Risk assessment of defined benefit pension schemes: an economic capital approach

In this thesis, we consider the amount of economic capital that defined benefit pension schemes potentially need to cover the risks they are running and to back long-term investment and longevity risks. As pension products offered by European insurance firms will come within the scope of Solvency 2, an insurance firm’s pensions customers will benefit from the protections offered by the Solvency 2 regime. However, members of occupational defined benefit pension schemes do not have such a rigorous capital requirement to protect them against the risks the pension schemes are running.

We argue that a risk-based quantitative economic capital requirement could be adopted by occupational defined benefit pension schemes to bring the risk management of pension products on equal footing with insurance firms.

In order to achieve this goal, we first use the Universities Superannuation Scheme as an example to show the risk level of an individual pension scheme

using economic capital as a measure of risk. We also show the effect of different risk control actions which can be employed by the pension provider to control its risk exposure, again measured by economic capital.

After quantifying the risk level associated with a defined benefit pension scheme, we extend our analysis to show the possibility of risk control by changing the design of the pension itself to a hybrid set-up.

Following the risk assessment of an individual pension scheme, we analyse the risk levels of the Pension Protection Fund (PPF) which is a central fund guaranteeing benefits of all eligible UK defined benefit pension schemes. By estimating the risk level on a group basis, we discuss how pension risks can be managed by using a central fund.

We find that the economic capital requirement for an individual occupational defined benefit pension scheme is generally very large. Instead of requiring each individual scheme to hold an economic capital, it is perhaps more practical and efficient for the PPF itself to hold adequate assets to back its own economic capital. However we find that the capital requirement for the PPF is also large and de-risking is needed for the PPF as well.

This thesis illustrates that the economic capital framework can be used as a risk management tool to improve our understanding of the risks embedded in defined benefit pension schemes.