A practical guide is helping pension actuaries understand the impact of R&E risks on the advice they provide, writes Evie Calcutt.
At the end of 2015, as global leaders were strengthening their commitments to tackle climate change at the COP21 conference in Paris, the Resource and Environment (R&E) Board decided it was time to research the impact of environmental risks on the advice actuaries provide to pension schemes. And so the snappily titled “Resource and Environment Implications for Pensions Actuaries Working Party”, of which I am a member, was born.
We set out to better understand R&E risks and investigate the as yet unknown implications of these issues on the work of pensions actuaries; addressing financial variables and the impacts on annuity pricing, covenant assessment and mortality assumptions (see figure 1). In May 2017, we published the first strand of our work: a practical guide highlighting where R&E issues are relevant to pension schemes and the work of pension actuaries.
Relevance for pensions actuaries
R&E issues, particularly climate change, are being increasingly recognised as relevant to the work of actuaries. In the 2014 discussion paper, ‘A Risk Perspective’, the Joint Forum on Actuarial Regulation (JFAR) identified a series of high-level risks to the public interest relating to actuarial work. Changes in the external environment was classified as one such high-level risk and within this, climate change was acknowledged as a hotspot.
The IFoA acknowledged the relevance of R&E risks by making it one of its four public policy priorities and naming it as a seventh practice area. It was keen to engage with members on this issue and in June 2016 held an R&E sessional debate to argue the case for and against the statement: "This house believes that actuaries should incorporate climate change and sustainability risks into their work”. Although the majority of the (albeit self-selecting) audience were in support of this statement, there was strong challenge centring on the high level of uncertainty on climate change and sustainability issues, and the difficulty of quantifying the potential impacts of these risks. Given this fair challenge, the aim for us was to produce something that could be viewed as useful and important.
The IFoA subsequently issued a risk alert on climate change which requires actuaries to understand, and be clear in communicating, the extent to which they have taken account of climate-related risks in any relevant decisions, calculations or advice.
To date, the majority of research connecting R&E issues with the work of actuaries has been led by those in the investment and general insurance field. We were not aware of any pensions actuaries explicitly reflecting such issues in their funding advice and wanted to refine the debate further to ask whether pensions actuaries should be allowing for such risks, in the context of the liabilities as well as assets.
Our objective is to raise awareness of the topic, encourage discussion and prompt further research. As a first attempt at helping actuaries assisting their clients in navigating the uncertainties associated with R&E issues, we felt actuaries would benefit from a guide.
It is clear that R&E issues are likely to have some impact on all types of pension schemes; defined benefit/defined contribution, private/public, occupational/personal and the UK will not be affected in isolation. However, to make the scope of our work manageable the focus was narrowed to UK trust-based defined benefit pension schemes only and it omitted investment angles that have been covered extensively elsewhere. We think our work will still be useful for those advising other types of pension scheme and perhaps life actuaries.
The Practical Guide
The practical guide is centred on three funding considerations: the financial variables; the covenant assessment; and the mortality assumptions. There is also a hypothetical case study, walking the reader through these issues within an integrated risk management framework. The guide is only eleven pages long and is aimed at all DB pensions actuaries. It formed the first strand of our work. We have since published two supplementary technical papers (about covenant and mortality) and a third is planned for late 2018, as shown in figure 2.
Producing something new is never easy and we faced significant challenges in trying to meet our objectives and the needs of the target audience.
Challenge 1 – Is this something or nothing?
Although the evidence for climate change is pretty conclusive, there is uncertainty over the timing of the physical effects and the magnitude and timing of any financial impacts (i.e. when and how will markets react). Making sense of this uncertainty is key to understanding how these risks will impact on the work of pensions actuaries. The challenge for us therefore lay in unpicking this uncertainty.
Meeting the requirements of such a diverse target audience is not easy and we took several opportunities to engage with actuaries along the process; a session at the Pensions, Risk and Investment conference 2016 was used to float the idea of a practical guide; and a consultation meeting was held in February 2017 with a small but varied group of senior pensions actuaries and regulators to review how the guide could better meet the ‘practical’ requirement. Both sessions met with largely positive support and we concluded that this was an important topic and that we did have something useful to say.
