How do I reduce the risk of benefit cuts and non-indexation?
Dynamic balance sheet policies significantly reduce the risk of benefit cuts and non-indexation
Reducing the risk of benefit cuts and non-indexation will introduce a sense of calm into the pension fund boardroom. Dynamic balance sheet policies put this at your fingertips.
By Jeroen van der Hoek, risk manager at Cardano
Long-term investment policy
Generally speaking, pension funds pursue a long-term balance sheet policy, which I believe is synonymous with market risk policy. Changes to the policy are only prompted by multi-year assessments, which means you run the risk of acting when it is already too late. Financial markets are prone to volatility, and other factors can change quickly, too, such as interest rates and legislation. These changes affect the fund’s funding level and/or the investment risk that the fund can take on behalf of its members. Static long-term balance sheet policy is not perfectly compatible with such developments.
A different approach to funding level risk
You can manage your funding ratio risk by pursuing a dynamic balance sheet policy. Making this change is easy: simply adjust the fund’s balance sheet policy as the funding ratio increases or decreases. From the perspective of pension goals, these changes are rational, but they feel counter-intuitive.
First of all, dynamic balance sheet policy consists of reducing risk at low funding levels: when the funding level is at or under the 100% mark, you’re in the danger zone, as you’ll be legally obliged to start cutting pension benefits. Moreover, paying out full pension benefits when the funding level is already below 100% would cause funding levels to drop even quicker, in what we call the sinking giant effect.
Dynamic policy also consists of reducing risk when funding levels rise to the point at which you can guarantee (virtually) all indexation for the future. Depending on the duration of liabilities, this level is usually between 130 and 150%. If the fund has enough money at its disposal to pay out all indexed pension benefits for the entire lifespan of said pensions, there is no need to take any more risks: the pension fund will have achieved its ambitions.
You can also increase your funding level risk if the fund is well-fed but doesn’t have sufficient capital to guarantee all indexation, i.e. between low funding levels and approximately 130%. The key question, of course, is how much? This is the situation in which the boardroom has to balance the two objectives of a pension fund most explicitly: guaranteeing nominal pensions and aspiring to realistic pension.
Eliminate uncertainty about taking action
Dynamic balance sheet policy eliminates any uncertainty about whether or not to take action and whether it is already too late. Besides, it allows risk policy to be more closely aligned with the fund’s pension objectives, providing peace of mind and contributing to an even more robust development policy.