Trustee focus: integrated risk management – a trustee's perspective
“What are your clients doing about integrated risk management (IRM)?”
“What are your clients doing about integrated risk management (IRM)?” I was asked at a recent interview for an independent chair of trustees role. “Well” I said, “that’s a great question”, (which it is), “perhaps we could talk about how we might use it in your scheme because there is no clear pattern in what others are doing”.
Working with so many defined benefit (DB) schemes at Law Debenture we get a great view of what’s going on. Most schemes now make reference to IRM somewhere in their agenda. For some it’s a check box approach appended to the risk register; for others it’s a deep-seated review. Perhaps because it extends across different aspects of the scheme, no one adviser dominates the territory. Actuaries and covenant advisers have more often taken the lead than others, with some good work being done by inhouse teams and the best involving a collaborative cross-function approach.
Pension schemes that are well funded, have strong sponsors and have done a lot to manage their risks may not need to spend much more time considering IRM and others may have been using IRM-type thinking for many years. However, for many, used well, IRM can be a very valuable tool to help trustees and sponsors improve alignment on pension challenges, and take some of the heat out of valuation discussions.
IRM - it’s really quite simple
Amongst the mass of complex regulation and processes it is easy for trustees to lose sight of how simple DB pensions are at heart. Using an IRM workshop approach I have seen trustee groups start to focus on what really matters for long-term success, as they explore properly how logically the different strands hang together.
A scheme-specific picture like the one below can stimulate a great discussion. It illustrates the
undiscounted liability cash outflows and how that cash is expected to be funded. Usually actuaries move quickly into the world of discounting, but it may be worthwhile to linger a little longer before doing this.
The approach builds on the simple principle that the trustees’ job is to ensure there are sufficient funds to pay all the pensions that have been promised. And as most DB schemes are now closed there are only three sources of funds to pay the pensions – deficit recovery contributions from the employer, investment returns and asset sales.
If the three components on this diagram don’t add up to the required value, or if the target is
underestimated, there is a problem. Discussions using this approach have led to trustee comments like “what if the sponsor is not there in thirty years and the assets don’t perform?”, “I can see why a point comes for all schemes where they’ll probably want to buy out” and “if people live longer we’ll inevitably run out of capital”. And discussions of this sort are exactly what IRM should be about.
The main risks
Trustees need to assess the risks around:
- The accuracy of the estimate of the cash ultimately required to fund benefits.
Discuss how wrong these might be with the actuary. What is meant by prudence and how much is there? The Regulator’s IRM materials refer to funding as one of the three IRM "pillars", but the critical part is narrower than that. It’s thinking about the liabilities. Typically, the two big uncertainties in determining the liabilities are the life expectancy of members and the extent of future inflation.
- The ability of the assets to deliver the required income and capital returns. The investment adviser will be able to advise on this and how to measure the degree of uncertainty. Risks are specific to the current or expected assets, but there are some common ones. For example, the risk that there is a permanent shift in capital values of equities or property, or a deviation from the yield priced in by the bond markets. This is the Regulator’s IRM investment pillar.
- The ability of the employer to pay expected deficit recovery contributions and
underwrite risk. Employer covenant is the third IRM pillar. Who can know what the position
of any sponsor ten, twenty or thirty years out will be? So better ask the covenant adviser to help the trustee understand the risks around the current and potential reliance on the covenant, as early as possible.
While identifying the risks, their magnitude and likelihood, consideration can be given to what factors may cause the risks to materialise and whether up-side and down-side consequences are likely to mitigate one another or correlate. For example, how might a recession impact investments and the sponsor’s covenant?
IRM is not of course an end in itself. Having assessed the risks, the trustee and sponsor should endeavour to agree appropriate actions. These should include a journey plan that extends beyond the statutory requirement at the valuation to fund the technical provisions. They should agree what to do if things don’t work out as expected - up-side as well as down-side. If the scheme’s deficit reduces faster than expected, is there a plan to bank the benefit, perhaps by reducing the level of more risky investments? If investments fall sharply in value should this trigger additional sponsor contributions? If the sponsor’s credit rating slips should it transfer some cash into escrow in case it’s not there in the future to act as backstop? The questions and answers will be specific to the circumstances of the sponsor and the
A small digression is in order here. Consider two schemes with identical obligations to members. Scheme A is invested in higher returning more risky assets such as equities and hedge funds, while Scheme B is very cautious and invests only in government bonds. Because the investment return expectations will be very different, Scheme A is likely to report a significantly lower technical provisions liability than Scheme B (because a higher discount rate can be applied to the liabilities) even though the long-term cash outflow to members is identical. Other things being equal Scheme A will require a lower level of contributions from its sponsor to fund its technical provisions than Scheme B. The point here is not
that this is wrong, it is that the trustees and the sponsor need to understand what they are doing. Once Scheme B is fully funded on a technical provisions basis it can be fairly certain that it will be able to meet all its liabilities, while when Scheme A is fully funded it will still depend on uncertain returns from investments and, in the event these don’t materialise, on the sponsor.
The position of most schemes is probably between the extremes of Schemes A and B. So, trustees and sponsors should agree what they are trying to achieve beyond funding the technical provisions.
The one certainty is that things will not work out as expected, so IRM needs to be regularly re-considered.
For more information on scheme funding, see our practice notes:
Reproduced from Practical Law with the permission of the publishers. For further information visit www.practicallaw.com.