Integrated risk management
On this page
- About this guidance
- Terms used in this guidance
- What is IRM?
- What does IRM look like in practice?
- Step 1: Initial considerations for putting an IRM framework in place
- Step 2: Risk identification and initial risk assessment
- Step 3: Risk management and contingency planning
- Step 4: Documenting the IRM framework and decisions reached
- Step 5: Risk monitoring
About this guidance
What is the purpose of this document?
Code of Practice 3: Funding defined benefits (the ’DB funding code’) provides a principles-based framework on how to comply with the statutory funding requirements contained in Part 3 of the Pensions Act 2004 (’Part 3’).
Integrated Risk Management (IRM) is an important tool for managing the risks associated with scheme funding. It forms an important part of good governance. The defined benefit (DB) funding code sets out the importance of trustees adopting an integrated approach to risk management. It also provides a basic framework for doing so.
This IRM guidance provides practical help on what a proportionate and integrated approach to risk management might look like and how trustees could go about putting one in place. It should be read in conjunction with the DB funding code.
Who should use this guidance?
This guidance should be used by the trustees and employers of trust-based DB occupational pension schemes required to comply with the statutory funding requirements in Part 3. It will also be of use to their advisers.
How should this guidance be used?
While it is aimed at all employers and trustees, we believe that trustees of smaller schemes may find it of particular help.
Some of the text in this guidance is highlighted in purple boxes to emphasise key principles and questions for consideration.
Examples are used to illustrate concepts and provide practical guidance. Not all examples will be relevant to every scheme – the extent to which these are informative will depend on the scheme’s and the employer’s circumstances.
The terms used in this document should be read consistently with those in Part 3 and in the DB funding code.
The appendix to this guidance is technical in nature. Before studying ts content, we recommend that readers become familiar with the main guidance.
What other guidance could be useful?
- The DB funding code.
- Code of Practice 9: Internal controls.
- Assessing and monitoring the employer covenant (’covenant guidance’) – which provides guidance to trustees on how to assess, monitor and take action to improve the employer covenant of a DB scheme.
- Guidance on DB scheme investment strategy (’investment guidance’) that we intend to publish in 2016.
Footnotes for this section
-  See paragraphs 38 to 60 of the DB funding code.
Terms used in this guidance
Contingency plans: Plans setting out actions that will be undertaken in certain circumstances to limit the impact of risks that materialise or to introduce additional risk capacity. ’Contingency planning’ should be construed accordingly.
Funding risk: The risk that the actuarial and other assumptions used to calculate the scheme’s technical provisions and any recovery plan (or any other target the trustees and employer have agreed to track) are incorrect and liabilities exceed assets in future by a greater margin than anticipated.
IRM approach: The practical steps and decisions taken by the trustees to introduce, maintain and develop IRM for their scheme as represented by the process diagram under paragraph 12.
IRM framework: The output of the trustees’ and employer’s IRM approach in terms of its agreed processes, procedures and documentation to be used by current and future trustees, for and between subsequent valuations.
Overall strategy: The sum of the various strategies the trustees have in place in order to meet their scheme objective. These strategies will include, but are not limited to, decisions taken regarding the Part 3 technical provisions assumptions and recovery plan (and any other secondary funding target or plan the trustees may agree with the employer) and the trustees’ investment strategy.
Part 3: Part 3 of the Pensions Act 2004.
Risk appetite: The trustees’ or employer’s readiness to accept a given level of risk.
Risk capacity: The scheme’s or employer’s ability to absorb or support risks.
Scheme objective: This covers the trustees’ objective to pay benefits promised in accordance with their scheme rules as and when they fall due linked to the statutory funding objective, and to have sufficient and appropriate assets to cover their scheme’s technical provisions under Part 3.
Footnotes for this section
-  See section 222 of the Pensions Act 2004.
What is IRM?
- IRM is a risk management tool that helps trustees identify and manage the factors that affect the prospects of meeting the scheme objective, especially those factors that affect risks in more than one area. The overall strategy the trustees have in place to achieve this objective will be dependent on the scheme’s and employer’s circumstances from time to time.
