Pension funds need balance between risks and resilience
The capacity to absorb financial setbacks differs markedly across pension funds. The financial position of a fund is a key factor, as is the ratio between the number of active members and the number of pensioners. It is crucial that a pension fund’s investment policy matches the risk-bearing capacity arising from a fund’s specific features.
A pension fund’s capacity to absorb risks without lowering nominal pension entitlements depends on various factors. The first is the capital buffer, which pension funds can draw on before a shortfall arises. This buffer is essential for being largely certain of meeting nominal pension promises and has proven its usefulness during the financial crisis. At end-June 2011 the average funding ratio of the total pension sector was 111%. This corresponds to a capital buffer of 11%, signifying that the buffers for the sector as a whole are not yet back at the desired level.
The second relevant factor is the effectiveness of the contribution rate as a steering instrument. This indicates the degree to which a pension fund can correct its course by adjusting pension contributions. For a young pension fund with many active members and few pensioners, the effectiveness of this instrument is strong and so the fund can absorb more severe shocks by levying a temporary recovery contribution. For the pension sector as a whole, the effectiveness of this instrument is limited. An average fund [1] can no longer quickly recover from a moderate shock of 5% of the technical provisions by adjusting the contribution rate; in that case, a recovery contribution of 9% of pensionable earnings would be required for three years.
The chart below presents, for a large number of pension funds, the effectiveness of the contribution instrument and the funding ratio. It reveals large differences in the resilience of pension funds. Funds at the bottom-left of the chart are vulnerable and have a funding shortfall while the effectiveness of the contribution instrument is relatively weak. They can neither use capital buffers nor an increase in contributions to absorb new shocks. Funds in that quadrant are therefore in a difficult position and that may prompt another close look at the financial structure or consultations with social partners on the pension scheme that is to be carried out.
Chart 1: Funding ratio and effectiveness of the contribution rate as a steering instrument
Note: Pension funds use different methods for setting contributions. The chart only shows the funds that set the contribution as a percentage of pensionable earnings. For these funds, the effectiveness of the contribution rate as a steering instrument at end-2010 was calculated as the number of percentage points by which the funding ratio can recover if the fund levies a three-year recovery contribution of 5% of pensionable earnings. The 50 biggest pension funds are represented by larger circles.
Thirdly, the resilience of a pension fund depends on the maturity of its pension liabilities. A young pension fund holding liabilities with relatively long maturities has more time to recover from weak returns by reducing indexation. This may be a reason for taking more investment risk. For the entire sector, the average maturity of liabilities is around 17 years. Owing to the changing age profile of pension funds, the average time horizon will become shorter over time.
The maturity of liabilities generally relates to the effectiveness of the contribution instrument. For many young funds, the effectiveness of the contribution instrument is strong and their liabilities are relatively long-term, giving them several means of recovery. Exactly the opposite applies to older funds. However, this connection does not always apply, a case in point being young funds with many members who are not building up any more pension entitlements because they are no longer employed in the companion enterprise, for example in the employment agency sector. At such funds, the contribution instrument’s effectiveness is weak but liabilities are relatively long-term. The reverse occurs too, i.e. funds with many older active members but few pensioners.
The chart below presents the relationship between the maturity of liabilities and the investment risk of pension funds. The chart shows that, on average, funds with a shorter horizon take less investment risk. However, there are large differences between funds whose liabilities have a similar maturity. Some funds with relatively short-term liabilities can nonetheless absorb considerable setbacks, because they have very large capital buffers or because their sponsor is obliged to make supplementary contributions. In other cases, a high investment risk coupled with a short time horizon could indicate that the risks do not match the pension fund's resilience. It therefore remains important that pension funds align their investment policy to the specific characteristics of the fund. This responsibility lies with the pension fund’s management board.
Chart 2: Investment risk and maturity of liabilities
Note: The maturity of liabilities is reflected in the modified duration of the technical provisions for risk funds at end-2010. The strategic investment risk is shown by the own funds required in the equilibrium situation as a percentage of the technical provisions for risk funds at end-2010; this measure is mutually comparable among pension funds. The 50 biggest pension funds are represented by larger circles.
[1] Average of all funds that set the contribution as a percentage of pensionable provisions for risk funds. These funds form around 80% of the pension sector.
