Stakeholders in defined benefit pension funds should redefine who exactly takes which risks, what constitutes solvency and who owns which part of it. Theo Kocken takes the baton in the first instalment in a series of discussion papers
In a bid to preserve the advantages of defined benefit (DB) pension schemes without unduly burdening companies with DB liabilities, the Netherlands has introduced a pension model whereby active scheme members and pensioners assume some of the scheme’s risks.
UK actuarial groups have also called for similar risk sharing to be introduced in the UK in an effort to make DB schemes sustainable.(1)
Although risk sharing goes a long way to create a more viable DB model, this paper contends that a long-term sustainable solution requires additional changes to the design of the pension contract. Redistribution of risk does not resolve the issue of ill-defined ownership of the various entitlements within a pension fund.
Stakeholders shy away from DB schemes not merely because the risks involved are increasing, but because of an ever more acute imbalance between risk and (lack of explicit) returns. Even with better risk sharing between stakeholders, at some point employers get uncomfortable with the long-term risk-return perspective.
The source of this instability can be found in the lack of clear ownership, more specifically:
Solvency that is required within DB plans by regulators is capital that does not belong to anyone. In economic terms, it is irrational to add capital to a pension fund in case of a solvency shortfall, when this investment is not able to create (explicit) returns in case there is a surplus exceeding the solvency requirements; The risk-return trade-off is therefore exceedingly biased to risk-only, which prompts even the biggest risk takers to shy away from pension funds.
The solution can be found in two principles of pension redesign:
1. Redefine what amount of economically sensible solvency is required in a pension fund, more specifically, what capital has to be protected as a kind of senior (secured) debt, who assumes the additional risks in a pension fund and in what manner;
2. Ensure that there is an explicit agreement about the ownership of this solvency and that there is a proper definition of how the potential positive future returns are shared between the various stakeholders in a pension fund.
The first principle ensures that no more capital is allocated to solvency than required, given the objective of securing certain parts of the pension provision. The second principle ensures that participants are willing to invest in solvency and share risks in pension funds, since it also provides fair, market consistent, return incentives. If practically implemented, these two principles may provide a better foundation for sustainable DB plans in the long run.
Anomaly of ownerless solvency
Employers are understandably wary of the potentially significant P&L impact of highly volatile pension fund costs. In addition, without any entitlement to the return on pension fund investments, they are loath to assume the risk of having to make future capital injections into the fund. At best, the entitlement to scheme surpluses is unclear and bears little relation to the risks involved. Employers are thereby confronted with ever more imbalanced risk-return trade-offs: they take more and more risk without being able to share in the upside.
The lack of properly defined return sharing is different from all other investments that corporates make and runs contradictory to economic theory.
In the Netherlands, to avoid closure of their plans, both employees and members have shouldered a considerable part of the mounting risks. Scheme members’ contributions fluctuate contingent on funding ratio and members agree to forgo indexation in case of a low funding ratio.
The Dutch approach has prevented employers from bailing out en masse as risk takers. In some cases, where employers have retrated almost completely as risk taker, the DB features remained in place in what are called ‘collective DC’ structures. However, even within these collective, risk-sharing systems, imbalances between risk and return exist and will continue to grow as pension funds mature. To be sustainable, these risk-sharing agreements need to address the issue of ownership and bring the corresponding return entitlements in line with risk taking.
To repair the imbalanced risk-return trade-off - without reverting to shifting all risks to the individual beneficiary, as in DC - we need to bring return potential in line with risks taken, and allocate risks to those stakeholders who are willing to assume these risks and their corresponding return possibilities.
Defining ownership and solvency
Two principles of pension design may solve the problem of unstable DB schemes:
1. Define who takes which risks (which part is secured, which is the risky part that acts as solvency) based on the risk appetite of the different stakeholders;
2. Define ownership of this solvency and upside entitlements.
The best way to explain how these principles may work in practice is to consider a case of a real life pension fund.
For this particular stylised real life case, the agreements are as follows:
At the age of 65, people retire and retirees receive a pension of 80% of their average career salary; In case of insufficient funding ratio, both active members and pensioners forgo their indexation for the year; In the unlikely event that the nominal funding ratio drops below an extremely low threshold level, parts of the nominal entitlements of the younger active members (below 50 years) are marked down. The maximum amount of write downs is eg 25% and active members have the possibility to use additional contributions to steer towards a higher benefit level); The employers ensure that the funding ratio is replenished to secure the 100% nominal pensions for retirees plus older active members and hence, the 75% nominal pension level is well-secured senior debt.
It should be clear that the transfer of risk of an extreme nominal shortfall to younger active members prevents employers from assuming excessive risks and investing in excessive amounts of solvency capital. This risk transfer is acceptable if properly rewarded; in particular as the younger active members can anticipate a significant period of employment ahead of them.
In addition, this risk sharing agreement is designed such that in case of a surplus in excess of the solvency requirement, beneficiaries receive additional entitlements on top of their accrued pension entitlements and the employer receives a restitution or contribution reduction. The exact allocation of surplus to each stakeholder can be determined by applying various techniques such as embedded option theory.(2)
Conclusions and recommendations
Risks in very mature pension funds have increased for many stakeholders and asymmetric risk-return trade-off requires risk takers to assume downside hits without a well-defined return potential. This has put the sustainability of the DB system at risk. The introduction of two principles might avoid the extinction of collective pension funds:
1. Alternative risk sharing can be agreed upon between stakeholders, accepting that the new situation requires different solutions;
2. Explicit ownership per risk category in line with economic principles of risk- return should be introduced. This can be achieved via fair market-price based rules determining who gets what part in case of a surplus.
Risk sharing might take away tensions in the short and medium-term. Together with clear and fairly defined ownership, two conditions are met that provide a system that can also survive long into the future.
(1) See Ian Farr (2007), ‘A New Breed of Shared Risk Schemes to Re-Energise the Provision of Employer Sponsored Occupational Pension Schemes in the UK’, ACA policy statements.
(2) See for example Nijman, T E, Koijen, R (2006) “Valuation and Risk Management of Inflation-Sensitive Pension Rights” in “Fair Value and Pension Fund Management”, N Kortleve, Th E Nijman and E Ponds (eds.), Elsevier Publishers.
Theo Kocken is founder and CEO of Cardano and (co-)author of various books and articles in the area of risk management and pension funds
This series of articles, published in conjunction with our Netherlands sister title IPN, seeks to create a platform where various authors, academics and practitioners discuss possible solutions to solvency and risk sharing issues that have the common objective of making the DB pension system more robust for the future.