The risk from defined benefit pension promises is inextricably linked to the sponsoring company's finances This was always the case but the accounting standard FRS17 has emphasised it in a way that ma

Company boards are increasingly seeking high level input to understand the potential impact of pensions on corporate objectives. Risk management teams need to understand the potential downside from pensions and what the implications are. Equally, pension scheme trustees are looking at their sponsoring company's financial position to determine the quality of the pension scheme's covenant. Consequently, risk managers need to understand the potentially conflicting interests of pension scheme trustees in order fully to appreciate the risk a pension scheme poses to their company.

The new accounting standard FRS17, which takes a snapshot of a UK pension scheme's assets and liabilities, has not only spurred the increased interest in pensions, but has also provided the raw material, through increased disclosures, to improve the communication of pensions risk. Using this newly available information, my own organisation recently risk-analysed all FTSE 350 companies' pension schemes using a wide range of criteria, including funding position, investment strategy, scheme demographics, liability profile and the size of the pension risk compared with the financial position of the sponsoring employer.

We found that UK pension schemes' level of investment in equity markets appeared to be unrelated to how well they were funded, their maturity, or the financial strength or relative size of their sponsoring company.

Higher equity exposure provides an investor with the expectation of higher returns over the long term, but also with greater volatility. One might have assumed that those companies with above average levels of equity investment would be those that have strong funding positions. But this appeared not to be the case. There was only a weak correlation between high funding levels and the amount schemes put into relatively risky investments.

It may be that schemes with poor funding levels still feel that they need to gamble on a continued upturn in the equity market in order to restore the scheme's funding to a satisfactory level.

We also found there to be little correlation between equity investment and the maturity of the scheme or the strength of the sponsoring employer's covenant. Immature schemes - those with a relatively low proportion of retired members - can be assumed to have more capacity for taking investment risks, but there is little correlation between the maturity and equity exposure. Similarly, it is surprising that there is little correlation between the sponsoring company's capacity to absorb risk and equity exposure.

Companies with large pensions schemes in comparison to their own size appear just as likely to have high exposure to equities as companies with small schemes. This begs the question as to whether pension scheme trustees are adequately factoring in the strength of the employer's covenant when setting investment policy.

With a few notable exceptions, a major issue for most pension schemes and scheme sponsors is how to nurse them back to a healthier state. The solutions are many and varied, ranging from additional cash or contingent funding through to numerous asset strategies over different time horizons for managing further downside, perhaps at the cost of limiting some upside potential. The solution for individual schemes will depend on the characteristics of the scheme and sponsoring company, as well as the influences of the various stakeholders. The time horizon for achieving the desired objective will also vary by scheme.

Risk managers need to be conscious of the potential conflict between the interests of pension scheme trustees and those of the sponsoring company.

Pension scheme trustees' primary aim is to secure the long-term benefits of the scheme for their members. Faced with funding deficits and with schemes often closed to new members, trustees are having to look long and hard at their sponsor's ability, commitment and willingness to support the scheme in the long run. In essence, they need to form a view of the corporate covenant, recognising that it can be no more than informed judgement.

So, what are the factors that pension trustees should take into account?

Assessing the sponsor

The ability of a company to honour the pension promise is linked primarily to the financial security of the business. The credit rating of a company measures the quality of creditworthiness in relation to bond holders.

If pensions are viewed as subordinated debt, the link is clear, both in terms of the priority that pensions debt would receive on the insolvency of the employer and to the ability of the employer to service the debt while the company remains a going concern.

The scheme's funding status is another important factor. This provides a measure of security in terms of money already committed to the pension scheme which is separate from the employer's business. The ongoing funding commitment of the company further strengthens security. The investment policy pursued, on the other hand, has the potential to weaken the security provided by the assets if there is a high weighting towards risky assets.

Snap shot figures provide little useful information in this context unless scheme discontinuance is imminent. Different measures to highlight short and long-term risk, showing the uncertainty around central best estimates under given funding and investment strategies, should give a better insight into the underlying risks of the proposed policies over appropriate time horizons.

