A majority of defined benefit (DB) pension fund sponsors routinely use quantitative asset-liability models to analyze the potential outcomes of alternative funding, investment and benefit design policies. 

As more and deeper markets develop in risk management instruments, such as interest rate, inflation and equity derivatives, these models have in turn evolved to capture market-implied information about future volatility. As a result, their short-term predictive capabilities are, arguably, better than ever, though dependence on the past and present as a solid predictor of the future is still substantial.

However, projecting the long view remains extremely challenging.  While we may be reasonably comfortable with a one-year quantitative projection, and somewhat comfortable with a three-year horizon, any sensible financial modeler will tell you to limit your reliance on a 10-year projection, let alone one that extends to 2030. Perhaps the best tool we have available to help plan over even longer horizons, therefore, is “scenario thinking.”  In this article, we adopt the perspective of a multinational sponsor of DB plans and reflect on the potential consequences of each of the World Economic Forum scenarios for the financial management of these plans. The three scenarios –”The winners and the rest,” “We are in this together,” and “You are on your own” – provide a snapshot of the types of retirement environments that might exist and their effects on both employers and plan participants.

“What if?”: Playing out the odds

Globally, DB liabilities are concentrated in developed economies: arguably, the US, the UK, the Netherlands, Ireland, Germany, Canada, Switzerland and Japan represent almost 100 percent of global liabilities.

Privately sponsored DB plans are predominantly funded through external mechanisms with the exception, at least historically, in Germany. There is, of course, an acknowledged trend toward plan closure, an increased focus on volatility and risk management, and a gradual drift downward in levels of exposure to equities and other return-seeking assets. Changes to accounting standards and strengthened legislation for funding requirements are accelerating these trends. More changes may come, which, while not affecting the financial risk management fundamentals of DB plans, may well further accelerate the focus on risk management and effective means to manage risk.

So, while dynamics vary by country, we believe that a majority of sponsors are managing, and will continue to manage, what are in essence legacy DB plans, toward an ultimate endgame. Given the “long tail” on the liabilities for these plans – current participants will be alive 60+ years into the future – the only question is who will be carrying and managing the financial risks that have been incurred: the sponsors themselves; insurance companies; government-mandated pension protection funds; or, in the worst case, the participants themselves?

We are talking about significant macro financial and societal trends. While there are many possibilities for how each scenario will materialize, one thing is clear: No scenario will present smooth sailing for sponsors of DB plans. While the financial risks of the “near future” can be measured and managed with a significant degree of precision, is there anything a multinational employer can do to sail the financial seas of the more distant future more successfully?

Based on our conversations with a broad range of multinational companies, there are several lines of thought regarding approaches that can be profitably pursued in setting broad policy going forward:

• “My favorite scenario” – Companies often pursue scenario planning for their businesses as a whole. If the company views one scenario as more likely than another – to the extent that it will (to some degree) “bet the business” on the scenario – it can feel better about betting the pension plan on it. Or, if there is not a favored scenario, contingency planning across scenarios can be consistent for the business and the pension plan, as can the risk management techniques embraced.

• “What would really happen?” – In the scenario table, we have sketched out one view of the possible consequences for DB plans under each scenario. This is the future – and as carefully constructed and detailed as the scenarios are, they do not tell a simple story. The discussion of the range of specific outcomes for DB plan risk management, in and of itself, leads to insights that help to foster good corporate policy setting in a more powerful way.  Of course, to keep the value of using scenarios to set policy alive, the scenarios and their consequence need to be periodically updated based on evolving conditions.

Scenarios on DB plan financial dynamics

• “Size counts” – The size of the plan relative to the size of sponsor is important. For some sponsors, the pension assets and liabilities are not of a proportional size relative to the business, where even extreme stress might threaten the business. For others, even moderate pension stress can cause significant business strain. If the sponsor wants to (or legally must) maintain a commitment to managing the pension plan exposure on an ongoing basis, the approach to managing the risks that emerge under each scenario needs to reflect the severity of the exposure.

• “Size changes” – A merger or acquisition can create a sudden change in a sponsor’s exposure to pension risk. Equally important, over the long timeframe contemplated in these scenarios, pension funds take on a growth and a maturity dynamic independent of the underlying business. Absent active approaches to interdict this cycle, the plan’s liabilities will continue to grow over a 30 to 40 year span independent of the underlying growth of a business. The long span of this dynamic means that it has not played a part in most sponsors’ risk management planning for pensions. But over the time span in these scenarios, employers must (and are starting to) take this dynamic into account.

• “The DB plan is for life – or is it?” – DB plans in most countries have been an integrated accumulation/spend-down vehicle: The employee earns a benefit and then gets an annuity for life. Paying out the full value of the benefit at time of retirement, so that ex-employees can manage their funds during the spend-down phase, has not been common, whether for reasons of paternalism or a perception that paying lump sum benefits is “expensive” (and in some cases, illegal). But the benefit can be defined as a lump sum, and in a broader sense the “cost” of a lump sum takes on a new hue in the perspective of long-run risk management. And as the population in DC plans matures and more effective products appear in the market to help retirees manage their funds during their retirement (removing some of the paternalistic concerns of sponsors), DB plan design may show a more pronounced split between an employer-sponsored accumulation and a retiree-managed, spend-down phase.

• “Can I really do much?” – The breadth and depth of means to price, hedge, share and monitor financial risks of DB plans are expanding rapidly. Some devices are still in their infancy, others are considered exotic and are used only by sponsors in the vanguard of practice. The initial complexity of some of these devices means that they may not be given the attention they deserve. But not all approaches are complex, and a majority are migrating toward mainstream practices. One common theme we find in discussions with multinational DB sponsors is an almost universal recognition that governance structures around financial management of these plans need to be strengthened – to be “fit for purpose” for more complex instruments, if desired, but also to be able to consider and deploy the whole range of available risk management techniques in an integrated and effective manner. This range covers assets, financial hedging instruments, contribution policy and benefit design.

The long view

When looking out over 25 years, one can’t help but feel that DB plans, whether in a familiar or a different form, will have a place in the infrastructure of future retirement provisions. We humans like guarantees – especially when something as important as our financial security is at stake. Much of the pain and many of the lessons of the 20th century, which has seen a backlash against guarantees, originated with poor pricing of and an inability to hedge these guarantees. Will the mid-21st century, under at least two of these scenarios, see disillusionment with individual retirement arrangements, and respond with a push back toward models with some significant but simple – and hedgeable – guarantees?  It’s certainly not beyond the realm of possibility.

Additional reading:

Managing an unwanted risk for defined benefit pension funds 

This article considers the issues underlying active management of pension fund interest rate exposure and offers practical ways of adopting some of the solutions now available. (Eighth edition: 2006 Perspective)

Managing corporate pensions exposure: The power of Value at Risk 

This article introduces Value at Risk methodologies for managing corporate exposure to defined benefit pensions. (Twelfth edition: 2007 Perspective)