Decomposing Funding Ratio Risk

19 May 2015

OVERVIEW

During the latter years of the last decade, adverse market conditions demolished the funding status of many defined benefit (DB) pension plans and demonstrated the need for improved approaches to risk management.

In their recent paper, “Decomposing Funding Ratio Risk: Providing pension funds with key insights into their liabilities hedge mismatch and other factor exposures”, senior members of the financial engineering and multi-asset solutions teams at BNP Paribas Investment Partners provide a new and novel framework for obtaining key insights into the principle investment risks faced by DB pension funds. We asked the authors to provide us a summary of the main findings from the paper, which they have provided below.

HIGHLIGHTS FROM THIS PAPER AS PRESENTED BY THE AUTHORS …

Previous work in this area has been focused on surplus risk, which in our view is not a useful risk measure. Instead, our framework is based on the decomposition of the funding ratio risk, which we believe is the pertinent risk metric for DB pension funds.

In the following comparisons, we illustrate the devastating impact of the 2008-2009 subprime credit crisis and the subsequent euro sovereign debt crisis on the funding ratios of typical DB pension plans in the US, the UK and the Netherlands.

There are differences in starting points and impact sizes but the trends are clear. In just one year, from year-end 2007 to year-end 2008, funding ratios declined rapidly and heavily, by about 20% in the UK to 30% in the US and the Netherlands. At their worst since 2007, funding ratios had fallen by an average of about 35% and initial overfunding turned into serious underfunding. Funding ratios recovered, but in 2014 remained well below the levels found at the end of 2007.

Deteriorating funding ratios and tougher regulations, together with a more difficult business climate, eroded many companies’ financial health and put many plan sponsors on track for phasing out or even closing their traditional DB plans. As a result, interest in defined contribution (DC) and/or hybrid pension schemes has been growing rapidly.

This emerging trend implies a transfer of risk from employers to employees and retirees. Although this is not the place to comment on the pros and cons of this development, we believe that the heart of such changes derives from the fear of sponsors being forced to make additional contributions to repair an underfunded status. It is in this context and to soften this fear that we want to emphasize the importance of liability-driven investment (LDI) approaches to managing pension funds.

An effective LDI approach is inevitably interwoven with effective risk management. To us, pension funds still need to make significant progress in this area. In a recent survey of pension funds and sponsor companies, most of them European pension funds, authors from the EDHEC-Risk Institute assessed their views and usage of LDI strategies. One of the survey’s main findings was that, although participants were generally familiar with the LDI paradigm, the rate of adoption remained rather limited. In concrete terms, many pension funds were still more concerned with stand-alone performance than with risk management. For example, many respondents had not yet translated regulatory minimum funding requirements into strategies to protect the funding ratio by imposing a floor. It is precisely in this area of risk management that our paper makes a contribution.

There are two primary objectives we hope to achieve through this paper. The first is to demonstrate to DB plan sponsors the advantages of using funding ratio risk over surplus risk. Given existing academic literature, our preference for funding ratio risk as a key risk measure is not necessarily obvious. We argue, for example, that surplus risk offers a less complete view of the health of the pension fund and, at times, can be misleading. We show, in fact, that an increase in surplus can be accompanied by a fall in the funding ratio. This leaves no doubt about the deterioration of the financial health of the pension fund. Therefore, it is logical that funding ratio, not surplus, tends to be the focus of regulators.

The second objective is to propose a framework for decomposing funding ratio risk. This framework is based on a standard linear factor model. Asset-only applications of such factor models are nowadays frequently used by academics and by practitioners alike. Two reasons warrant that a factor model for DB pension funds needs to be tailor-made.

First, a pension fund is not an asset-only investor, so customization is needed to account for the fact that its investments are driven by liabilities. Second, pension funds invest not in one asset class but in many. This has repercussions on the choice of which factors to take on board. In particular, a couple of macroeconomic factors, rather than many asset class-specific style factors, might prove to be enough to capture the lion’s share of risk exposures.

To our knowledge, we are the first to propose a decomposition methodology for funding ratio risk. As said, it is based on a factor model and it is flexible with regards to the choice of risk factors.

We illustrate our framework with a case study based on a real DB pension fund and decompose its funding ratio risk into a couple of macro-economic factor risks like Real Rates Risk, Inflation Risk and two economic growth risks, namely Credit Risk and Equity Risk. We also included a risk factor to measure accurately the risk impact of not hedging fully away the interest-rate sensitivity of the liabilities.

The case study was based on forward-looking simulations rather than historical regression. In our view, this information is more powerful and useful for DB pension funds. The case example made clear that our decomposition methodology delivers valuable insights about the key risk exposures in the portfolio.

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