MANAGE YOUR RISKS
Mary Spencer Partner
We have known for years that risks should be managed in an integrated way, and market practice has naturally evolved as a result. That said, we have observed a continuing tendency to consider risks from the perspective of the traditional silos: covenant, investment, funding and governance risks; and then to try to bring these together afterwards.
In our view it is essential to consider risks in a truly integrated way, and this means moving away from silos. What we’ve found most effective is for schemes to consider, at a high level, which drivers could throw them off course: this enables a consistent dialogue across all risk types – as shown in our dashboard below.
We’ve evolved our risk profiling tool, LCP Sonar, to reflect a more holistic approach. Ask your usual LCP contact to show you how you stack up against the LCP peer group, and against best practice.
SCENARIO ANALYSIS
MODELLING INTERDEPENDENCIES
DYNAMIC MONITORING
SCENARIO ANALYSIS
Scenario analysis can help shape understanding of risks and how best to manage them
Looking at different future economic scenarios can help understand what the scheme’s future journey can look like, as well as develop plans to manage and mitigate future risks.
Whilst it might feel that some of the worst financial implications of Covid-19 are behind us, in practice there is still much uncertainty on how the economy and financial markets will behave as we recover from what has been a severe economic shock. There is also significant uncertainty about what climate change may mean for the future economy.
INTERDEPENDENCIES ARE IMPORTANT WHEN IT COMES TO RISK MODELLING
At the end of the day, every pension scheme exists to pay pensions, so security of member benefits is of paramount importance. If we boil down this challenge into simple terms, as long as the scheme achieves full funding, and/or the sponsor remains solvent, benefits will be paid. This helps to focus the mind when undertaking risk analysis but also highlights the importance of the link between scheme and sponsor solvency.
Our integrated approach to risk modelling, LCP Triangulate, projects covenant strength as well as assets and liabilities, applying the same economic scenarios consistently. In this way, you can better understand the interdependencies between covenant and scheme strength. It also enables a more member-focussed way of thinking about risk. You can start to ask questions such as “what is the probability I pay all pensions promised?” or “what is the likely proportion of benefits each member will receive?”
Read more about our approach to integrated risk modelling, including case studies, here.
DYNAMICALLY TRACK YOUR POSITION USING DASHBOARDS
An important part of risk management is to agree the key metrics to measure and monitor for your scheme. Key metrics can vary depending on where you are on your journey, and the key features of your scheme.
Our online funding, investment and covenant tool LCP Visualise provides real time information on key metrics. Many of our clients find this helpful and our LCP Sonar tool gives a starting point of risks you can consider.
It can also be informative to see a dashboard ahead of meetings to have all the key information about your scheme in one place.
Illustrative dashboards
MACRO- ECONOMIC SCENARIOS
We have developed four key scenarios to illustrate how various economic conditions could play out over the next five years and to help you understand potential implications for your scheme. We can of course model other variations too.
Illustrative effect of potential shocks triggered by our scenarios
CLIMATE CHANGE SCENARIOS
Whilst historically, much of the discussion around climate risk has centred on scheme investments, this is not a self-contained issue: climate risks are systemic and could impact all aspects of a pension scheme, as well as our daily lives.
Indeed, we are already starting to see the effects of climate change with rising temperatures and more extreme weather events (physical climate risks) and governmental action, technological innovation and changing consumption patterns to mitigate these impacts, by transitioning to a lower carbon economy (climate transition risks).
To assess the impact of climate change on a scheme’s potential funding progression, we consider what the potential impacts of different climate scenarios might mean, applying those consistently to the assets and liabilities of the scheme, and considering how the covenant might be affected.
We have partnered with Ortec Finance and Cambridge Econometrics to develop three plausible scenarios demonstrating different global responses to the Paris Agreement. For more discussion on climate scenarios check out this edition of our podcast Investment Uncut.
- Failed transition: Paris Agreement goals not met, only existing climate policies implemented – we currently believe this is the most plausible scenario, based on the extent of commitments and policy change that would be required.
- Paris orderly transition: Paris Agreement goals met, rapid and effective climate action and a smooth market reaction.
- Paris disorderly transition: similar climate actions to the orderly transition, but with financial markets slower to react, compensating with a more abrupt subsequent reaction.
As the main difference between the Paris Orderly and Paris Disorderly scenarios is the financial market reaction, the two scenarios result in similar outcomes for GDP (shown by the dark blue line in the chart) but different impacts across asset classes.
Projected UK GDP in real terms (2020 = 100)
These scenarios can be compared to a climate-uninformed scenario, which assumes no increase of physical risks associated with climate change, nor explicit assumptions about the transition to a low carbon economy. By looking at these scenarios and understanding how the global economy could react to both physical and transition risk drivers, we can start to explore how climate risk will affect a pension scheme.
From the climate scenario work we have undertaken to date, we have put together the five case studies below.
(click on the outcomes to learn more)
- Rotating investment portfolios into low-carbon alternatives
- Informing choice of long-term targets
- Considering the impact of both physical and transition risks on sponsor covenant
- Enhancements to climate-related governance processes
- Altering the timing of risk taking, increasing climate-informed risk in the short term to reach a stronger funding position before the scheme faces material climate risk impacts
As these key outcomes illustrate, action can be taken, particularly on the investment side, to mitigate climate risks directly, as well as strategic planning being informed by the results.
It is essential to understand how climate risks around your covenant may interact with investment and funding risks and this needs to be considered on a scheme-specific basis. Our survey shows that whilst nearly half of schemes do already allow for climate change risks on the employer covenant, some 40% do not (with remainder believing it is not relevant for them). We have set out our thoughts on how you can consider the impact of both physical risks and transition risks on your sponsor covenant in case study 3 above.
Have you considered the impact of climate change risks on your sponsor covenant?
Keep in touch