- The output of an IRM approach informs trustee and employer discussions and decisions in relation to their overall strategy for the scheme. This encompasses risk capacity, risk appetite and contingency planning as well as the assumptions to be used for calculating the scheme’s technical provisions and any recovery plan. If a scheme has a secondary funding target (as well as the statutory funding objective) or journey plans, then IRM also helps to manage the scheme against this secondary target or plan.
- IRM is a method that brings together the identified risks the scheme and the employer face to see what relationships there are between them. It helps prioritise them and to assess their materiality. It can take many forms but should involve an examination of the interaction between the risks and a consideration of 'what if' scenarios to test the scheme's and employer's risk capacities. Quantification of risks may help these considerations but the rigour of quantification should be proportionate to the risk and resources available.
- If the three fundamental risks to DB schemes are illustrated as a triangle with employer covenant, investment and funding risks at each corner, and each edge of the triangle examines the relationship between two risks bilaterally (for example, the right edge examines the relationship between covenant and scheme funding), IRM is the surrounding circle that encompasses all these risks together. IRM investigates the relationships between these risks (the triangle edges) altogether, examines their interrelationship and seeks to understand how risk at one corner of the triangle might affect the other two.
- The DB funding code and our separate covenant and investment guidance provide more material on the three DB scheme risks at the triangle corners. Ultimately the employer covenant underwrites investment risks and funding risk held within the scheme. If too much risk exists under the scheme relative to the employer covenant, it is more likely that the scheme objective will not be met.
- IRM goes further than merely understanding risks. It also considers what could be done should risks materialise (especially those which impact across more than one area). It may be necessary for contingency plans to be put in place to cater for the more significant risks. In addition, IRM helps to identify when opportunities arise to reduce scheme risk.
- IRM also informs the trustees' approach to monitoring these risks, implementing their contingency plans and, where necessary, adapting those plans as events unfold.
- Most schemes should be able to apply most of the key steps for IRM. Its sophistication can be scaled up or down depending on the scheme and employer’s circumstances and needs, allowing for it to be proportionate.
- Implementing effective IRM requires good governance. Trustees need to establish appropriate internal governance (for example, using sub-committees) and ensure their advisers are working together to deliver advice in the form trustees need to take their decisions.
- IRM is not a replacement process for identifying what the scheme’s overall strategy should be. However, where the strategy has to change, an IRM approach will inform the change by identifying any additional risk associated with it.
What does IRM look like in practice?
- When these steps have been completed, the trustees will have an IRM framework that sets out both their and the employer’s approach to IRM.
- The following diagram outlines a logical process for these steps to implement IRM. Steps 2 to 5 are iterative. They may overlap, be done in parallel, or be undertaken more than once.
Step 1: Initial considerations for putting an IRM framework in place
- There is no one set formula for what IRM should look like. It will be determined by, and will be proportionate to, the trustees’ scheme objective and the employer’s objectives, in the light of their needs and circumstances.
- Trustees should consider introducing IRM wherever the scheme lies within its actuarial valuation cycle. It does not have to wait until the next valuation is due.
- Putting an IRM framework in place, with appropriate documentation, requires an initial investment of time and resources. This will then be repaid as the framework is used by current and future trustees, for and between subsequent valuations.
- The extent of that initial investment will vary between schemes. Many schemes already have a risk assessment and management process in place. It may not be labelled as IRM but its steps and outputs may be similar. Schemes without such a process already should, nonetheless, find that the basic IRM inputs are in hand (for example, covenant assessment, actuarial and investment reports).
- Trustees are responsible for ensuring that their scheme’s IRM approach is appropriate and effective. They should consider who should be involved in the process, how they will engage with the employer and how advisers should work together.
