An Introduction to Risk Budgeting

John McManus

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A brief look at how considering the risk characteristics of liabilities in the asset allocation process can assist in controlling scheme risks and help achieve objectives.

The key objective of any defined pension scheme is to provide the promised scheme benefits as they become due.  This is also the key funding objective of trustees as set out in the Pensions Regulator’s Code of Practice.

To meet this objective, the scheme liabilities must be backed by sufficient scheme assets.  The objective can be funded by contributions but also by investment returns.   Clearly, assets and liabilities are connected in achieving this goal.  However, in the past they have not always been considered together when allocating the assets of the scheme.  Static asset allocation seems to be an established approach but is this appropriate, and is there an alternative?

By taking a risk budgeting approach, a disciplined framework can be created for investment decision making.  The scheme can then look at the ‘levers’ available in order to strike a balance between controlling these risks whilst meeting funding objectives.

The key liability risks relate to interest rates, inflation and longevity.  Schemes can use a bespoke portfolio of bonds and derivatives to hedge against interest and inflation risk.  Historically, the only way to mitigate longevity risk was by way of an annuity purchase.  This also removes other associated liability and investment risks.  In recent years longevity swaps have started to appear but this is still a developing market.

To illustrate how risk budgeting can be approached we will look at a simplified example.  Say we have a scheme which is 70% funded and there are two portfolios available for investment – one that perfectly matches the movement in liabilities (‘Matching Assets’), the other a portfolio of growth assets (zero correlation to the matching assets).  Assume the scheme invests 50% of its assets into matching and 50% into growth (figure 1).

The amount of risk we are exposed to with regards the liabilities is the difference between the total liability and the total of the matching assets. We are also exposed to risk from the growth assets, discussed below.

If the scheme reduced its liability exposure by placing more assets in the matching portfolio (imagine sliding the dotted pink line upwards in the chart above), both the liability and growth asset exposure is reduced.  In the extreme scenario of investing wholly in matching assets, we have removed growth asset risk but we still have liability exposure (albeit minimised) and a deficit.  With no growth allocation and fully matching assets, the deficit can only be filled by contributions.

There is clearly a trade off between investing in matching assets and growth assets. While investing in return seeking assets may be rewarded by higher return, it also increases downside risk and the potential for unexpected contribution requirements if the assets don’t perform as hoped.  Therefore, discussions with the employer may be required given the sustainable growth and covenant aspects of the new Code of Practice.  The asset allocation may also affect the assumptions used for the technical provisions.

Other constraints to consider include:

  • Future cashflow and liquidity needs
  • Time horizon
  • Regulatory constraints

These constraints may also change over time.

Next, assume in the future the scheme becomes 100% funded but remains in the same 50% growth and 50% matching asset allocation (figure 2).

Is it appropriate to have the same asset allocation when the scheme is 70% and when the scheme is 100% funded?  By rebalancing growth into matching assets we reduce both the liability and growth asset exposures.  Compared to figure 1, the scheme is perhaps in a better position to reduce its claim on the overall risk budget.  By removing risk from the pension scheme it may enable the enterprise to use this budget to benefit the business elsewhere.

It’s worth noting the above examples are highly simplified but they illustrate the importance of both the funding level and liability profile when allocating assets of the scheme.  As these quantities change over time, the need to keep a close eye on market conditions and funding levels is apparent.

There are various tools that can assist in both quantifying risks and creating an effective strategy to control these risks whilst maximising the likelihood of meeting funding objectives.  By taking a holistic approach to assets and liabilities it is possible to control some of the risk the scheme faces.  Regular monitoring enables more optimal implementation of risk management strategies.  It’s clear a risk based approach along with a dynamic investment strategy can assist in achieving the key objective of the scheme and should be in the toolkit of well-advised trustees and employers.