Chapter 40: Risks in benefit schemes

Question 1

The risks may relate to the level and incidence of (3)

Answer 1

• benefits
• contribution / premiums
• investment returns

Question 2

key risks to the beneficiary (2)

Answer 2

• the benefits will be less valuable than expected, or

- they will not be received at the expected (or required) time.

Question 3

key risks to the sponsor (2)

Answer 3

• costs will be greater than expected, or

- payments will be required at an inopportune time

Question 4

6 Key BENEFIT risks for a defined benefit scheme

Answer 4

• Inadequate funds due to
• —>UNDER-FUNDING
• —>SPONSOR INSOLVENCY
• —>ASSET/LIABILITY MISMATCHING
• ILLIQUID ASSETS
• risk that the benefit promise is changed, eg by the State
• members’ NEEDS NOT MET, either due to design or inflation erosion of value.

Question 5

3 Key BENEFIT risks for a defined contribution scheme

Answer 5

• investment returns being lower than expected, or expense charges higher
• annuity purchase terms being poorer than expected (if an annuity is purchased)
• members’ needs not being met, either due to design or inflation erosion of value.

Question 6

For both DB and DC schemes, there are further BENEFIT risks resulting in benefit uncertainty. These are (6)

Answer 6

• default by sponsor
• decision by the sponsor that benefits will be reduced
• takeover of the sponsor
• failure by sponsor to pay contributions/premiums in a timely manner
• inadequate communication by sponsor / provider (S/P) with beneficiaries about the strength of the S/P, guarantee, promise etc. leads to complaints and compensation for some beneficiaries and shortfall for others

Question 7

3 Key contribution risks for a defined contribution scheme

Answer 7

• the contributions / premiums are unaffordable and hence not made
• insufficient liquidity to make the payments in a timely manner
• the contributions / premiums are linked to an inflationary factor, thereby introducing an inflationary risk

Question 8

Future contributions for a defined benefit scheme will depend on (5)

Answer 8

• the amount of the promised benefit
• the probability of individuals being eligible to accrue the benefits
• the probability of individuals being eligible to receive the benefits
• the effect of inflation on the level, or the real level, of the benefits
• the investment return achieved on the contributions / premiums (net of tax and expenses, if appropriate)

Question 9

If there is a shortfall in DB scheme, a sponsor may be required to make extra contributions. Associated risks include (2)

Answer 9

• lack of liquid funds

- excessive contributions / premiums which the sponsor may not be able to afford.

Question 10

For both schemes there are further risks resulting in contribution / premium uncertainty. These are (7)

Answer 10

• loss of funds due to fraud or misappropriation
• incorrect benefit payments
• fines or removal of tax status resulting from non-compliance with legislation.
• changes to tax rates or status.
• administrative costs, eg to comply with changes in legislation
• inappropriate advice
• decisions by parties to whom power has been delegated

Question 11

10 Investment risks in a benefit scheme

Answer 11

• benefits are not appreciated due to poor investment returns
• uncertainty over the level and incidence of:
  ———->income
  ———->capital
  (This gives rise to mismatching assets/liabilities and hence reinvestment risk)
• reinvestment risk arising from mismatching assets and liabilities
• default risk
• liquidity risk
• inflation erosion of value
• tax and expenses
• opportunity cost of the capital
• lack of diversification

Hint: think of factors you need to consider for investment strategies-institutions and think exactly what risk the institution is exposed to from failure to consider some of the factors

Question 12

3 Overall security risks

Answer 12

• the security of the sponsor and ability to make good any shortfall
• the strength of the sponsor promise (covenant)
• model, parameter and data error

Question 13

3 Extra risks in a defined ambition scheme

Answer 13

• not knowing whether any guarantee offered will bite or not
• the uncertain cost of any guarantee offered
• additional complexity in the areas of administration, investment, regulation, valuation and communication.

Question 14

Risk of inadequate funds may be as a result of (4)

Answer 14

• insufficient funds having been set aside, ie underfunding
• insolvency of a sponsor or provider of the benefits
• the holding of investment which are not matched to the liability
  or a combination of these events.

Question 15

Risk of failing to meet the members’ needs may be as a result of (2)

Answer 15

• failure to recognize the needs when the benefit promise was made, or
• inflation eroding the value of the benefits.

Question 16

Annuity risk

Answer 16

The level of the benefits will also be reduced if the terms of purchase for any investment vehicles are worse than had been anticipated.
Eg if an annuity were to be purchased to provide a retirement pension, the level of the pension would be dependent on the terms on which an annuity could be purchased.

Question 17

Liquidity risk

Answer 17

Any requirement to make good any shortfall by payment of extra contributions clearly creates a risk that the sponsor / provider has insufficient liquid funds to do so.

Question 18

Takeover risk

Answer 18

There is also the risk that if the sponsor is taken over by a third party that the new owner may not be willing to continue to sponsor the benefits.