- IRM works best when the trustees and employer work together. Their interests are often aligned such as with their mutual interest in sustainable growth of the employer. IRM helps the trustees and employer to understand each other’s risk capacities and appetites. Additionally this engagement may assist the employer in relation to any company financial reporting requirements.
- In multi-employer schemes, it is beneficial for the IRM framework if the employers have an agreed risk capacity and risk appetite. This is likely where the employers are all part of the same group. In such schemes, the principal employer or another nominated employer generally engages with the trustees on behalf of all of them. The nominated employer should similarly engage with the trustees to communicate the employers’ agreed risk capacity and appetite when agreeing an IRM framework.
- In non-associated multi-employer (NAME) schemes, the employers might not initially have an agreed risk capacity and risk appetite. This is because there will be employers of different sizes and their businesses may be focused on different industry sectors. In addition, some employers within NAME schemes may be commercial competitors. It would be best practice and more efficient for the employers to nominate representatives to agree a collective risk capacity and risk appetite. Having a collective employer risk capacity and risk appetite will enable the IRM framework to operate more smoothly. The nominated representatives should then engage with the trustees to put in place an IRM framework on behalf of all the employers.
- Sometimes the trustees and employer may have different views on their risk capacities and risk appetites, and/or what risk management actions to take. However, each party should understand both the reasons for the other’s views and the consequences of choosing a different risk capacity or risk appetite. This is partly because the risks faced by the parties are interdependent and partly because understanding the other’s views and their rationale makes it more likely that a funding agreement can be reached.
- Trustees might wish to ask one (or a small number) of their advisers who have more experience in this area to take the lead in putting the IRM framework in place initially. While all trustees remain responsible for scheme governance, they are likely to find it helpful to give oversight responsibility to a committee once the framework is established, to ensure that advice from different sources is drawn together and co-ordinated efficiently. This includes ensuring that advisers work together effectively, and that relevant trustee subcommittees work in a connected manner, for example by holding joint meetings where needed. Given the importance of IRM, it is important for the committee with oversight responsibility to report directly to the main trustee board.
- Effective governance helps the trustees and employer not only to focus how they spend their time but also to make the best use of adviser resources in managing the scheme against important risks. For example, trustees should ask each adviser to take into account, and seek to ensure that their advice is consistent with, the work of the trustees' other advisers. This does not necessarily mean all advisers must agree on all issues, rather that their advice should have the same starting points for consistency of approach.
- Advisers who work well together should be better able to help trustees make good decisions. Trustees should therefore consider taking steps to build relationships between their advisers, making clear an expectation that the advisers will work collaboratively. This may involve taking measures to address contractual and confidentiality issues the advisers have.
Step 2: Risk identification and initial risk assessment
- The trustees should start from the scheme’s current position and examine the scheme’s current risks. The scheme’s current position should reflect the trustees’ funding and investment strategies already in place to meet the scheme objective. IRM risk assessment is then developed from this point. Its delivery will normally require close working between the trustees and their advisers.
- It is important for trustees to have an understanding of the employer covenant as well as the scheme’s funding and investment positions before they take decisions which affect the scheme’s funding. They will achieve this understanding through advice and analysis, some of which is mandatory. From this advice and analysis, the trustees should know the range of material risks and the drivers including:
- the risks associated with:
- the assumptions used to calculate the scheme’s technical provisions and any recovery plan, and
- the investment strategy and Statement of Investment Principles together with
- an awareness of the risks associated with the employer covenant
- the risks associated with:
- This advice and analysis is likely to focus on each element (funding assumptions, investment strategy and employer covenant) separately. The IRM approach takes this analysis further by examining methodically, and on a consistent basis, how the risks identified as significant for each element individually also impact upon the other two, and thus their overall effect on the scheme and employer. Some of these risks may impact in the same or a similar way; others may not have any wider impact. Additional risks may also be identified from this exercise. Trustees can then understand the extent to which risks are interdependent and their sensitivities, as well as their overall likelihood and potential impact if one or more occur.
