Managing Investment Risk in Defined Benefit Pension Funds
Occupational pension funds operate along a simple mechanism: Contributions are being paid into the fund, which are subsequently invested on the capital markets, and finally paid out in the form of pension benefits. But as the operational variables implied in this process are uncertain, this mechanism is inescapably embedded in risk. Investment returns are uncertain, and this holds true for mortality or salary trends as well. Pension funds are inevitably active risk takers.
The two most important risk categories pension funds take are investment and longevity risk. Unlike defined contribution (DC) pension funds, which re-distribute these risks to their participants, defined benefit (DB) pension funds, which give the employee the security of a pre-defined pension benefit, perform their task of providing safe pension benefits by assuming and retaining risk. DB pension funds can become complex risk-sharing institutions, as they may subsequently redistribute risk between the different groups of stakeholders. The risks pension funds take need to get managed. But managing risk is not equivalent to avoiding risk. This paper argues that the risk-taking capacity is a central element of defined benefit (DB) pension funds. Moreover, this capacity is increasingly impeded by regulatory and accounting standards with longstanding detrimental effects threatening the future existence of DB pension funds....