An Economic Capital study of the Pension Protection Fund and UK’s Defined Benefit Pension Sector

With the advent of formal regulatory requirements for rigorous risk-based, or economic, capital quantification for the financial risk management of banking and insurance sectors, regulators and policy-makers are turning their attention to the pension sector, the other integral player in the financial markets. In this paper, we analyse the impact of applying economic capital techniques to defined benefit pension schemes in the UK. We propose two alternative economic capital quantification approaches, firstly for individual defined benefit pension schemes on a stand-alone basis and then for the pension sector as a whole by quantifying economic capital of the UK’s Pension Protection Fund, which takes over eligible schemes with deficit, in the event of sponsor insolvency. We find that economic capital requirements for individual schemes are significantly high. However, we show that sharing risks through the Pension Protection Fund, reduces the aggregate economic capital requirement of the entire sector.