Pensions

Actuarial practice is the subject that makes you happy everyday.

In answering all the questions, notice the following tips.

Advantages of Defined contribution scheme
Flexibility + Transparency
Flexibility: Cater to personal circumstances (both the benefit type and the contribution level) + risk appetite
Transparency: turnover
  • The greater flexibility on retirement will allow the member to purchase an annuity that best reflects their individual circumstances (e.g. with regard to spouse’s pension, increases to pensions in payment, guarantee periods). Also, for individuals in poor health on retirement, it may be possible to purchase an impaired life annuity (or use the income drawdown approach), thereby receiving a higher level of pension income than would likely have been provided through the DB pension scheme.
  • In addition, the DC pension scheme is likely to offer a range of investment opportunities prior to Retirement, so that the individual member can invest his/her own fund in a way that reflects their own risk appetite. And, the opportunity to purchase a with‐profit or unit‐linked annuity and/or an income drawdown product on retirement, allows the member to continue to share in investment performance after retirement too.
  • Also, in most DC pension schemes, it will be possible for the member to vary the level of contribution payable in any given year to reflect current circumstances (e.g. if the member is recently married or has a young family, contributions can be temporarily reduced, and if the member has more disposable income or receives a one‐off bonus payment, a higher contribution can be made to the fund).
  • Finally, DC pension plans are more portable and transparent when a member moves from one job to another. In a defined‐benefit pension scheme, the link between current salary and accrued pension is broken when the member leaves the company (and, as a result, the value of the accrued pension is usually much lower than if the member had remained in service). However, this is not the case in a DC pension scheme, as the accrued pension pot is (largely) unaffected by moving from one employer to another. Given that employment is much more transient nowadays, this greater flexibility and transparency may be welcomed by employees.
Risks in defined benefit plan
For members
  • The main risk for a member of a defined benefit pension scheme is that there are insufficient funds to meet the promised benefit.
    • This may be due to underfunding, insolvency of the provider or to an inappropriate investment strategy
    • Possible reasons: actual experience worse than expected (particularly with regard to investment return, but also salary growth and mortality/longevity), employer did not (or was not able to) make contributions at the level recommended by the actuary
  • Another key risk faced by the member is the risk that promised benefit is changed.
    • In practice, legislation usually prevents a worsening of accrued benefits (unless the member agrees to it). The member might agree to change the benefit to avoid the company being insolvent.
    • However, benefits relating to future service may be changed or terminated altogether ( e.g. some defined benefit schemes have been closed with accrued benefits becoming a deferred pension and future benefits that are defined contribution in nature).
  • The member of a defined benefit pension scheme also faces the risk that inflation erodes the value of the pension in payment (unless inflation-proof increases are included).
For sponsors
  • In a defined benefit pension scheme, the main contribution risk is that the overall cost of the benefits is unaffordable.
    • This may be due to poor financial circumstances of the sponsor or simply that the costs have increased to such an extent that they have outweighed the benefits (to the sponsor of providing the scheme).
  • A further risk for the sponsor of a defined benefit scheme is the uncertainty of cost.
    • The total cost will not be known with certainty until all benefits have been provided and no future liabilities remain.
    • However, the required contribution rate will fluctuate over time according to the actual experience since the previous valuation, creating uncertainty in long-term business planning.
    • In particular, the funding level of the scheme may fall to an unacceptable level in times of recession (when the value of the scheme assets is likely to be fall). This, in turn, will require a higher contribution rate to be paid by the sponsor (and, indeed, may even require an immediate contribution to make good some of the deficit).
    • However, the main problem here is that this payment is required at a time that the sponsor is least likely to be able to afford it.
    • Risk mitigation method: pay more than is required when economy is performing well (within the maximum limits prescribed), retain investment surpluses within scheme to provide cushion (rather than using it to reduce current contributions and/or provide discretionary benefit increases).
  • the expenses of operating a DB pension scheme are considerably higher than that of a DC scheme. particularly with regard to legal, actuarial and investment management costs.
Risks in defined contribution pension scheme
  • In particular, there is the risk that investment return achieved is lower than expected, leading to a lower fund at retirement with which to purchase a pension.
  • In addition, the member also faces the risk that the expenses deducted are higher than expected, again leading to a lower fund at retirement.
  • At retirement, the member also faces an annuity risk – i.e. the risk that the cost of purchasing an annuity is higher than expected, leading to a lower level of pension. This may be caused by increased longevity and/or a fall in interest rates.
  • To mitigate this risk, individuals can switch to long-dated bonds as retirement approaches to control interest rate risk (i.e. effectively matching the assets held with those used to price annuities). then, if bond yields fall (and prices rise), fund held will also increase.
  • members of defined contribution schemes also face the risk that higher than expected inflation erodes the real value of the benefit provided.
Why do employers provide pension schemes?
  • paternalism
  • a desire to attract and retain good quality employees ─ pension income can be thought of as deferred remuneration ─ by linking the benefit provided to the length of service, employees are encouraged to remain with the employer
  • pooling pension arrangements for a large number of employees can create economies of scale and lower expenses
Retain the pension scheme versus transferring the risk to an insurer
Advantages of transferring risks
  • transfers longevity risk from scheme sponsor to insurance company, and, thus, will require no further contributions from the sponsor
  • will increase the security of the benefits for existing members
  • (depends on the question) if no new members would enter the scheme, scheme can then be wound up, thereby reducing administrative burden and costs
  • If the pension scheme is small, transferring to the insurer may achieve economies of scale.
  • The company may be contributing only in respect of increases in salaries on the historic service of what is now a small number of individuals. The contribution rate, and the actual amount of contributions is unlikely to be high.
  • Emergence of any of the risks above that affect pensioners or deferred pensioners may involve a large amount of money. This could lead to very volatile contributions, particularly if expressed as a percentage of salaries of the small number of active members. Depending on accounting regulations this could also lead to volatility in the company’s disclosed profits.
  • Transferring risks will require an immediate cash outflow, but future volatility will be greatly reduced. Record keeping for a large number of people that the company is not particularly involved with will be removed.
  • Running the pension scheme is not the company’s core activity, and currently the potential financial consequences if risks emerge are such that management time must be diverted to the scheme.
  • Benefits for the members are only guaranteed to the extent of the employer’s covenant and any statutory support scheme. On transfer to an insurance company, particularly in a regulated environment, the guarantees for scheme members will be greater and more valuable. (But there is a cost to this – see disadvantages).
Disadvantages of transferring risks
The main disadvantages of transferring the risks is that the premium required by the insurance company will probably be greater than the assets held by the scheme in respect of the transferring members.
  • The insurance company will include risk and profit margins in its price.
  • scheme members and/or sponsoring employer will not benefit from good investment returns in future (e.g. through discretionary increases to benefits or refunds to employer)
  • The additional guarantees given to members will probably involve matching more closely with fixed interest and index linked stocks. The potential additional return from equity investment will disappear.
  • The scheme will be funded on a best estimate basis, possibly with a degree of prudence. When the insurance company sets the premium required, the risk of the employer needing to make additional contributions will be factored into the price up-front. By transferring the risks the scheme loses any potential upside if the risks do not materialise – for example, for mortality experience.
  • Thus the employer will need to make a one-off payment to benefit from the risk transfer.
  • If the company is considering transferring all risks then a disadvantage is that the company may not get a good price for all of them; it may therefore decide to transfer only those risks where it is able to get a good price.
  • Diseconomies of scale will come into play for the remaining active members – there will be much higher costs of investment and administration, and there may possibly be investment restrictions.