Chapter 40: Risks in benefit schemes Flashcards
The risks may relate to the level and incidence of (3)
- benefits
- contribution / premiums
- investment returns
key risks to the beneficiary (2)
- the benefits will be less valuable than expected, or
- they will not be received at the expected (or required) time.
key risks to the sponsor (2)
- costs will be greater than expected, or
- payments will be required at an inopportune time
6 Key BENEFIT risks for a defined benefit scheme
- inadequate funds due to UNDERFUNDING
- inadequate funds due to SPONSOR INSOLVENCY
- inadequate funds due to 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.
3 Key BENEFIT risks for a defined contribution scheme
- 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.
For both DB and DC schemes, there are further BENEFIT risks resulting in benefit uncertainty. These are (6)
- default by sponsor
- failure by sponsor to pay contributions/premiums in a timely manner
- takeover of the sponsor
- decision by the sponsor that benefits will be reduced
- inadequate communication by sponsor / provider of assets and liabilities.
3 Key contribution risks for a defined contribution scheme
- 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
Future contributions for a defined benefit scheme will depend on (5)
- 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)
If there is a shortfall in DB scheme, a sponsor may be required to make extra contributions. Associated risks include (2)
- lack of liquid funds
- excessive contributions / premiums which the sponsor may not be able to afford.
For both schemes there are further risks resulting in contribution / premium uncertainty. These are (7)
- loss of funds due to fraud or misappropriation
- incorrect benefit payments
- inappropriate advice
- administrative costs, eg to comply with changes in legislation
- decisions by parties to whom power has been delegated
- fines or removal of tax status resulting from non-compliance with legislation.
- changes to tax rates or status.
10 Investment risks in a benefit scheme
- uncertainty over the level and incidence of income
- uncertainty over the level and incidence of capital
- reinvestment risk arising from mismatching assets and liabilities
- default risk
- tax and expenses
- benefits are not appreciated due to poor investment returns
- opportunity cost of the capital
- inflation erosion of value
- liquidity risk
- lack of diversification
3 Overall security risks
- the security of the sponsor and ability to make good any shortfall
- model, parameter and data error
- the strength of the sponsor promise (covenant)
3 Extra risks in a defined ambition scheme
- 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.
Risk of inadequate funds may be as a result of (4)
- 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.
Risk of failing to meet the members’ needs may be as a result of (2)
- failure to recognise this when the benefit promise was made, or
- inflation eroding the value of the benefits.