Understanding a Defined Benefit (DB) Pension Plan's Risk Tolerance
Pension plans are regularly tested on the CFA Level 3 exam. Not only that, problems involving them usually account for 15-20+ points.
So you need to be prepared.
This post, part of a four part series of posts on pension plans, covers the risk and return objectives of defined benefit pension plans.
Four Part Pension Series
- Defined contribution vs. Defined benefit pension plans
- The Risk and Return Objectives of DB Plans (this post)
- Asset-Liability Management and mimicking pension liabilities
- Pension Plan IPS Constraints
This is "foundational" Institutional IPS material (pun intended).
Pension Plan - Return Objective and Calculation
This should be straightforward, but it’s also virtually guaranteed to be the first part of any pension problem you see.
In this case the passage should indicate the discount rate (a minimum actuarial rate), inflation, and fees.
- The required return calculation is usually a mandatory minimum actuarial rate (i.e. a discount rate) plus inflation and management fees
- The expected return should be sufficient to meet pension liabilities
- From there you just need to add them (or use the multiplicative approach).
Pension return = Discount rate + inflation + fees + any desired surplus (if applicable)
Here's a sample answer from one of the exams. Essentially, you've read this passage and it says the return objective is 200 basis points above the rate so that's 2%. You add that to the rate plus you know any inflation etc., that gets sort of thrown in and you're good to go.
Risk Tolerance of a Defined Benefit (DB) Plan
A defined benefits plan is built using ALM so that their pension assets are highly correlated to the pension liabilities. In other words, the key risk a pension fund tries to mitigate is shortfall risk relative to the projected benefit obligation or PBO.
These legally binding obligations mean a defined benefit pension plan has below average risk tolerance.
The above is table stakes. Pension risk is also almost always tested in a compare and contrast way. In this case you will need to look at one pension plan against another and compare their different risk factors.and decide which one has more or less ability to take risk.
Factors Used in Comparing Ability to take Risk between DB Pension Plans
This is a list that you need to memorize and be very comfortable applying. I would be surprised if it is NOT tested.
Risk Factor 1 - Plan Surplus
Factor number one is the plan surplus itself. The higher your surplus of assets the greater your ability to take risks (the individual analogy is that the richer you are, the more risk you can take). Now if a pension plan has a shortfall there might be a tension between ability to take risk (very low) and desire to take risk (to bridge the gap). Within a CFA L3 exam passage you should be looking for details on a company’s
Risk Factor 2 - Company Financials
Factor number two is just general financial health and status of the firm. The more profitable a firm is, the higher the risk the pension plan can take. Intuitively, that's because the company itself has a greater ability to make up any shortfall from the pension plan returned simply by increasing the dollar contributions into the plant. When looking for signs of financial strength or weakness look for leverage ratios (debt-to-asset) and profitability metrics (ROE). You should compare these to the industry averages when drawing any conclusions.
Risk Factor 3 – Correlation between DB Plan and Company
The correlation between the fund performance and the company performance is a vital risk factor. The less correlated the fund is to the company performance, the greater the risk ability.
You can think of it sort of in simple terms, right? If a fund's returns go down at the same time a company's profits do, then the company is less able to fund any shortfall at the exact time the fund may most need more contributions. As always, anytime we see diversification in the CFA curriculum it's a good thing.
Factor 4 – Plan Features
Plan features generally impact when the employees get their distributions from the trust. The more liquidity the plan needs, i.e. the more payouts it needs to give to retirees, the less risk the plan can take.
There are two things to pay attention to: early retirement provisions or lump-sum distributions. If a plan allows for early retirement or permits a person to take their benefits as a lump-sum distribution this increases the uncertainty of liabilities and likely decreases their overall duration. Both factors indicate higher liquidity needs and lower ability to take risk as a result.
Factor 5 – Workforce Characteristics
When we talk about workforce characteristics we’re really referring to the age of employees and the ratio of employees that are retired vs. those that are still working.
The higher the age of employees the closer they are to drawing benefits, the lower the duration of the plan’s liabilities, and the lower the ability to take risk. That’s straightforward: they have to provide for more people in the short term than a plan with a younger average age of employee.
The second component of this is the ratio of active to retired lives. Active lives refers to the workers that are not retired/still working at the company. The higher the ratio, the higher the funds' ability to take risk.
Summarizing Risk Factors for DB Plans
Here's how this could get tested: