Pension Risk Management in the Enterprise Risk Management Framework

Yijia LinUniversity of Nebraska - Lincoln

Richard MacMinnIllinois State University

Ruilin TianNorth Dakota State University

Jifeng YuUniversity of Nebraska – Lincoln

Presented at

International Conference on Financial and Insurance Risk ManagementBeijing, China

July 4, 2015

Enterprise risk management (ERM)

Assess all enterprise risks and coordinate various risk management strategies in a holistic fashion

Enterprise risk management (ERM)

Assess all enterprise risks and coordinate various risk management strategies in a holistic fashion

Superior to the silo-based risk management Facilitate risk control (Lam, 2001) Mitigate information asymmetry (Liebenberg and Hoyt, 2003) Generate synergies between different risk management

activities (Lin et al., 2012; Gamba and Triantis, 2014) Optimize the trade-off between risk and return (Nocco and

Stulz, 2006)

Motivations The current ERM practice and literature disregard

off-balance-sheet items. Defined benefit (DB) pensions are the most significant

off-balance-sheet item: $2.34 trillion in 2012 DB pensions introduce significant risks

Market downturns Low interest rates New pension accounting standards Improved life expectancy of retirees

Motivations (Cont’) From the 2008 Coca-Cola annual report

DB plans of General Motors (GM) were underfunded by $8.7 billion in 2012 Reduce GM’s share value (Bunkley, 2012)

“… As a result of the decline in the fair value of our pension plans assets and a decrease in the discount rate used to calculate pension benefit obligations, we have made and will consider making additional contributions to our U.S. and international pension plans in 2009.”

Motivations (Cont’) The implications of pension risk on firm overall

risk have been largely unexplored.

Motivations (Cont’) The implications of pension risk on firm overall

risk have been largely unexplored.

How significant is it to incorporate pension risk in an ERM program?

No ERM model currently exists to integrate the pension scheme into a firm's decision making process (Kemp and Patel, 2011) Ai et al. (2012) present an ERM framework but they

do not consider pensions.

Contributions We propose an ERM optimization model by

consolidating pension risk with various business risks for a firm sponsoring defined benefit (DB) plans. If we manage pension risk and different business-related risks

in a holistic way, it will notably increase firm value by 17%.

Contributions We propose an ERM optimization model by

consolidating pension risk with various business risks for a firm sponsoring defined benefit (DB) plans. If we manage pension risk and different business-related risks

in a holistic way, it will notably increase firm value by 17%.

We study how much pension risk a plan should transfer given that pension risk and other business risks are managed holistically.Ground-up strategy (e.g. pension buy-ins and buy-outs, ₤5.5

billion in 2013)Excess-risk strategy (e.g. longevity swaps, ₤8.9 billion in 2013)

Contributions (Cont’)

The existing literature suggests that the excess-risk hedging strategy is more attractive. The ground-up strategy is more capital intensive and expensive

(Lin and Cox, 2008; Lin et al., 2013).

We show the excess-risk strategy is less effective in improving overall firm performance in the ERM framework.

Two Divisions of a DB Pension Firm

Operation Division

Involves real project investments

Faces project risk, operational risk, insurable hazard

risk, and etc.

DB Pension Division

Deals with pension assets and liabilities

Faces investment risk, interest rate risk and longevity risk.

Risks from the Operation DivisionProject risk: The risk of potential losses due to unsatisfactory

performance of a firm’s real project operations.

Risks from the Operation DivisionProject risk: The risk of potential losses due to unsatisfactory

performance of a firm’s real project operations.

Hazard risk: The risk related to safety, fire, theft and natural disasters. Suppose the annual hazard loss per dollar invested, h, is a

lognormal random variable:

Risks from the Operation DivisionProject risk: The risk of potential losses due to unsatisfactory

performance of a firm’s real project operations.

Hazard risk: The risk related to safety, fire, theft and natural disasters. Suppose the annual hazard loss per dollar invested, h, is a

lognormal random variable:

Operational risk: The risk of unexpected changes in elements related to operations arising, directly or indirectly, from people, systems and processes. The loss caused by the operational risk from project j in period t, opjt, equals a proportion, , of project j’s total return

where is the net return of project j in period t.

Risks from the DB Pension Division Pension risk: Pension investment risk, interest rate

risk and longevity risk

Risks from the DB Pension Division Pension risk: Pension investment risk, interest rate

risk and longevity risk

Assumptions A pension cohort joins the plan at the age of x0 at time 0 and

retires at the age of x at time T. Annual survival benefit B after retirement The pension fund is invested in n assets. The annual pension cost (PC) is paid by the operation

division. The pension cost is the sum of a constant normal contribution (NC)

and a supplementary contribution (SC).

