The Pensions Regulator (TPR) has today issued regulatory guidance for trustees and employers, intended to help develop an Integrated Risk Management (IRM) approach to scheme funding.
Trustees will already be familiar with the three key financial risks to pension schemes which TPR expects to drive scheme funding decisions. However, this new guidance is intended to help trustees model, understand and mitigate the ways in which funding, investment and covenant risks interact.
Whilst the guidance will be particularly useful reading for trustees who are about to undertake a scheme funding valuation, TPR is however keen to emphasise that IRM is an on-going process and that trustees should consider its introduction 'wherever the scheme lies within its valuation cycle'.
We therefore encourage trustees to discuss with their advisers how their risk management processes could evolve to take account of TPR’s latest publication.
What is Integrated Risk Management?
TPR says “IRM is an important tool for managing the risks associated with scheme funding”. In particular, IRM focusses on the interaction between risks in three key areas:
- the trustees’ funding strategy
- the scheme’s investment approach, and
- the ability and willingness of the employer to financially support the scheme (the employer 'covenant')
and considers relationships between them in a structured way.
The idea of collectively monitoring these three risks as being an important part of an overall strategy is not new. The regulator’s code of practice on funding Defined Benefit (DB) schemes devotes an entire chapter to IRM, noting that 'trustees should adopt a proportionate integrated approach to risk management'.
This guidance however, sets out the ways in which Trustees can work with their advisers and sponsoring employers to build an effective risk management structure. It also considers what IRM will look like in practice, and explores some examples of risk assessment approaches.
How to approach IRM
TPR has said that it expects trustees to adopt a long-term proportionate approach, noting that 'there is no one set formula for what IRM should look like'. Trustees are expected to work together with the employer in developing their IRM, and should take account of the ‘risk appetites’ of all parties involved.
Schemes may already have a risk-management framework in place which can be used as a starting point, though many will have to undergo an 'initial investment' to get IRM up and running.
TPR recommends a multistage approach:
TPR’s guidance also considers some of the tools they might use to develop an IRM framework, including:
- Stress testing: Identifying variables that affect the finances of the employer or scheme, changing these variables individually and then modelling the impact on the scheme
- Scenario testing: In which several variables are stressed simultaneously and the impact modelled
- Scenario projections: Complex models in which the future progression of risk is modelled under varying conditions
- Stochastic modelling: A statistical approach in which the model is run through several iterations to produce a range of possible outcomes, each with an associated likelihood
- Reverse stress testing: Working backwards from an adverse outcome to identify the series of events that would lead to that outcome and their likelihood
The future: Illuminate
Trustees should read the guidance, and discuss with their advisers how to go about developing an IRM strategy, regardless of where they are in their valuation cycle.
In due course, trustees should engage with sponsoring employers and advisers to identify and model the key risks, around which a robust structure can be put in place.
Our funding tool, Illuminate can help trustees and employers explore the complex relationships between funding, investment and reliance on employer support. It is more than just a simplified online modeller – it forms an integral part of our valuation advice. Using Illuminate, our experts can easily demonstrate how the moving parts of a defined benefit (DB) strategy fit together, enabling trustees and employers to make informed decisions.
Illuminate can be used to help trustees meet the IRM requirements set out in TPR’s latest guidance, particularly through real-time 'what-if' analysis, and stochastic modelling of the impact of investment strategy changes on funding and investment risk.
For more details click the link below or speak to your usual Barnett Waddingham contact.