Defining and Measuring Investment Risk in Defined Benefit Pension Funds

Abstract

A formal definition of investment risk in actuarial investigations is given. Case studies estimating the investment risk associated with different investment strategies for defined benefit pension funds using historic market data are presented. It is shown that a few decades ago, when bond markets only extended in depth to 20-year maturities, the investment risk of investing in equities was of the same order of magnitude as the investment risk introduced by the duration mismatch from investing in bonds for immature schemes. It is shown that now, with the extension of the term of bond markets and introduction of strippable bonds, the least risk portfolio for the same pension liability is a bond portfolio of suitable duration. It is argued that investment risk voluntarily undertaken in defined benefit pension plans has grown markedly in recent decades, at a time when the ability to bear the investment risk has diminished. Investment risk in pension funds is quite different to investment risk for other investors, which leads to the possibility that current portfolios are not optimised ö that is, there exist portfolios which increase the expected surplus without increasing risk. The formalising of our intuitive concept of investment risk in actuarial applications is a first step in the identification of more efficient portfolios.

Has regulation killed off the defined benefit scheme as a cost effective tool for human resource management?

“…A seminal paper in the British Actuarial Journal , “The financial theory of defined benefit pension schemes” (Exley et al , 1997) brought this situation, rather forcefully, to the attention of the members of the profession. This contribution started a long and acrimonious debate within the profession between the advocates of a financial economics based approach and traditionalists who advocating sticking to the old methods (see Whelan, 2008, for recent discussion of this issue).…”