Robin Ellison asks whether our approach to risk needs to change.
Older readers will be familiar with the Monty Python running gag of the Spanish Inquisition. No-one expected it. And in our hearts we all know that many of the risks that we may face will be ones that we cannot anticipate.
That does not mean of course that we should ignore the risks that we can anticipate. We expect the Civil Aviation Authority to manage the risks of flying on aeroplanes so that they are less than the risks of walking down the stairs at home. It's just that we should have regard to the risks in a proportionate manner.
Cambridge professor David Speigelhalter spoke at a recent PLSA Investment Conference on the public understanding of risk. He was looking at the impact (or minimal impact) on cancer rates of eating bacon; but he could have chosen any number of other examples, looking at the risks and rewards of breast or prostate checks or whether horse-riding is worse than taking ecstasy.
taking risk off the table also has a price, the cost of which (even if known, which it often is not) might be better spent elsewhere.
Today the pensions advice and investment industry is devoting much of its efforts to managing risk. As The Pensions Regulator rather redundantly pointed out, pension schemes carry a variety of risks. They have mortality risks, inflation risk, investment risk, currency risk and of course employer risk.
For over a century it has been possible in the provision of defined benefit arrangements to buy protection against all or at least most of those risks. This protection was known conventionally as annuities.
Annuities have come in for some stick in recent years, especially individual annuities, because their perceived cost was too high, particularly in a period when discount rates were artificially depressed. But many years ago companies decided to run their own annuity systems, through a funded occupational pension system, because laying off the risk was so expensive.
Insurance companies had to invest sub-optimally, because of regulatory obligations, they had to create reserves, and they had to make profits - and unsurprisingly they were expensive. Which is why self-administered pension schemes emerged in the first place, and why companies were prepared to act as an insurer of last resort. This was also in the days before the PPF, funding obligations and pension guarantees.
But now employers and others are being encouraged to lay off those risks but, rather than buy annuities, buy slices of protection, either through LDI, or swaps, or other forms of derivatives. Mature funds are under pressure from their own relatively new regulator to enter into ‘journey plans', which means buying more gilts, really to protect against claims against the PPF rather than claims by pension scheme members.
The question that pension fund trustees may need to ask themselves, the employer and the regulator, is whether such a policy invites the taking on of additional and different risks, the nature of which may be imperfectly understood and almost certainly mispriced. And taking risk off the table also has a price, the cost of which (even if known, which it often is not) might be better spent elsewhere, e.g. in the provision of benefits or reducing employer costs.
In theory it might be sensible to spend money in laying off risks, which we understand. But maybe we are overdoing it. Maybe it would be better to keep such money in reserve to cope with the risks we do not understand or expect, i.e. the unknown unknown, the Black Swan – or the arrival of the Spanish Inquisition.
Robin Ellison is head of strategic development for pensions at Pinsent Masons
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