Will your pension fund have enough in it to fund your old age? A regime switching approach to pension fund solvency

By | July 26, 2011

pensionIf you are a trustee of a pension fund, what keeps you awake at night?  One of the many concerns for pension fund managers, trustees and regulators is to make sure there will be enough money in the cupboard when it comes to paying out pensions in five or thirty years’ time.

1. Dramatic swings in pension funding

Over the last four years, the net funding position of defined benefit pension plans in the UK swung dramatically from a surplus of £149.2bn in June 2007 to a deficit of £208.6bn in March 2009 and back to a surplus of £48.4bn in February of this year.

These fluctuations were primarily caused by two factors; changes in asset values following the credit crisis, and sharp declines in interest rates, which caused the present value of future liabilities to rise steeply.

2. Statistical models for pension fund deficits

Working with colleagues from both the University of Leeds and University of Strathclyde, we are working on statistical models that predict the probability of a pension fund being in deficit far more accurately over long periods of time.

A key warning for pension fund managers and trustees is that under current models, money invested today is predicted as seeing a 3 ¼-fold return over a 30-year period – with a probability of 97.5%.  Under our new statistical models, it may be under a 2¾-fold return.

3. What could a dollar be worth in 30 years?

In figure 1, we simulate the dollar future value of $1 invested in a pension fund whose assets have been split 20% US equity, 30% UK equity, 10% Europe equity, 10% Japan equity and 30% UK Treasuries.   The red lines show the projected returns using the traditional ‘one-state’ model; the blue lines take account of the more complex world we live in and are based on the new four-state model.

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The largest differences appear at the top end of the model – the traditional model shows a 2.5% chance of growth to $61.08, whereas, for our more advanced model, growth is up to $78.51 with this level of probability.

While this may appear interesting to some, the focus for pension fund trustees has to be watching the worst case scenarios.  In the four-state model, there is a 2.5% chance that the future value of the dollar invested will be below $2.73 in thirty years, against the traditional one-state model which would have predicted this at $3.34.

In these cases, the more sophisticated statistical model implies a greater risk of future pension fund solvency problems.

4. Pension funds must remain solvent

The concern for every pension fund manager and trustee has to be ensuring that their fund will remain solvent into the future.  This new way of modeling better accounts for the real world of financial market peaks and troughs and will ensure that investment decisions are based on more accurate probability assessments of future pension fund surpluses and deficits.

About Mark Freeman

Mark joined the School of Management in 2006, following previous full-time academic appointments at the Exeter Centre for Finance and Investment (University of Exeter) and the University of Warwick. He has held visiting academic positions at the Kellogg Graduate School of Management (Northwestern University), the University of California, Irvine, and the University of Technology, Sydney.

Before becoming an academic, he worked as an equity research analyst specialising in the brewing and distilling industries for stockbrokers Savory Milln and James Capel, in London. He also has corporate finance experience with United Distillers in Scotland.

Specialties: Economics of climate change, Long term funding of nuclear power, Pension funds - long term deficits