A further factor is the extent to which the finances of the company have been geared by the pension scheme. This determines the importance of the pension promise in terms of its potential strain on the business. Many measures can be employed linking the fundamentals of the pension scheme and the company, to determine the gearing on the balance sheet, profit and loss account or cash flows. A company's appetite for risk will be influenced by a number of considerations, among them the size of the scheme relative to the company in terms of cash and profit; the strain to the company of any deficit, or the value to it of any surplus; the expected pay-off from such risk on the measures and timescales that the company values, and the correlation between the sponsoring company's financial strength and the funding position of the scheme.

The company's commitment to the pension scheme is in part governed by its contractual obligations and in part by its willingness to continue with the scheme in the future. Contractual obligations depend on legislative requirements as well as those imposed individually on each scheme by its trust deed and rules. Of particular interest are the safety valves which the employer can invoke to limit his liability during difficult times.

Equally important are the balance of powers on the key policies that determine the employer's financial commitment to the pension scheme. Such powers include the power to make amendments to the scheme, the power to terminate the scheme, the power to set contributions, the power to set investment policy, the power to decide how surplus should be spent and discretionary powers to augment benefits. Clearly, the extent to which the sponsor can control its contractual obligations by some or all of these powers, or expose scheme members to some risk, has a bearing on how scheme trustees view the the corporate covenant.

There are also some softer factors that may have an effect on the company's behaviour. These include the corporate brand, the culture of the organisation, the importance or otherwise of keeping up with market practice as well as moral and other pressures. These factors are unique to each sponsoring company and would be highly influential in decisions of a voluntary nature.

They are not capable of precise evaluation, but, in practice, pension scheme trustees will have a good feel for some of them, based on experience elsewhere in the business.

Quality of governance is also an important factor for scheme trustees to consider in assessing the sponsor's covenant. Governance in this sense encapsulates the management structure and the processes put in place for the sound operation of the scheme. For example, in schemes where there are clear decision-making processes and there is appropriate oversight to prevent or limit leakage of benefits or wastage of resources, employees should feel more secure. Similarly, if there are sound processes and oversight over delegated decisions such as investment management, benefit payments and record keeping, then the security of the benefits members ultimately expect to receive is improved.

While companies and trustees can re-map their governance strategies to exercise greater control over discretionary practices, there is little they can do about re-defining the pensions deal for the past. Indeed, legislative risk has reared its ugly head once more, this time by retrospectively hiking up the exit price on what were, after all, voluntary commitments.

Added to this is further uncertainty from the Pensions Directive which, strictly interpreted, could require a discontinuance funding approach instead of the more benign scheme-specific funding requirement that has been promised for so long.

Traditionally, pension schemes have undertaken large equity risks to maximise investment return. But this may change, since corporate behaviour is now influenced by a highly volatile gap between assets and liabilities, requiring assets and liabilities to be modelled together. Switching to bonds may be an option for reducing risk, but the arithmetic of paying for the deficits locked in could saddle UK plc with an additional overhead in the region of 10% of current operating profits for 10 years or more.

New strategies involving a greater diversity of assets and the management of further downside risk, perhaps at the cost of some upside potential, are inevitable.

The characteristics of pension liabilities are also changing fast. In closed or mature schemes, some generic risks - liquidity and cashflows, duration and credit risks, volatility from demographic risk and the impact of liability options - assume greater importance. A deeper understanding of discontinuance risk and its implications for members' expectations - including the challenge of getting them to understand that there can be no absolute guarantees - will be paramount in future.

The behaviour of sponsors and trustees will be another powerful agent for change. The asymmetry between risk and reward for sponsors will be accentuated, calling for innovative funding and risk management solutions.

Pension risks will be viewed as components of total corporate risk and will be modelled for their impact on the sponsor's balance sheet and cashflows.

Funding strategies may move towards leaner funding targets based on guaranteed benefits only, with remaining risks and uncertainties managed from the sponsor's balance sheet.

Efficient management of the defined benefit legacy is clearly going to be a key issue - and in many cases a new issue - for risk managers for some time to come.