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A Stochastic Approach to Risk Management and Decision Making in Defined Benefit Pension Schemes

Published online by Cambridge University Press:  10 June 2011

S. Haberman ,
C. Day ,
D. Fogarty ,
M. Z. Khorasanee ,
M. McWhirter ,
N. Nash ,
B. Ngwira ,
I. D. Wright  and
Y. Yakoubov
S. Haberman
Affiliation:
Faculty of Actuarial Science & Statistics, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, U.K., Email:s.haberman@city.ac.uk
C. Day
Affiliation:
Watson Wyatt Partners, Watson House, London Road, Reigate, Surrey RH2 9PQ, U.K., Email: christopher.day@eu.watsonwyatt.com
D. Fogarty
Affiliation:
William M Mercer Ltd, Noble Lowndes House, PO Box 64, 5 Bedford Park, Croydon CR9 2ZT, U.K., Email: david.fogarty@uk.wmmercer.com
M. Z. Khorasanee
Affiliation:
Faculty of Actuarial Science & Statistics, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, U.K., Email: m.z.khorasanee@city.ac.uk
M. McWhirter
Affiliation:
Scottish Widows' Fund & Life Assurance Society, 15 Dalkeith Road, Edinburgh EH16 5BU, U.K., Email: martin.mcwhirter@scottishwidows.co.uk
N. Nash
Affiliation:
Aon Consulting, 40 Torphichen Street, Edinburgh EH3 8JB, U.K., Email: nicola.nash@aonconsulting.co.uk
B. Ngwira
Affiliation:
Faculty of Actuarial Science & Statistics, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, U.K., Email:b.ngwira@city.ac.uk
I. D. Wright
Affiliation:
Faculty of Actuarial Science & Statistics, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, U.K., Email:i.d.wright-1@city.ac.uk
Y. Yakoubov
Affiliation:
Aon Consulting, 15 Minories, London EC3N 1NJ, U.K., Email:yakoub.yakoubov@aonconsulting.co.uk
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Abstract

The trustees and sponsors of defined benefit schemes rely on the advice of the Scheme Actuary to make important decisions concerning the funding of the scheme, the investment of its assets, and the use of surplus assets to improve benefits. These decisions have to be made in the face of considerable uncertainty about financial and demographic factors that will affect the future experience of the scheme and its success in meeting various objectives.

The traditional actuarial valuation combined with actuarial judgement has played an important role in guiding decision making; but we argue that stochastic methods can add value in certain crucial areas, in particular the financial risk management of defined benefit schemes. Rather than dealing with risk by incorporating margins in the valuation basis, a stochastic approach allows the actuary to evaluate specific and quantifiable risk and performance measures for alternative funding and investment strategies.

This paper recommends a framework that, when combined with a suitable stochastic model, measures the risks inherent in contribution rate and asset allocation decisions, allowing better decisions to be made. In doing this, we suggest and apply various risk and performance measures that may be thought appropriate, although our intention is to illustrate their use rather than prescribe them as objective standards. The framework provides the means to explore the trade-offs involved in possible contribution and asset allocation decisions, and points to decision strategies expected to give improved outcomes for the same level of risk. A feature of the approach that marks it out from current asset/liability techniques is that it examines the funding and investment decisions together. It does not derive a contribution rate in the traditional way, but leaves this as free variable, in the same way that the investment decision is taken to be a free variable. Another distinctive feature of our framework is that it is based on projection rather than on valuation, involving stochastic simulation of the experience of the scheme over a time horizon reflecting the concerns of the trustees and the sponsoring employer.

The paper provides a case study (based on a model final salary pension scheme) showing the advantages of the framework, and goes on to explain how the results may practically be communicated to trustees and scheme sponsors.

Keywords

Defined Benefit Pension SchemesProjectionStochastic SimulationRisk and Performance MeasuresRisk ManagementDecision Making
Type
Sessional meetings: papers and abstracts of discussions
Information
British Actuarial Journal , Volume 9 , Issue 3 , 01 August 2003 , pp. 493 - 586
Copyright
Copyright © Institute and Faculty of Actuaries 2003

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