Black swans: The threats to the pension system nobody is talking about

Like the infamous black swan, which was unknown to Europeans until its discovery in 1697, all of this brings us to the rather uncomfortable conclusion that we should not limit our estimates of the future by what we have observed in the past.

It is widely discussed in academic literature that correlations break down in times of financial crisis. However, the challenges of modelling this line of thinking in economic scenario-generators is often glossed over.

Changes such as voluntary indexation have the potential of having significant downside for members, yet are rarely discussed by trustees or part of an IRM monitoring framework

In practice, many environmental, social and governance, or value-at-risk models draw on historic data to build their forecasts – opening themselves up to black swan-type surprises.

Due to the surge in popularity of VaR as a risk measure, this lack of consideration for unexpected events has the potential to catch the majority of the pensions industry off-guard.

Although VaR models are sophisticated, scenario-testing can be a better tool to help explore downside scenarios to key parameters. The only limit is our own imagination.

Scenario analysis also has the added bonus of allowing the impact of pre-defined macroeconomic parameters on both the scheme and its employer to be assessed in parallel. This kind of deterministic modelling can identify correlations between the risks to the scheme and the risks to the sponsor in a proportionate manner.

Integrated scenario testing such as this is also a primary thrust of the Pensions Regulator’s integrated risk management guidance.

Consider risks specific to your sponsor

Risks that are even more difficult to consider can arise from the operational, strategic, or governance deficiencies of sponsors, which we can only hope do not materialise.

Yet history is full of examples: Gerald Ratner’s “total crap” comment about a product sold by the Ratners jewellery chain; Nokia’s underestimation of its competition; BP’s Deepwater Horizon oil spill; Volkswagen’s emissions testing; and even the Maxwell pensions scandal come to mind.

We can attempt to forecast some of these failures by considering technological advances, market intervention, or other destabilising trends – currently, one might focus on populism, deglobalisation and rising wealth inequality.

For example, it might not be appropriate to take long-term covenant risk in a sector where participants are inherently exposed to technological change.

Trustees with such sponsors cannot be sure what technological advancements will arrive, when this will happen, or whether their sponsor will benefit. But they can be confident change will occur. Today’s ‘impossible’ can and will become tomorrow’s ‘normal’.

Trustees should be aware of the lessons of the past, and stay tuned in to current trends to consider how the status quo of their sponsor may change.

The pension framework can change

Foreshadowed by the consultation on the security and sustainability of DB pension schemes, we should not forget to consider what an alternative pension system could look like.

Inspiration can be drawn from the Dutch system, where indexation is voluntary; from the German system, where obligations do not have to be funded; or even from recent changes to American multi-employer plans, where accrued benefits can be compromised if funding is deemed unlikely.

Such changes have the potential of having significant downside implications for members, yet are rarely discussed by trustees or part of an integrated risk management monitoring framework.

What all of this demonstrates is that we must not be blinkered and focus our analysis solely on what our experience and knowledge tells us – the only thing constant is change.

Instead, we have to be open to the new and explore areas where risks can emerge that are deemed unlikely or even near impossible. Horizon scanning can be a helpful tool in this context to complement a scheme’s integrated risk management framework.

Lastly, it has never been more important to ensure appropriate funding for a scheme in good years, as the bad years may well come. Who knows what medical breakthroughs or sovereign defaults may be around the corner. Predicting their arrival and impact is a fortune teller’s game.

Matthew Harrison is managing director at covenant specialists Lincoln Pensions