Towers Watson begins its risk assessment process with an examination of three factors: target, time to target and risk tolerance. The higher the target or the shorter the time to the target, the higher investment returns or contributions are required; the lower the risk tolerance, the lower the expected returns. This helps create a ‘journey plan’.
Alasdair Macdonald, senior investment consultant, says that this journey plan will be set by the trustees in consultation with Towers Watson. He says: “It is a ‘map’ looking at how the solvency level is likely to develop over a period of time. A risk budget for the pension scheme will be agreed with the sponsoring company and we will then find an investment strategy to meet that risk budget.”
In defined benefit schemes, the strength of the company will also influence the ‘time to target.’So, for example, a BBB-rated sponsor might target self-sufficiency (i.e. the point at which the scheme no longer needs support from the sponsor) by year seven.
The schemes will always consider the likely funding gap in the event of financial difficulties by the sponsoring company. If the sponsor defaults, the scheme assets become of key importance. As such, MacDonald says he will always consider the correlation of the underlying assets to the default of the sponsor.
At each stage in the journey plan, actions will be taken to lock in gains and therefore improve the schemes’ security if it is ahead of target. If it is behind target, there will be adjustments as well.
The credit crisis has derailed a number of these journey plans and upset risk budgets. It has increased the size of funding deficits and it has made defaults among the sponsors more likely. The high market uncertainty has also meant that expected investment returns have had to be lowered, leaving more pressure on other areas.