PENSIONS RISK APPETITE: WHAT DETERMINES A PENSION SCHEME’S ABILITY TAKE RISK?
 
 
 
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What Determines A Pension Scheme’s Ability Take Risk?
A scheme with a long time horizon (duration of obligation), has the ability to take on risk
BY BEN AMENYA | OCTOBER 2016

Investing involves risk, and certainly, when investing pension assets to meet pension payment, the risk and return objective should be appropriate to meet the long-term aim of the pension scheme.

Because pension schemes have many working parts, taking risk can be influenced by many factors. Some of these factors are dependent on the sponsoring company, while others are dependent on the characteristics of the pension scheme itself. Below I explore the five main characteristics that determine a pension scheme’s ability to take risk.

Pension Scheme’s funded status

A scheme may or may not have all the assets needed to meet its pension obligation. A scheme that is in surplus (have more than is needed to meet its pension obligation) could experience some level of negative returns without putting the scheme assets at risk , as the surplus acts as a cushion to offset some or all of the losses. In such cases, the pension scheme can take on more risk with the knowledge that the surplus cold act as a buffer to absorb any losses.

This also means that, schemes in deficit (have less than is needed to meet its pension obligation), have limited ability if any at all, to take on risk due to the absence of the cushion to absorb losses when the pension scheme experience negative returns.

Therefore, a scheme that is 110% funded, has a higher ability to bear risk, than a scheme that is 75% funded.

Company’s financial status and profitability

There are two principal ways to close the pension deficit (the amount needed to close the gap between pension assets and the expected pension payment). These are:

- returns generated by investing the pension assets, and
- when the company pays money into the pension scheme (pension contribution)

Paying money into the pension scheme will depend heavily on the financial status of the company. A profitable company in good financial standing can easily contribute to the pension scheme, without straining the company’s finances.

Additionally, the level of debt ratio (debt relative to total assets), could also limit the company’s ability to bear risk. The lower the debt ratio, the greater the ability for the scheme to bear risk, knowing that the company can pay in money to meet any deficit that may occur through losses.

Therefore, a profitable company with lower debt to total assets has greater ability to bear risk. However, when the sponsoring company is financially weak, it has a reduced ability to pay into the pension pot when unfavourable investment experience.

Company and pension fund common risk exposure Ideally, you want the company to be in a position to contribute into the pension pot to close any deficit if investment returns are not expected to be enough. However, when the company and the pension scheme have common investment, there might arise a situation where the company will be unable to pay into the pension pot, when the money is most needed. Consider a case where Canbrium Consulting Ltd, a property consulting company, has a Pension scheme that is heavily invested in property. When the property market experiences huge losses, the pension scheme will also suffer huge losses because of the heavy investment in property. In such a case, the scheme might require contributions from the company to make up for these losses. But the company may also be unable to contribute as it has also suffered losses through the property market. The pension scheme would have been better off not investing in a common market as the sponsoring company.

Plan features

When a pension scheme experiences losses on its investment, it will need to recover and recoup any losses over time. A pension scheme with a long time horizon (duration of pension obligation), has the ability to take on risk by investing in growth assets such as equities and property, with the knowledge that it has a long time to recover from any losses. However, certain features of the scheme reduces this time horizon, therefore, reducing the scheme’s ability to take on more risk, which has the expectation of higher return. Two such features that reduce the time horizon are:

- provision for lump-sum distribution, and;
- Provision for early retirement;

Lump-sum distribution is a one-time payment for the entire amount due, rather than breaking payments into smaller instalment; whiles the provision for early retirement allows employees to take their retirement benefit before the statutory retirement age. That is an employee taking pension at age 55 instead of a statutory age of 65.These provisions reduce the time horizon of the scheme, as well as requiring the company to generate money to pay off members, limiting the scheme’s ability bear risk.

Workforce characteristic

The effect of workforce characteristics on a scheme is similar to point 4 above, in that it involves a reduction of the pension time horizon, and requires the company to generate money to meet retirement needs. Workforce characteristic refers to the:
- Age of the workforce, and; - Active lives relative to retired lives;

Younger workforce and a greater proportion of current versus retired employees, implies a longer time horizon, and less need to generate money for benefit payment. On the other hand, an older workforce means shorter time horizon and higher need for money to pay pensions. Also, should the Scheme need money to close pension deficit, it will have less time to generate money and make contribution.

You can see from the above that, understanding the characteristics of the expected pension payment becomes important when making decisions about how and when to invest the pension assets. There will be no use investing in a bond with a maturity of 10 years, when a pension scheme has 25 years of liability duration.


The writers - Ben Amenya leads Africonomie institutional fixed income strategies.
 
Editorial Philosophy
Independent and objective practitioner–led insight on institutional investing in Africa
Africa Private Equity & Debt Investment (APEDI) Forum
 
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