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Markets (Economics)

Pension Risk: A Growing Concern for Corporate Balance Sheets

Strategic Insights

— 2 min read

During the long bull market, companies generally did not assess the risk of their pension funds on their corporate balance sheets. However, with the introduction of new accounting rules and the realization of the havoc that markets can wreak, companies are now challenging the trustees' focus on long-term risk. The "Value at Risk" (VaR) measure of risk, commonly used in the corporate world, is now being applied to pension funds to understand the one-year severe case loss from the pension fund's financial performance.

Key Takeaways:

  • The average FTSE 100 company has a VaR in its pension fund of £180m, while one in 10 companies have a VaR measure above £1.3bn.
  • The pension fund VaR is 3% of market capitalization or 34% of one year's pre-tax profits for the average company in the FTSE 100.
  • For one in 10 companies, the VaR measures are at or above 13% of market capitalization and 168% of one year's pre-tax profits.
  • Risk budgeting can provide answers to which risks create value for the company and its members by assessing the returns expected alongside the risks taken.
  • The biggest sources of value creation in risk budgeting exercises are:

+ More exposure to global equities to increase diversification for portfolios dominated by UK equities.

+ More in alternative assets, primarily hedge funds and private equity, to increase diversity.

+ Better management of duration of bonds in the portfolio to reduce interest rate risks.

+ Limiting unintended "bets" through better management of exposure to currency and inflation.

  • Good governance is essential in executing "good" risks to avoid them turning into "bad" risks.
  • Long-term risk varies over time, and optimal strategies for long-term investors can exploit short-term risks.
  • Pension funds and sponsors are increasingly taking a balanced stance to understand and mitigate risks.

Statistics:

  • £180m: The average VaR in the pension fund of a FTSE 100 company.
  • £1.3bn: The VaR measure of one in 10 FTSE 100 companies.
  • 3%: The pension fund VaR as a percentage of market capitalization for the average FTSE 100 company.
  • 34%: The pension fund VaR as a percentage of one year's pre-tax profits for the average FTSE 100 company.
  • 13%: The VaR measures as a percentage of market capitalization for one in 10 FTSE 100 companies.
  • 168%: The VaR measures as a percentage of one year's pre-tax profits for one in 10 FTSE 100 companies.

Sources:

  • Watson Wyatt (no date) - Research carried out by Watson Wyatt.
  • "Value at Risk" (VaR) - a measure of risk developed by the banking community.
  • FTSE 100 - a stock market index of the 100 largest companies in the UK.
  • Pensions and Investments - various sources on pension funds and risk management.
  • Watson Wyatt - global head of investment, Roger Urwin.

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