How to measure and evaluate the key risks facing your DB scheme

Investment and longevity risks are quantifiable to an extent and therefore can be reasonably measured while the others can be subjectively quantified by estimating their probability of materialising and assessing their potential impact.

However, the challenges for trustees and sponsors go beyond measuring and evaluating risk, and extend to having the requisite time and expertise to implement and monitor risk-mitigating strategies.

We address both issues here, starting with an overview of three key methods of quantifying and evaluating risk:

• Value-at-risk;

• Scenario and stress-testing;

• Sustainability test.

Value-at-risk

This measure can be thought of as the amount of money a scheme expects to lose over a certain period in a worst-case scenario (typically the 95th percentile of possible outcomes).

VaR is usually illustrated over a one-year time period as this can provide guidance on the possible range of deficit at the next actuarial valuation. Other values in this context include funding level, required contribution and expected return.

One criticism of this measure during the financial crisis of 2008 was that it ignored tail risks. However, VaR should serve as a guide with subjective overlay applied to give a better handle on risk. Such judgment could be informed by scenario and stress tests.

Scenario and stress-testing

This entails determining the vulnerabilities in the scheme by testing its resilience to various scenarios, both historical, such as the equity returns; changes to long-term interest rates and inflation, realised during the last financial crisis; and hypothetical, through which its resilience can be tested by applying even more severe assumptions.

The traditional approach to measuring risks in pension schemes is based on the relationship between the market value of the scheme’s assets and present value of liabilities. So funding level, deficits, required deficit contribution all relate to market value and present value.

However, one of the main objectives for a pension scheme is to meet the cash flow payments – not present value of cash flow payments – as they fall due.

Therefore a sustainability test measures the ability of the market value, possible deficit repair contribution and portfolio expected returns to cover cash flow payments over the life of the scheme.

This incorporates a level of stress-testing such as varying the expected return of assets in the portfolio to see if current and future assets still cover cash flow payments over the life of the scheme.

Gaining a solid grasp of the risks inherent in the scheme should help to inform an investment strategy that is compatible with the objectives of both trustees and the sponsor.

But once implemented, it must be regularly monitored to ensure it remains appropriate. This can take the form of a flight plan where risk is progressively removed as the funding level outperforms its expected path.

Alternatively where the funding level is underperforming its expected path, re-risking the portfolio may be necessary.

Managing these processes requires considerable resources in terms of time and expertise, the former of which is often scarce among UK trustees.

A fiduciary manager can assist trustees by providing investment advice, implementation and continuous monitoring through a flight plan framework.

A key benefit of this arrangement is that trustees retain strategic control of the scheme but have the comfort that day-to-day investment responsibilities are being undertaken on their behalf within clearly defined parameters.

Cyprian Njamma is director of advice at fiduciary manager SEI’s institutional group