What Lies Beneath: The hidden cost of pension fund equity risk

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Read the full paper here

update, this paper was quoted in a front page article in Financial News in the weeks of 7th April 2014. The online version can be found here

A recent change to the banking regulatory landscape brought pension risk
to the fore…

On 29th November 2013, following a consultation, the Prudential Regulation Authority, responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms, announced[1] changes to the capital framework applying to UK banks and building societies, specifically with respect to defined benefit pensions risk.

The PRA has decided that firms should meet all Pillar 2A risks (5), including pension risk, with at least 56% CET1 capital from 1 January 2015 onwards. This matches the proportion of CET1 capital required for Pillar 1. In its consultation the PRA asked for views on whether Pillar 2A should be met in full with CET1 capital from 1 January 2016. In light of consultation responses, the PRA has decided that it will not require firms to meet Pillar 2A in full with CET1.”

Source: The Bank of England *

Here, “pension risk” means the 1-year 99.5% Value-At-Risk (“VaR”) of the scheme assets relative to the liabilities. This is quite an onerous shock, for example for equities the 99.5% VaR would be around 2.5x the annual volatility of equities. The historic annual volatility of equities varies depending on the time period but is generally 16-20% per annum. The 99.5% VaR would also be nearly twice the 95% VaR which many pension schemes use for risk modelling.

Why is this a problem?

Equity portfolios across the UK bank pension funds are considerable, and the 99.5% VaR
used to determine the capital requirement is a large shock…

Figure 1: Assets & liabilities of bank pension funds, source individual 2012 annual reports and accounts
Figure 1: Assets & liabilities of bank pension funds, source individual 2012 annual reports and accounts

Source: Individual bank annual report & accounts 2012. See full paper for full data source information

The Capital Requirement for Equities

The capital charge is based on a 1-year 99.5% VaR estimate. There is no prescribed method for calculating this by the regulator, with each banking using their own modelling approach and calibration which are not publicised. The exact modelling approach and calibration used will affect the result of this calculation but one independent and public guide is the Solvency II standard formula, which gives an equity shock (base level) to determine the capital requirement of 39% for developed, quoted equities. For comparison, this is roughly equivalent to an annualized volatility of 16%. Redington’s own modelling produces a very similar result of a 38% equity shock.

While each of the banks’ pension schemes will have other diversifying risks which makes the overall ALM VaR analysis more complicated, we can look at the new capital requirement arising solely from the equity portfolio simply by multiplying the capital charge of 39% by the £ size of the equity portfolio and then multiplying by 56%, that being the proportion of pension risk that is met with CET1 capital under the new regulation.

Need – Enter Volatility Control

While a “conventional” equity benchmark will result in these higher capital requirements being felt, there are well-known approaches that can significantly reduce this.

Using a volatility controlled benchmark greatly reduces the cost of protecting an equity portfolio against large losses using put options, while maintaining return expectations similar to a conventional equity portfolio

In previous articles I have introduced the idea of using a volatility controlled index to manage the equity portfolio .
This is an index that systematically adjusts its exposure to equity markets dynamically, in response to changes in the realised volatility of equities. It drives to the conditions. This means that the index has a lower, and more constant level of volatility.
Both our own work, and external studies find that a volatility controlled equity benchmark has delivered greater risk-adjusted returns than a static benchmark, over a wide variety of long-term time periods and equity indices. This means we can reasonably expect a similar level of return as a static allocation for a lower level of risk.
Another consequence of reducing and controlling the level of volatility in an equity investment is the fact that put options (instruments that ensure capital protection at a certain level) on the value of the portfolio become much cheaper than on a static portfolio, which means that credible investment strategies can be adopted which embed this “hard floor” protection of the portfolio value on a rolling basis.

By controlling the volatility, and employing a rolling program of downside protection, the capital requirement associated with the portfolio can be greatly reduced (see Figure 2).

Figure 2: The risk reduction benefits of employing a volatility controlled benchmark with rolling capital protection

In conclusion

Adding pension risk to banks’ CET1 capital calculations focuses the mind clearly on the extent of risks being run in the scheme and whether they are rewarded.

Equities are likely held on the asset side in the expectation they will deliver excess returns compared to cash or other assets, but the risks are considerable. Clearly reducing the size of the equity portfolio will reduce risk, but will also reduce return.

There are approaches that we have outlined that give regulated entities such as banks options for reducing the capital requirement from the equity portfolio without simply reducing it.

Read the full paper here


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