Wearing a cap

Further to the discussion on Saturday, here are some more thoughts on risks in pensions and who should bear them.

Pensions are complicated things. Consider a typical defined benefit scheme. Here the pensioner has a right to a certain level of pension - often index linked - and the employer has an obligation to provide it. The pension is simply collateral against that obligation.

The first risk, then, is that the employer cannot meet that obligation, typically because they have defaulted, and the pension fund is not adequate. It is this risk that pensions protection legislation is meant to address.

The second risk is that the fund is not judged be adequate to meet the employer's liability, causing the need to 'top up' the fund. I say 'is not judged to be' rather than 'is not' because the law requires an assessment of the future likelihood of adequacy to be made rather than a spot assessment. Ignoring for a moment the veracity of the assessment - which is questionable - let's look at how a fund might fail to be sufficient to meet an employer's liabilities.

There are two moving parts here: the fund assets, and the fund liabilities. Funds are typically invested in some or all of corporate bonds, equities, and inflation linked bonds, plus perhaps other asset classes. Therefore they are typically:

• Short credit spreads (if credit spreads increase, the fund loses money on a MTM basis);
  
• Short nominal rates (because if rates increase, fixed rate bonds are worth less);
  
• Long equities; and
  
• Long CPI inflation (to the extent that they hold inflation-linked assets).
  

On the liability side the fund is:

• Short longevity (if people live longer it has to pay a pension for longer and hence loses money);
  
• Short wage inflation (if final salaries increase, so do pensions);
  
• Short CPI inflation (if inflation increases, so do index-linked pensions);
  
• Long nominal rates (because future liabilities are discounted back to today along some interest rate curve).
  

The risk is then that the spread assets - liabilities goes negative. In a DB scheme then the employer has to top up a fund if this spread falls beneath some threshold value, and hence they are short an option on the spread. In a defined contribution ('DC') scheme the pensioner bears all the risk and hence they are short this complicated spread cap: if their funds don't meet their pension expectations, then they have to find the cash for their retirement from somewhere else.

The details of the cap in any particular situation of course depend on how funds are invested, but typically it will have some elements of equity risk, interest rate risk, corporate credit spread risk, and both wage and CPI inflation risk, together with the risk of the comovement of these factors (which you can simplistically think of as correlation risk). Given it is a very long dated instrument - perhaps as much as ninety years for someone entering the workforce now - and very complicated, it is hardly a surprise that it is difficult to know what it is worth.

Note in particular that because we have a long-dated problem, the details of the dynamics of each component of the spread are crucial. It might be reasonable to assume that some of them, such as corporate credit spreads, are mean reverting. This makes the problem easier. For others, notably inflation and equity returns, there seems no reason at all to assume long term mean reversion. This means there is an awful lot of model risk in pensions analysis.

Some dimensions of pensions risk can be minimised: for instance if the scheme holds inflation linked gilts then it can hedged inflation risk and bears no equity risk. However it still have longevity risk, and (absent a liquid longevity swap market anyway) contingent inflation risk (since if longevity increases the fund is mismatched on the duration of its assets vs. its liabilities and hence has inflation term structure risk). Moreover, of course, a low risk pension fund has to be much more comprehensively funded than one that is taking market risk in multiple dimensions (equities, corporate credit, property, alternative investments, ...) Finally note that longevity risk is remarked considerably less often than other risk components so it is less visible - but that does not mean that it is not there.

The key policy question, then, in pension is who should bear the risk of underfunding, i.e. who should write the spread cap. Recently, there has been a suggestion that rather than one party bearing all of the risk as in current DB and DC schemes, perhaps it should be shared between employers, employees, perhaps with a far out of the money state backstop*. (See here for a further discussion.)

This is certainly a policy option that could be considered. Pensions policy is bedeviled by a failure to address risk issues openly, not least because most pensioners do not want to face the harsh reality that either a pension has significant risk or it is extremely costly to fund. Education is needed to address this point. Once we are ready for the debate, though, I would suggest there is room for a creative sharing of risk. There are no easy options here, not least because of the considerable uncertainty in estimating the size of the risk. But the problem is hard enough without artificially restricting the domain of possible solutions.

*One issue not addressed here is the use of DC schemes to reduce employer contributions. DC does not imply lesser employer contributions and legislation could (and probably should) stop employers using DC as a way of reducing their funding obligations.