Ch27: Financial product and benefit scheme risks

Question 1

Benefit risks for defined benefit and contribution schemes

Answer 1

DB: - Inadequate funds due to: underfunding, sponsor insolvency, asset/liability mismatch
- Illiquid assets
- Benefit changes (regulation)
- Members’ needs not met due to: misunderstanding, inflation erosion of value, changed
circumstances

DC: - Lower than expected investment returns
- Higher than expected expense charges
- Annuity terms poorer than expected annuity terms (affected by bond yields and longevity)
+ mitigated by holding assets that underlie the annuity as retirement approaches
- Members’ needs to met due to: design, inflation erosion of value

General risks:

   - Default by sponsor/provider
   - Failure by sponsor/provider to make payments in a timely manner
   - Takeover of sponsor by organization unwilling to continue to meet benefit promises
   - Decision by sponsor that future benefits will be reduced
   - Inadequate communication from sponsor
   - General mismanagement from a sponsor

Question 2

Contribution risks for DC and DB schemes

Answer 2

DB (not known in advance) :
- Future contributions unknown and depend on:
+ Amount of the benefit
+ Eligibility to accrue benefits
+ Eligibility to receive benefits
+ Inflation
+ Investment return
- Extra contributions may be required to meet a shortfall, resulting in liquidity risk
- Takeover by third party not willing to continue to pay contributions

DC (known in advance) :

   - Unaffordable contributions
   - Insufficient liquidity to make contributions in a timely manner
   - Inflationary risk, if linked to inflation-index
   - If contributions fixed in monetary terms, risk that resultant benefits not enough