The price of risk aversion for defined benefit pension schemes


9 Jan 2024

Morten Nilsson looks at whether risk aversion is hard-wired into defined benefit pension schemes.


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Morten Nilsson looks at whether risk aversion is hard-wired into defined benefit pension schemes.

There has been a lot of talk in recent months about whether UK defined benefit (DB) pension schemes are too risk averse when it comes to investments. Whilst deliberate de-risking of investment portfolios for closed DB schemes is arguably a logical approach, is risk aversion hard-wired into the sector and is this a problem?

Economist Paul Collier and Tan Suee Chieh, a former president of the Institute and Faculty of Actuaries, have previously explored this concept of ’safetyism’ (defined as the displacement of judgement by procedure) and its inherent pitfalls.

These pitfalls are particularly salient in highly regulated and risk-averse environments such as DB scheme management – where decision making is often slow to evolve, quantitatively based and procedural.

These conditions are too lenient on the status quo and hinder the application of judgement. Risks are often shifted elsewhere in the system from somewhere they’re known, to somewhere they’re unknown.

How has ‘safetyism’ impacted the pensions industry?

Safetyism has been a key driver for the move away from DB in favour of more affordable defined contribution (DC) alternatives, resulting in the transition of risk from sponsors ‘known’ to individuals ‘unknown’.

Whilst other countries have introduced collective defined contribution (CDC) schemes and other risk sharing arrangements as ‘workarounds’ for the provision of more stable (and therefore valuable) benefits for individuals, the UK industry’s inability to reach an appropriate middle ground for now has left employees harbouring certain ‘risks’ that safetyism has made too onerous for companies to accept.

For DB and DC, perhaps due to the long-term nature of the industry, maintaining the status quo has become embedded. Advisers are re-appointed, administrators renewed and objectives re-worded due to a defensive mindset and a lack of appreciation that not making decisions and just following process is also a decision.

Endgame and a challenge to the status quo

Looking at the DB market, the prevailing notion is that the optimal endgame solution is insurance buy-out – reinforced by a lack of established alternatives. The notion in its extreme is that it should be safer to buy-out £1.5trn of DB liabilities and concentrate this risk with a handful of insurers rather than be supported by 5,000 employers is, at a societal level, hardly convincing.

While buy-out may be a suitable choice for some schemes looking to remove funding or covenant risks, this often comes at a cost of the high premiums and the ‘opportunity cost’ associated with forfeiting future asset returns.

Schemes with adequate access to resources and scale to manage uncertainty may question the value of such buy-outs, considering the regulatory limitations insurers face in investing across broad asset classes such as private equity, private credit and infrastructure.

Considering all this, it is easy to appreciate where ‘value leakage’ and conflicts of interest may creep in at various stages of an insurance buy-out.

It is worth remembering that trustees are not only responsible for securing member benefits, but more fundamentally, for acting in members’ interests.

Relinquishing discretion of trustees and a surplus to insurers may be questioned – especially if the sponsor has pension risk capacity and schemes have access to the expertise to manage risks and potentially distribute benefits or surplus to members and sponsors through alternative endgame solutions.

Transitioning to cashflow-aware assets as schemes mature and using specialist capabilities, such as LDI or longevity swaps, may allow schemes to limit exposure to key risks and release surplus value as a scheme runs off. This is fundamentally the same approach that insurers take but with a less constrained investment universe, leaving any surplus with the scheme and sponsor.

Maintaining oversight of the scheme also means trustees retain the power to make changes to administration provision, exercise discretion and act on members’ feedback. This is especially relevant if the level of service being provided to members is adversely impacted by administrators’ lack of capacity and outdated technology platforms.  

More broadly, as an industry we need to come up with solutions for the DB to DC transition and a nuanced approach is required. Balancing certainty of benefits with minimising value leakage and retaining some risk could be a more rounded and open-minded strategy.

We also need to see closed DB schemes make the right decisions for their journey plans and endgame. Procedural thinking and quantitative analysis, while essential, is not enough for decision-makers to navigate the complexities of optimal choices in pension scheme management.

There is need for a willingness to think unconventionally, acknowledging that accepting the status quo is an impactful decision in its own right.

With thanks to Harry Bridger, manager, Unit X, Brightwell for the input to this article.

Morten Nilsson is the chief executive of Brightwell, which manages the BT Pension Scheme.


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