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
- —>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.
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
- 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
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
- 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
10 Investment risks in a benefit scheme
- 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
3 Overall security risks
- the security of the sponsor and ability to make good any shortfall
- the strength of the sponsor promise (covenant)
- model, parameter and data error
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 recognize the needs when the benefit promise was made, or
- inflation eroding the value of the benefits.
Annuity risk
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.
Liquidity risk
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.
Takeover risk
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.
Inappropriate advice may result from (6)
- 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
Errors in determining contribution / premium requirements may result from (4)
- 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
7 Reasons why benefits may be less valuable than expected in a DEFINED CONTRIBUTION SCHEME
- 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
9 Reasons why benefits may be less valuable than expected in a DEFINED BENEFIT SCHEME
- 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
Key risk to the state
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.
What is meant by “means-testing”?
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.
Why might a funded benefit scheme be underfunded? (3)
- 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.
Why might a sufficient and liquid fund not meet members’ needs? (2)
- 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
Why might the STATE want to change benefits?
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.)
Why might an EMPLOYER want to change benefits?
- 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
Why might INDIVIDUALS want to change benefits?
Personal arrangements need to change due to changes in an individual’s circumstances, eg marriage or children.
2 Main factors that lead to a worsening of the terms on which an annuity can be purchased.
- falling bond yields (because annuity providers back annuities with bonds)
- increasing longevity
Which type of investments are most likely to underlie an annuity?
Fixed interest bonds are typically held to back fixed-interest annuities and index-linked bonds are typically held to back index-linked annuities.
2 reasons why contributions may not be made by the sponsor.
- 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.
3 ways in which a deficit in a defined benefit scheme may be corrected
- 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
Defined Benefit Scheme
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.
Funded
means that money is set aside in advance of the benefits being paid.
Unfunded
a.k.a. pay-as-you-go
means that no funds are accumulated.
Defined Contribution Scheme
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.
Defined Ambition Scheme
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.
