Pension plans rely on the investment of contributions to produce returns. It is these returns that make it possible for retirees to be paid either as a lump sum or through monthly payments. As with any other form of investment vehicle, pension plans do experience risk.
In this blog post, we look at what pension risk is and the two common types of risk that pension plans face.
Pension Risk
Pension risk refers to the possibility of losing money that has been invested in a pension plan. There is no guarantee that a particular investment strategy will meet investment objectives or provide a given level of income.
The consequence of the inability to properly manage risk results in underfunding which means there is not enough money to pay those who are retired. It is up to the administration of the pension schemes to carefully select investment vehicles that will bring the most returns or ensure that there is enough money to pay employees who have attained the age of retirement.
Which Pension Plans Face Pension Risk?
All types of pension plans face a certain level of risk considering that they are investment strategies. The difference is who bears the consequence of the risk.
For defined benefit plans, the organization providing the pension plan is fully responsible for bearing the risk and remains obligated to provide the members with their payout when they reach the age of retirement. On the other hand, in defined contribution plans, the members are wholly responsible for bearing the pension risk.
Similar article: Getting Started with a Pension Fund
Funding for pension plans has recently endured extreme fluctuations which will likely continue for several years. Although strong returns from equities and higher bond yields increase plan funding, they also provide an opportunity to develop and implement an effective risk management strategy.
Types of risk:
1. Shortfall Risk
A pension shortfall occurs when the fair value of the plan assets is less than the benefit obligation.
Determining whether a company has an underfunded plan appears to be as simple as comparing the fair value of plan assets to the accumulated benefit obligation.
However, it isn’t that easy since the company is not likely to have to pay the full amount within a relatively short time frame. A company should place a current value on the benefits that won’t be paid until much later and compare the number with the current value of the pension assets.
3. Assumption Risk
This occurs when organizations use assumptions to reduce the need to add cash to their pension funds.
Long-term obligations and uncertainties will adjust their assumptions to minimize the shortfall and the need to contribute any more money into the pension fund.
Assumptions need to be regularly reviewed by competent investors concerning current economic trends and expectations. This is because an underfunded workforce presents a very real risk to companies and investors at large.
Summary
As with any investment, pension funds do face some form of risk. It is important to regularly check the systems in place and compare them with current trends to avoid underfunding.
