What running on means for risk modelling 

Pension schemes have entered a new era. After years of deficits, many now benefit from stronger funding positions and greater flexibility in choosing their endgame. With this choice, many schemes now view run on as a realistic strategy to deliver long term value.

While this approach offers many benefits, it hinges on one crucial factor: the strength of the employer covenant. As schemes lean on their sponsors for longer and wish to avoid regret risk, understanding how covenant risk can evolve over time is more important than ever. Getting this right means rethinking how risks are modelled and managed to safeguard the scheme’s future whilst delivering on the value a run on strategy has been designed for.

Many pension schemes are now exploring run on as a viable option as corporate sponsors increasingly recognise its strategic benefits. Running on offers an opportunity to access low-cost capital in the future, enhance existing member benefits or provide more to employees at a lower cost, support contribution payments and avoid the accounting implications that buying-out with an insurer might bring.

Some corporates have reservations about the insurance market, and in many cases, a transaction is not needed to manage the risks and costs associated with their DB schemes anymore. Retaining control of the scheme and managing the risks internally using the premium that would otherwise be paid to a third party is a valid approach that can bring significant financial benefits. 

Schemes considering a long-term run on strategy must weigh several factors. A key consideration is how to model funding outcomes over the run on period. This is crucial due to the potential uncertainty surrounding the employer covenant’s reliability over such a long timeframe and the possible regret risk if member benefits are ever put at jeopardy. With confidence over long term covenant, greater reliance can be placed on the investment and funding strategy delivering the desired outcomes.

There are two key elements to consider: what happens to scheme funding and what happens to the employer.

On the funding side, trustees and sponsors are well-versed in working with their actuary and investment consultant to assess funding levels through regular valuations. But long-term run on requires moving past single point-in-time valuations to exploring a full range of possible outcomes. This includes understanding how different investment strategies might influence benefit payments and surplus growth over time.

Stochastic modelling continues to play a key role to help trustees and sponsors visualise a range of potential outcomes; assessing how different levels of risk affect the build-up of surplus and how tail risks, such as longevity shocks or climate-related stresses, might impact outcomes. In addition, those schemes running on should go beyond stochastic modelling and work through scenarios to ensure all avenues have been considered and the full range of outcomes are understood. 

This is where the second aspect comes in: a robust run on strategy must also consider the covenant. This can’t be bolted on as an afterthought, it needs to be fully integrated into the analysis. This means stress-testing the employer’s strength against market shocks, downturns or climate disruptions to assess their ability to support the scheme, in concert with similar analysis of scheme funding.

Our structured scenario planning approach involves walking through plausible what-ifs and worst-case situations, bringing together all components of the integrated risk management framework and assessing funding, covenant and investment as one. This “pre-mortem” approach helps stakeholders spot vulnerabilities in advance and prepare accordingly. It also prevents schemes from progressing with run on, only to find they are not able to mitigate changing situations, negatively impacting member outcomes.

By thinking ahead and preparing for these possibilities, schemes can put themselves in a stronger position to ensure that if they choose to run on, they do so with a clear understanding of the risks and a plan for managing them.

Formulating a successful run on strategy requires trustees and employers to adopt a different approach to risk management:

Where risks are identified, schemes should decide whether to adapt the overall strategy to reduce exposure or build in specific protections, such as contingent assets or external security, to bridge gaps in certain downside scenarios. Ultimately, ongoing horizon scanning and covenant monitoring are essential. Trustees must be prepared for disruption in their plans and have an exit strategy if unexpected issues arise – at Mercer, by having an integrating Funding, Investment and Covenant team, we are best placed to be able to assist in help set and monitor a scheme’s run on strategy.

Run on modelling and advice typically focuses on the positives – surplus growth and release. To provide stakeholders with confidence in the strategy broader stress testing and resilience planning is necessary. 

The most effective stress testing strategy focuses on potential worst-case scenarios and their impact on the scheme, rather than relying on models that can average out risks and make them seem less material than they are.

By focusing on severe “black swan” events, trustees and sponsors can assess the real financial impact, such as increases in liabilities, decreases in asset value and the impact on the employer covenant strength.

The aim is to prepare plausible downside stress scenarios with clear pound-value estimates of the impact these scenarios would have and determine if the scheme and sponsor, in tandem can withstand the downside. If not, the trustees can consider ways to manage or reduce the risk.

This approach helps trustees gauge whether risks are small, medium or large, and if they could materially undermine the strategic decisions when running on. Based on this, schemes can decide which risks require attention, which can be ignored or which should be hedged.

A long-term run on strategy offers clear benefits, subject to covenant, funding and investment risks being appropriately understood and managed where necessary.

Running-on is not a new concept; however, with improved funding, more corporate and political support for run on as a strategy, and better risk management techniques, choosing to run on when schemes or sponsors might not have done so before is increasing.  To do this effectively requires a different approach to the historical triennial valuation cycle. 

The decision to run on can set a scheme’s investment and funding strategy for a long time to come and downside support should be developed from the beginning with the long-term in mind. Therefore, it’s essential to encourage open dialogue between trustees and the employer early in the decision-making process. Together, they should review the endgame objectives, the financial implications of running on and the feasibility of providing the necessary support to the scheme in downside scenarios, to determine if this is the best option. 

Assessing the implications of run on, the potential risks and likely mitigation strategies can take considerable time and experience. Where trustees are keen to explore these options or have received a proposal from the employer but are unsure of how to proceed, Mercer’s joined-up experts across funding, investment and covenant can provide you with the support and tools you need.