Question 19

Inappropriate advice may result from (6)

Answer 19

• incompetence or insufficient experience of the advisor
• lack of integrity of the advisor, perhaps due to sales related payments
• the use of an unsuitable model or parameters
• errors in the data relating to the beneficiaries
• State-encouraged but inappropriate actions
• over-complicated products

Question 20

Errors in determining contribution / premium requirements may result from (4)

Answer 20

• the use of an unsuitable model
• the use of unsuitable parameters
• errors in any data used to determine parameters for the models
• errors in the data relating to the beneficiaries

Question 21

7 Reasons why benefits may be less valuable than expected in a DEFINED CONTRIBUTION SCHEME

Answer 21

• lower investment returns or higher expense charges than expected
• poorer than expected annuity rates at retirement
• sponsor default on contributions or failure to pay contributions in a timely manner
• higher than expected inflation, eroding the real value of the benefits
• inappropriate advice and/or poor communication with beneficiaries
• fraud or mismanagement
• tax or regulatory changes

Question 22

9 Reasons why benefits may be less valuable than expected in a DEFINED BENEFIT SCHEME

Answer 22

• a change in benefits (eg by the State)
• a shortfall in the fund, resulting in the sponsor reducing the benefits
• takeover of the sponsor by an organisation that won’t meet the promised benefits
• sponsor insolvency
• sponsor default on benefits or failure to pay benefits at the times required
• higher than expected inflation, eroding the real value of the benefits
• inappropriate advice and/or poor communication with beneficiaries
• fraud or mismanagement
• tax or regulatory changes

Question 23

Key risk to the state

Answer 23

It might be expected to put right any losses that the public incurs.

This is particularly relevant if the State provide means-tested benefits, e.g. a minimum income level in retirement.

Question 24

What is meant by “means-testing”?

Answer 24

Means-testing is a process for establishing…
… whether an individual is eligible to receive benefits and/or
… how much benefit they should receive.

It is often based on an individual’s income or assets or both.

Question 25

Why might a funded benefit scheme be underfunded? (3)

Answer 25

• the assumptions about future experience were unduly optimistic, ie the contributions were unrealistically low.
• the assumptions were reasonable but the experience turned out to be unfavourable, eg poor investment returns or regulatory changes
• the sponsor did not pay what was required in terms of contributions, eg due to poor commercial performance or even insolvency.

Question 26

Why might a sufficient and liquid fund not meet members’ needs? (2)

Answer 26

• a failure to recognise (at inception) that the promised benefits would not be able to meet their needs
• inflation eroding the value of the benefits

Question 27

Why might the STATE want to change benefits?

Answer 27

State benefits usually change to reduce costs, eg to deal with the increased costs with an ageing society.

They may change to meet legislative requirements too, (eg the equalisation of State Retirement Ages for men and women following an EU court ruling.)

Question 28

Why might an EMPLOYER want to change benefits?

Answer 28

• An employer-sponsored scheme may be integrated with the State scheme, ie target an overall level of provision including the State benefits.
  Any change in State benefits will also have an impact on net employer benefits.
• Employer might also change to a benefit scheme that offers better terms for a pension

Question 29

Why might INDIVIDUALS want to change benefits?

Answer 29

Personal arrangements need to change due to changes in an individual’s circumstances, eg marriage or children.

Question 30

2 Main factors that lead to a worsening of the terms on which an annuity can be purchased.

Answer 30

• falling bond yields (because annuity providers back annuities with bonds)
• increasing longevity

Question 31

Which type of investments are most likely to underlie an annuity?

Answer 31

Fixed interest bonds are typically held to back fixed-interest annuities and index-linked bonds are typically held to back index-linked annuities.

Question 32

2 reasons why contributions may not be made by the sponsor.

Answer 32

• the party is unable to afford the contributions because it is in poor financial circumstances, or
• the party’s immediate cashflow position is poor and assets cannot be liquidated readily to meet the contribution / premium requirements.

Question 33

3 ways in which a deficit in a defined benefit scheme may be corrected

Answer 33

• an immediate lump sum contribution
• an addition to the contribution paid each year for several years to eliminate the deficit
• a reduction in the benefits payable

Question 34

Defined Benefit Scheme

Answer 34

Scheme rules define the benefits INDEPENDENTLY of the contributions payable, and the benefits are NOT DIRECTLY RELATED TO THE INVESTMENTS of the scheme.

The scheme may be funded or unfunded.

Question 35

Funded

Answer 35

means that money is set aside in advance of the benefits being paid.

Question 36

Unfunded

Answer 36

a.k.a. pay-as-you-go

means that no funds are accumulated.

Question 37

Defined Contribution Scheme

Answer 37

provides benefits where the amount of an individual member’s benefits depends on

• the contributions paid into the scheme in respect of that member,
• increased by the investment return earned on those contributions.

Question 38

Defined Ambition Scheme

Answer 38

Designed such that risks are shared between the different parties involved, e.g. scheme members, employers, insurers and investment businesses.

E.g.:

• a cash accrual scheme where benefits are defined as a lump sum rather than as a pension
• a defined contribution scheme offering a defined benefit underpin, e.g. the benefit will not be less than 1/100th of final salary for each year of service.