- The order in which the three fundamental DB scheme risks and the corresponding relationships between them are considered is less important than ensuring IRM is performed. However, it is best to start with the employer covenant assessment including appraisal of the reliable level of cash flow generation by the employer to determine the extent to which it can underwrite the risks to which the scheme is exposed. As such, for illustrative purposes, this guidance assumes that this approach will be followed.
Considering risks individually
- Initial risk analysis and scenario testing should be completed for the employer covenant to establish:
- the scenarios in which material risks arise
- how those scenarios arise
- the probability of them occurring
- what the impact of these material risks could be
- Initial risk analysis and scenario testing should then be completed to answer the same questions separately for funding risk and investment strategy risk, in either order.
Considering risks bilaterally
- The findings from the initial covenant risk assessment can then be related to the corresponding assessment input for funding risk and investment risk in turn (in either order) asking the following questions:
- Does the analysis reveal any causal links and/or any interdependencies? If so, how do risks from these interdependencies/relationships arise and how likely are they?
- What is their impact likely to be? More specifically (if relating covenant risk to the other risks), how do the identified covenant risks impact the scheme’s funding and investment strategy and what is the expected outcome from these risks?
- Is there a concentration of risk which affects one or more areas? If so, how remote is this concentration?
- Do significant risk themes (for example, market and economic or systemic) emerge?
- Are the scheme’s and employer’s risk capacities sufficient to cover the likely risks?
- Once the trustees have undertaken this assessment of covenant risk against the funding risk and investment risk, they should continue by examining the impact in the other direction, ie how their assessment of funding risk impacts the covenant risk and how their assessment of investment risk impacts the covenant risk. Following this, they should assess the funding risk against the investment risk (and vice versa) in a similar fashion.
Considering all risks together
- The trustees should then complete their current strategy assessment by considering their findings for all three DB scheme risks together, re-addressing the questions under paragraph 31.
- The following diagram illustrates the stages within this risk analysis and assessment.
- The trustees’ comprehensive risk assessment should equip them to open up dialogue with the employer on how best to deliver their overall strategy. This dialogue will be aimed at settling an agreed view of scheme and employer risk capacity and risk appetite by answering the following questions.
- Does the employer agree with the trustees’ assessment and prioritisation of the risks being run?
- Does the likelihood and impact of these risks fall within the trustees’ and the employer’s risk appetites?
- Do the trustees and employer agree that any action is needed to bring the scheme back in line within their risk appetites? What should this action be? Alternatively, should the risk appetites themselves be changed?
- It is essential that the employer understands the potential impact of the risks identified by the IRM analysis, for example the effect on its business plans of the corresponding increases in scheme contributions. This will allow it to evaluate that impact and compare it to its risk appetite. The employer can then work with the trustees on suitable risk management plans. It will also help to maintain visibility of the scheme’s financial position for the employer’s own investors. Further, an understanding of the employer’s risk appetite and circumstances helps inform the trustees’ own risk appetite and any risk management strategies proposed.
- The trustees and employer will not necessarily have the same risk appetite. Where differences of risk appetite exist, it may be possible to structure a solution which meets the risk appetites of both, for example by contingency plans which introduce extra risk capacity.
- As the IRM approach is iterative, risk identification is not a one-off exercise. The trustees and employer should consider repeating the risk assessment at intervals (that are proportionate to the size and circumstances of the scheme) to determine whether new risks or opportunities can be identified. Putting in place contingency plans and engaging in risk monitoring will assist in determining how frequently to undertake the risk identification exercise.
Footnotes for this section
-  See the DB funding code, covenant guidance and investment guidance.
-  See sections 222 and 226 of the Pensions Act 2004 and paragraphs 117 to 150 of the DB funding code.
-  See section 35 of the Pensions Act 1995 and paragraphs 88 to 98 of the DB funding code.
-  See paragraphs 61 to 75 of the DB funding code.
-  See the covenant guidance.
Step 3: Risk management and contingency planning
- This analysis of the current position, risks and risk capacities enables the trustees and the employer to know whether they are comfortable with the current investment and funding strategies in light of the available employer covenant and scheme circumstances.
