There are many risks that a pension scheme needs to be aware of, on both the asset and liability side of the balance sheet. A 10% increase in assets may look great but if liabilities have risen by 15% then the scheme (and sponsor) will be worse off.
Given the current volatility in markets and uncertainty over long-term solutions, many questions are being asked about tail-risk hedging and what actions should be taken to mitigate them. Our response always starts with, “What does your Pension Risk Management Framework (PRMF) say?”
Every scheme is different so there is no one-size-fits-all response. For example, it may depend on the funding level of the scheme, attitude to risk versus return, or the governance structure in place to take and implement decisions.
The best advice is to have ready a clear framework within which these discussions can take place. Sometimes the worst time to change strategy is during a storm, particularly when an alternative course has not been mapped out, leaving you at the behest of the tides.
The dashboard above provides pension schemes with a comprehensive, easy-to-understand overview of how well a scheme is performing against objectives:
1) Risk Radar – Highlights the biggest risk factors affecting scheme assets and liabilities, allowing decision-makers to focus on specific risks (Size of circle = Impact, Distance from centre = Importance)
2) Scheme Gauge – Shows the condition of the scheme based on four fundamental variables – funding level, liquidity, covenants and contributions.
3) Risk Monitor – Puts numbers to the scheme’s exposure to show how much risk the scheme is currently taking, as measured by four elemental risk metrics – required return to meet full funding target, funding value-at-risk, contributions at risk and required return at risk.
4) Performance Monitor – Displays the performance of investment markets which are most important to the scheme, eg. equity, credit spreads, gilt yields, breakeven inflation.
5) Traffic light system – Displays performance of the scheme against pre-agreed measures: Green if meeting targets, Amber if falling short by a small margin or Red if underperforming significantly. This is vital to address areas where effective action is most needed.
Further details on how pension schemes may use the PRMF to help deliver better outcomes can be found in this article.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]