There is a perception that climate change (and other associated risks) are a long way off and we received the direct challenge that actuaries and their clients currently have ‘bigger issues’ to address. These issues are however illustrative of more general challenges facing pensions actuaries and the guide draws on some of these trends, for example; the tendency for covenant assessments to focus on short-term, quantifiable aspects; a heavy reliance on current market pricing when setting financial assumptions; and the use of extrapolative mortality models that cannot readily incorporate changes in the underlying causes of death.
Challenge 2 – limitations of current research
The new and evolving risk landscape for pension schemes means that past experience is not necessarily a good guide to the future and there is limited research into what the implications of R&E risks may be on real investment returns and evolving longevity assumptions. As we delved further into the different work streams we had to acknowledge the following issues.
- Many pension schemes have a plan in place to target a low-risk funding strategy; this is driven by investment returns, gilt prices and annuity terms as well as time horizon and secondary covenant issues. The impact of R&E risks on these factors is very uncertain: there are scenarios which see bond yields and growth go up and others which see them go down.
- For many schemes the most relevant consideration may be the extent and speed at which insurers factor R&E impacts into annuity pricing. It is not clear what direct impact R&E issues will have on pricing; obviously any step change in insurance pricing might leave schemes particularly exposed.
- Covenant assessments are normally carried out by specialist advisers or the schemes’ trustees. The role actuaries play in the assessment process is therefore less defined.
- There is uncertainty over how R&E risks will impact on life expectancy, with arguments for it going up and down, and varying significantly across the UK. The impact is hard to quantify and compare to that of the other health-related drivers of mortality.
- Most of the literature we reviewed was dominated by the risk of climate change rather than wider R&E risks, but we wanted to frame our guide in general R&E terms.
Challenge 3 – Quantifying the impact is key
When advising on pension scheme funding, actuaries typically compare the market value of the scheme’s assets with a present value of its liabilities. To do this, they use several financial variables which are set by reference to investment markets. Illustrating the impact of R&E issues therefore requires the effect on these variables to be considered. To date, much of the work in this area has been qualitative or considered the impact on assets but not the associated liabilities. Our working party has been considering how it can help actuaries, trustees and companies understand the potential impact of R&E issues on pension scheme funding. We plan to publish our work in a financial variables supplementary paper in late 2018.
We recognise that, given the inherent uncertainty and complexity of R&E risks, any quantitative modelling will have significant limitations. As a first step our focus is therefore to use scenario analysis to indicate the potential order of magnitude and range of uncertainty. We hope that actuaries can then build on the results.
Please take the time to read the short practical guide and supplementary papers about covenant and mortality. The guide provides a useful and relevant introduction to R&E risks and will help you determine whether your advice needs to allow for these risks.
Actuaries are still at an early stage of developing their knowledge of this area and although the scope of our contribution is limited to UK trust-based defined benefit pension schemes we are pleased to see that others are now developing the profession’s thinking in other areas. Recently, the R&E Board published a sister practical guide for actuaries advising UK defined contribution pension schemes and established three new working parties to prepare practical guides to climate change for actuaries working in general insurance, life insurance and investment. In addition, we are seeing interest from other actuarial bodies and have close links with the R&E Working Group of the International Actuarial Association.
If you would like to provide feedback on the practical guide, please send your thoughts to the working party. There are also many opportunities to get more directly involved; please take a look at the volunteer vacancies.
Article written by Evie Calcutt.
Evie Calcutt is an actuary who works in the insurance and investment team at the U.K. Government Actuary's Department. She provides advice to government departments and public bodies on risk finance and transfer.
Figure 1 - What are resource and environment risks?
Environmental risks, such as climate change, are playing an increasing role in the function of society. Example R&E risks are:
- Rising and/or volatile energy prices (e.g. effect of carbon pricing)
- Changes to energy supply (e.g. leading to stranded fossil fuel reserves)
- Changes to transport patterns (e.g. distance, mode)
- Resource shortages (e.g. water, base metals, rare earth metals)
- Large scale migration of people (e.g. to escape the worst effects of climate change).
The World Economic Forum’s 2017 Global Risk Report highlighted the prominence of environmental (and other related social) risks as continued areas of concern in the risk landscape for the next 10 years.
Source: The Global Risks Report 2017 12th Edition, World Economic Forum
Figure 2 - Resource and environment documents