03rd Apr 2020

Stress tests are a useful measure of risk

The Pensions Regulator (TPR) has published the first stage consultation on its revised code of practice for defined benefit (DB) funding. The high-level principles had been widely trialed by TPR at events, via advisers and Trustees and in black and white. We think this forward-thinking by TPR has been hugely valuable in ensuring that the biggest change to UK pension scheme funding in 15 years didn’t come as a huge shock to the system at the point the consultation was launched. 

What TPR’s consultation document does very well is to introduce some level of detail and a significant number of questions on a broad range of pensions funding issues from covenant, to long-term planning, investment risk, contingency planning and, of course, the concept of fast track and bespoke. 

20-20 Trustees looks forward to responding to the consultation over the next few weeks. In the meantime, Trustee Director, Nadeem Ladha, looks at a very specific element of the consultation document which asks the question: how should TPR measure risk within a pension scheme?

Although there was nothing controversial in the three key investment principles in the consultation – there was one interesting new concept. Namely, that of measuring investment risk as part of the proposed fast track process by using a defined stress test. The use of stress tests makes good, pragmatic sense and is much better than the alternative which would be a convoluted and highly costly stochastic approach.

There’s nothing fundamentally novel about using stress tests to gauge pensions risk – the Pension Protection Fund (PPF) use a stress test when assessing the size of a scheme’s risk-based levy and The Prudential Regulation Authority (PRA) use it to measure pension risk exposure on financial institutions DB schemes. However, TPR’s consultation document clearly brings out the tension between the simplicity of using the PPF stress test and the robustness of a separate TPR-specific stress test for funding purposes.

PPF stress test: fit-for-purpose?

The PPF is concerned about a short-term risk assessment and the consultation even suggests that this approach to stress testing may not be fit for the purposes of long-term funding.

It is also important to note that the PPF does not have a credit spread stress, just a yield stress. This misses an important component in a mature DB scheme’s risk landscape. If TPR does decide to adopt the PPF stress test, then it could also make average credit quality subject to a limit, which may resolve this omission. However, this could create other issues in relation to investment strategy restrictions and governance complexity making it difficult for Trustees to take advantage of certain credit market opportunities.

PRA stress test: a better fit than you might assume?

The consultation seems to all but rule out the PRA test as it is not pension-specific and costly. Yet there is a clear methodology for measuring pensions risk within the PRA framework and investment consultants do know how to model both of the PRA’s two pension stress tests efficiently. Furthermore, the PRA pensions risk test also has a stress for longevity risk which seems to be missing from the consultation document. It is important to capture this risk otherwise it suggests longevity risk should not be a component of the risk budget for fast track purposes.

One possible outcome could be for a specific TPR-defined stress test, which uses the PRA pensions risk stress tests as a starting point (including the allowance for longevity risk). This should be a better measure of risk which could then be leveraged by the PPF and evolve its own stress testing methodology.