- However, IRM does not stop with initial assessment of risk. Actions to manage risk may need to be taken, both now and in the future. Working with the employer, the trustees need to develop their IRM approach by adopting the following:
- Applying risk management strategies now (if applicable)
Having assessed the current position, the trustees may have concluded that the scheme is currently outside their or the employer’s risk appetites. They should therefore work with the employer to examine ways of strengthening the employer’s covenant, or modifying the funding and investment strategies, to bring the scheme back within the relevant risk appetite. The trustees should use the approach they adopted to review the scheme’s current arrangements to analyse possible and reasonable alternatives, illustrating their risk and return in different environments and their suitability. This might lead the trustees to modify their overall strategy for meeting their scheme objective. In any event, they should select and implement the most appropriate available funding and investment strategies for their scheme.
- Developing contingency plans for how to deal with material risks as they emerge in future
Having taken steps (if applicable) to bring the scheme within the trustees’ and employer’s risk appetites, the trustees and employer should develop a shared understanding of what actions they may take should their risk appetites be exceeded in future. This is essential to enable action to be taken swiftly and effectively to reduce or manage the level of risk acceptably should this occur. This involves discussions between the trustees and the employer when putting the IRM approach in place to understand:
- how they would know that the covenant risk, investment risk and/or funding risk had exceeded risk capacity levels (for example by monitoring appropriate risk indicators, discussed below under Step 5: Risk monitoring)
- the actions that could be taken if required
- what effect these actions would have on the employer covenant, the funding deficit and assumptions (including those used for calculating scheme technical provisions and any recovery plan) and the investment strategy, and whether these actions are sufficient to manage risk to an acceptable level
- Applying risk management strategies now (if applicable)
- It may not be possible for all risks to be managed. The trustees’ IRM framework should enable them to establish whether any unmanaged risks remain, assess how these sit against the trustees’ and employer’s respective risk appetites, and monitor them on an ongoing basis. Where a material risk is not covered by a firm contingency plan, it would be good practice for the trustees and employer to commit at the outset that they will engage in discussions about how to monitor and manage these risks.
- Keeping track of the material risks can also mean that the trustees and employer do not miss valuable opportunities to lock in improvements. For example, if the investment strategy outperforms the funding assumptions, this might allow the trustees to adopt a lower risk investment strategy or buy out some current pension liabilities, all in line with their IRM approach.
Step 4: Documenting the IRM framework and decisions reached
- Clear documentation of trustee decisions is part of good scheme governance, not least because poor record-keeping can lead to poor decision making, significant additional costs and reputational damage.
- The great benefit for trustees in recording their thinking and the decisions made is that this should distil matters down to a series of key points so they retain a clear overview concentrating on what is important and why. A better understanding of risks leads to better decisions.
- Documenting the agreed IRM framework should not involve trustees spending disproportionate time and resources. There is merit in using existing documents as much as possible (for example, monitoring and contingency plans might be contained within the scheme recovery plan).
Step 5: Risk monitoring
- Treating the assessment of risk as a triennial, valuation-related hurdle to overcome will limit the benefits of the IRM framework. Circumstances can change quickly and significantly. Hand in hand with their contingency planning, trustees need to focus on how the important and material risks are developing. Frequency of monitoring depends on the materiality of risks and on scheme resources. If risk levels approach the agreed risk appetites, the frequency of monitoring should be increased correspondingly. As a minimum, trustees should consider conducting high level monitoring at least once a year.
- Monitoring all the material risks, together with appropriate contingency planning, will allow trustees to respond quickly and effectively should the risks emerge. It will also serve as a focus for future discussions among the trustees and between trustees and employer. For example a 'financial risk dashboard' could be used to monitor the key measures (such as risk parameters and performance indicators) for the material risks.