Overall Risk

Considers different risks at a holistic level.

The risk that the total value of all projects net of costs of operational risk, pension contributions and retained hazard losses is not sufficient to cover the entire financial obligations.

Model Setup

A firm has a total capital of M0 allocated to m investment projects and a DB plan at time 0.

A proportion wjp of M0 is invested in project j (j = 1, 2,…,m).

After financing m projects at time 0, the remaining amount PA0 goes to the pension plan and is invested in n assets with the weights of w1,w2,…, wn.

Basic Optimization Problem

Our ERM optimization model is to solve for the optimal project investment proportions wp=[w1p,w2p,…,wmp], the hazard insurance ratio u, the pension asset weights w=[w1,w2,…,wn] and the pension normal contribution NC, so as to maximize the expected value of the adjusted operation fund at time :

subject to the following constraints:

Constraints Constraint 1: Project risk

Constraint 2: Operational risk

Constraints (Cont’) Constraint 3: Hazard risk

Constraint 4: Pension risk I

Constraint 5: Pension risk II

Constraints (Cont’) Constraint 6: Overall risk

Constraints (Cont’) Constraint 6: Overall risk

Constraint 7: Budget constraint Constraint 8: Strategic constraint Constraint 9: Range constraints

Numerical Example

We focus our study on a cohort with all members who join the plan at age x0=50 in time 0 and retire at age x=65 after T=15 years.

Total raised capital M0=200

Numerical Example (Cont’)

Numerical Example (Cont’)

Numerical Example (Cont’)

What if Pension Risk is not Integrated? Assume the firm manages its pension risk separately.

Suppose at time 0, the firm allocates an amount of 40 to the pension fund, the same amount as the optimal PA0 in the ERM case.

What if Pension Risk is not Integrated?

What if Pension Risk is not Integrated?

Given the available fund 160 at time 0 for the real project investment, we maximize , the expected value of the operation fund for the firm at time :

What if Pension Risk is not Integrated?

In this scenario when the real projects and the pension plan are managed separately, the expected firm value is notably reduced to = 9012.34 from the previous optimum with ERM of = 10857.02, a 17% drop!!

What if Pension Risk is not Integrated?

In this scenario when the real projects and the pension plan are managed separately, the expected firm value is notably reduced to = 9012.34 from the previous optimum with ERM of = 10857.02, a 17% drop!!

Ground-up De-Risking Strategy The pension ground-up de-risking strategy, including

buy-ins and buy-outs, transfers a proportion of the entire pension liabilities to a third party.

Ground-up De-Risking Strategy The pension ground-up de-risking strategy, including

buy-ins and buy-outs, transfers a proportion of the entire pension liabilities to a third party.

The pension firm needs to pay a hedge price equal to

Ground-up: Numerical Example

As long as the firm transfers some of its pension risk with a positive hedge ratio, the firm can achieve a higher firm value than the value (10857.02) when the firm does not hedge.

Ground-up: Numerical Example

As long as the firm transfers some of its pension risk with a positive hedge ratio, the firm can achieve a higher firm value than the value (10857.02) when the firm does not hedge.

Excess-Risk De-Risking Strategy The pension excess-risk de-risking strategy, such as longevity

insurance, only cedes a proportion of the high-end longevity risk embedded in a pension plan to a risk taker.

…………

Excess-Risk De-Risking Strategy The pension excess-risk de-risking strategy, such as longevity

insurance, only cedes a proportion of the high-end longevity risk embedded in a pension plan to a risk taker.

The pension firm needs to pay a hedge price equal to

…………

Excess-Risk: Numerical Example

The hedge ratio and the pension asset allocation are not sensitive to the hedge cost.

Excess-Risk: Numerical Example

The hedge ratio and the pension asset allocation are not sensitive to the hedge cost.

Excess-Risk: Numerical Example

The hedge ratio and the pension asset allocation are not sensitive to the hedge cost.

Excess-Risk: Numerical Example

The hedge ratio and the pension asset allocation are not sensitive to the hedge cost.

The excess-risk strategy is less effective in improving the overall firm performance than the ground-up strategy.

Sensitivity Analyses

Conclusion We study how to make an optimal strategic decision

considering pension effects in an ERM framework.

The performance of a DB firm will be greatly improved if it integrates pension risk with other risks in an ERM program.

The excess-risk pension de-risking strategy underperforms the ground-up strategy in terms of value creation under the ERM framework.