from equities to bonds issued by external companies. Tax advantages arise if interest on corporate debt is tax-deductible, while risk neutrality assumes that shifting assets in a DB pension plan from equities to bonds reduces risk to an extent that exactly offsets the increased risk associated with higher corporate gearing. This article considers the practical relevance of the theory of pension tax arbitrage and how to assess the impact of reported financial information on the market capitalisation of the sponsoring companies. Concerns over large and increasing pension fund (PF) deficits have added to the sense of urgency to seek more conclusive evidence of the practical impact of PF asset allocation decisions, including those based on pension tax arbitrage strategies. The main contribution of this article is to develop an insight into pension tax arbitrage in the light of accounting standards, government policy objectives and corporate pension investment policy. Further research is recommended to explain the asset allocation of PPs and in particular the reasons why so few company boards apply pension tax arbitrage strategies, and to assess the value relevance of PP asset allocation information.