Examining pension plan risk in an economic capital framework

Examining pension plan risk in an economic capital framework

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Speakers: Steve Bonnar, Aniketh Pittea

Although declining in popularity, employment-based defined benefit pension plans (EDBPP) still are expected to provide an important source of post-retirement income to many individuals in developed countries. Such plans accumulate significant assets and are expected to operate over long time horizons; yet compared to many financial institutions such as banks and credit unions, with similar purposes but not nearly as long time horizons, these plans are lightly regulated with respect to capital adequacy.

The most common approach to assessing the adequacy of funding of a pension plan is to compare the actuarial present value of benefits to the present value of assets. Benefits might be accrued benefits, projected benefits, benefits on wind-up, etc., depending on the purpose of the valuation. This "balance sheet snapshot" provides useful information. However, as a tool to indicate the likelihood of being able to deliver on the long range benefit commitments it has deficiencies.

The regime of low interest rates for long-term bonds seems to be more long lasting and persistent than was previously thought. Additional research suggests that not only is life expectancy increasing but mortality improvement among retirement-aged cohorts is continuing (even accelerating in some cases).We use a multi-variate stochastic model for economic and demographic variables to estimate the risks underlying EDBPP. We apply an economic capital approach to a large open EDBPP in the UK and to a large open EDBPP in the US to illustrate the magnitude of the risks to which such a plan is exposed.
We find that the risk inherent in an EDBPP can potentially be very large depending on size and profile of the pension plan membership, the benefit entitlements, funding status and asset allocation strategies. We discuss the appropriateness of these results and what they mean for the defined benefit pension industry and plan sponsors.

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