- In addition, more frequent monitoring allows trustees to respond quickly to take advantage of opportunities to lock in improvements. This might occur, for example, where the employer covenant strength has rapidly improved and the employer has more cash available than expected, some of which it wishes to use as an unscheduled contribution to reduce the funding deficit.
- Monitoring triggers and their consequences should be reviewed on an appropriately frequent basis so that they can remain relevant to the position and performance of the employer and the scheme.
- In the majority of situations it should be possible to base the monitoring on information that is already being produced. For example, covenant monitoring could be based predominantly on information which is already produced in the employer’s regular management accounts.
- The monitoring approach can set out the points at which an agreed measure or combination of measures will trigger action by the trustees. They should be informed by the material risks and significant risk themes, and be capable of giving clear signals for action relevant to those risks. The trustees’ advisers should be able to advise on suitable risk indicators and appropriate triggers for action for the scheme given its and the employer’s circumstances.
Risk assessment tools
- When trustees consider an IRM approach, they should bear in mind the principles of proportionality. Sophisticated risk assessment tools may be time-consuming and costly, and not necessary if the risks facing the scheme are simple and straightforward. Trustees may wish to seek the help of their advisers on whether a detailed risk analysis and IRM approach would be beneficial, bearing in mind that the trustees retain responsibility for the overall IRM approach and its application. It may be helpful to conduct a basic risk assessment first, to inform this judgement.
- In the appendix, some of the more common risk assessment techniques currently used are outlined for illustrative purposes.
Footnotes for this section
-  See also section 3 of the covenant guidance.
Possible risk assessment approaches
- This appendix sets out a variety of approaches to risk assessment that trustees might find useful. It is not intended to be an exhaustive list. For those trustees and employers who have not undertaken a risk assessment before, it is likely to be most valuable to start with one of the less complex approaches (such as stress testing) and, as techniques become more familiar, progress through different approaches to more complex analysis (stochastic modelling and reverse stress testing).
- Some trustees and employers may already employ different risk assessment techniques. The relevance of the different approaches to any particular scheme will depend on the scheme’s circumstances; other techniques may be equally or more appropriate for a scheme’s particular requirements.
- The use of a range of techniques may help with the identification of different risks that might have been overlooked by following a single approach or be too unlikely to warrant further scrutiny. The identification of risk followed by discussion and analysis is key, followed up where necessary with appropriate negotiation and action. In all cases, employers and trustees will need to exercise judgment as to what is reasonable and proportionate for the scheme.
- Stress testing involves identifying variables that affect the finances of the scheme or employer, changing the values for those variables, and seeing what effect this has. This helps identify which variables are most important, through their impact on covenant, funding and investment.
- Stress tests are a type of forward-looking 'what if' analysis. Applying them to each variable individually at a single point in time can enable the trustees to see which variables individually have the most potential impact on the scheme’s position.
- Although stress tests often focus on financial market scenarios, considering a wide range of variables and possible values for them is important. By working together, both the employer and the trustees can increasing their understanding of the key drivers and influences on the scheme and the employer.
- The levels of stress applied to each variable can be chosen to reflect how likely the trustees and their advisers think it is to happen. The trustees might consider that there is a one in 20 chance of long term inflation being more than 3% per annum and factor this into their conclusions.
- Stress testing can be relatively simple to apply. It can provide an indication of the material risks the scheme faces, and is a good starting point for more sophisticated techniques.
- Scenario testing is a development of the basic stress-testing of individual variables. It involves stressing the values of several variables simultaneously at a single point in time, in a way that is self-consistent and reflects a chosen economic scenario. It considers the impact on employer covenant, funding and investment of a sudden change to different economic circumstances. Stress testing, in contrast, considers the impact of adverse movements in individual variables or 'stresses' separately from any particular economic scenario.
- The results of basic stress testing should influence the choice of scenarios analysed, so as to focus on the most relevant ones for the scheme. For example, if the stress testing suggests that the scheme is particularly exposed to changes in foreign exchange rates, then scenarios in which changes to foreign exchange rates occur should be considered and given appropriate weight.
