Risk Budgeting and Longevity Insurance: Strategies for Sustainable Defined Benefit Pension Funds
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Today, many defined benefit pension funds across the world are closing in response to twelve years of intense market volatility and dramatic increases in life expectancy. To the casual observer, it must seem as though the risk of maintaining a defined benefit pension fund has contributed to its rapid decline. Certainly, a defined benefit pension is a very significant promise for the plan sponsor, who has pledged to pay the plan participants for as long as they live and no matter what happens to the assets. The key question today is whether the defined benefit plans that remain open and accruing benefits for employees can be sustained. In fact, a sustainability model may be emerging in the best practices of a few pension plans. These plans generally have three things in common:1. They have engaged in a rigorous risk budgeting process, involving an analysis of their risk, an estimation of the potential losses in their pension funds and a decision regarding how much they can afford to lose. 2. They have dramatically reduced their asset risk in an effort to keep pension losses within the risk budget and they may have two-thirds or more of their assets invested in a low volatility strategy such as fixed income or total return. 3. They have a strategy for longevity risk, which may involve longevity insurance to ensure that the quantum of their liability is known and knowable so that funding and investing activities can be carried out with certainty as to the ultimate liability. While these strategies may seem less exciting than using risky assets to reach for high returns, they are rooted in the premise that investing in equities, private equity, commodities, property and other risky assets actually involves risk and to the extent that those strategies expose the plan sponsor to more risk than the sponsor can afford, too much risk is likely to lead to the closure of the pension fund and the elimination of the defined benefit from the employees' future retirement security. Perhaps risk budgeting and disciplined risk management, combined with new techniques to insure longevity risk can be used to sustain more pension funds and safeguard the health of the plan sponsors.
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All opinions, errors, findings, interpretations, and conclusions of this paper represent the views of the authors and not those of the Wharton School or the Pension Research Council. © 2013 Pension Research Council of the Wharton School of the University of Pennsylvania. All rights reserved.
This discussion document describes product concepts that are not final. It has been prepared for discussion purposes only. Prudential does not provide legal, regulatory or accounting advice. An institution and its advisors should seek legal, regulatory, investment and/or accounting advice regarding the legal, regulatory, investment and/or accounting implications of any of the strategies described herein. This information is provided with the understanding that the recipient will discuss the subject matter with its own legal counsel, auditor and other advisors.
Date Posted: 26 June 2019