- Some scenarios may be especially relevant to the employer’s business and have a potentially significant impact on its covenant. The scheme’s advisers should be able to suggest and put together appropriate scenarios, and advise on their likelihood.
- The approaches set out above consider the effect of an immediate change in conditions, as part of either a stress test or an economic scenario, on the employer covenant and the scheme’s assets and liabilities. However, it is important to understand how the scheme’s finances may evolve in future years. Projections into the future give more insight than just considering immediate changes.
- In order to make these projections, the advisers may use models of the employer and the scheme. Projection models vary in points of detail, and some can be quite complex. The models should take into account the scheme’s liability profile and its proposed deficit recovery contribution patterns to assess the extent to which the scheme would have the assets needed to pay benefits as they fall due and the extent to which employer covenant support would be required and available.
- The projections can be run across a range of economic scenarios that are relevant to the scheme’s circumstances. The difference from scenario testing is that the modelling covers the scheme’s finances over a number of years, not just the impact of immediate change. This enables a more nuanced range of relevant economic or market circumstances to be considered.
- It is difficult to predict scenarios that could affect schemes and employers over a 5, 10 or 20 year period. However, consideration of these can reveal qualities or factors about the employer or the scheme that had not been thought of before and can prompt a higher level of engagement between trustees and employers in the assessment of future risk.
- Stochastic modelling is a more sophisticated projection modelling approach which starts from the basis that future market conditions (eg investment returns, interest rates and inflation) are subject to a range of future uncertainties. It can be used to consider the risks involved in adopting complex investment strategies, or in situations where the risks facing a scheme are significant (for example where the scheme is significantly underfunded or the scheme is mature).
- A stochastic model produces a fuller range of possible future scenarios for market conditions, and projects the scheme’s finances in each of these. The projections can then be examined to indicate the likelihood of particular outcomes according to the model used and assumptions made.
- Stochastic modelling is primarily a technique applied to pension scheme assets and liabilities. It can be used to help trustees understand by how much the funding level of the scheme could change over a set time period in number of reasonable downside scenarios, whether this level of investment risk can be supported by the scheme and what this might mean for employer contributions. This can provide a useful comparator for the scheme’s position and risk profile against the risk capacity of the employer and trustees.
- Stochastic modelling is a useful method for comparing different investment strategies but it is highly dependent on the model and assumptions used. It is therefore important to understand the key assumptions and to consider the merits of plausible alternative assumptions.
- Reverse stress testing is a risk assessment technique which works backwards from an adverse outcome for the pension scheme and seeks to identify and aids understanding of the full range of scenarios and series of events which could have caused that outcome.
- The types of outcome to consider might include, but are not limited to, being in a situation where even though the trustees make full use of the flexibilities available under the Part 3 scheme funding regime, it is impossible to set a realistic recovery plan to full funding within a reasonable timescale.
- The sequence of events leading to this might, for example, comprise some combination of a significant weakening of the employer’s covenant, increases in scheme liabilities, reduced expectations for future investment returns and poor actual investment returns. The analysis for any particular scheme would look in more specific detail at why these events could have occurred, how they are linked and what their knock-on or compounding effects are for the scheme.
- Working backwards can help capture a wider range of possibilities and circumstances than those typically contemplated in a classic stress test. Classic (forward-looking) stress tests, described earlier in this guidance, consider the outcomes achieved under a range of pre-determined scenarios and typically include financial market stress scenarios only. In contrast, reverse stress tests focus on a particular outcome and seek to understand a full range of scenarios, including financial and non-financial market stress scenarios, which could have caused that outcome.
- Having used reverse stress testing to identify a broader range of risks to the pension scheme, the trustees should then assess their likelihood and importance. The trustees may then be able to take pre-emptive action as part of their IRM approach to improve outcomes and limit the impact that might otherwise occur where particularly negative scenarios have been identified. The identification of a wider range of risks should lead to a more informed debate about the risks the scheme faces, and the actions it is appropriate to take in respect of them.