It is widely acknowledged that pension fund investment strategy plays a crucial role in determining the funding cost to the employer of running a defined benefit (DB) scheme. What has been less clear, however, is the impact of very different national regulation and accounting rules on the pension fund investment strategy. For the first time, a research study demonstrates the complex interrelationship between regulation, pension liabilities, investment strategies, and funding costs for a ‘typical' (synthetic) scheme. The study investigated the position of typical schemes in five OECD countries under simplified regulatory frameworks as at July 2006: Germany, Japan, the Netherlands, the UK, and the US. All of these countries have introduced new regulation in recent years focused on improving risk management and, hence, benefit security.

The objective of the study was to explain why discrepancies in country-specific regulation have such a marked effect on the investment behaviour of employers seeking to mitigate the medium and long-term costs of their DB schemes.

The study discovered significant discrepancies under the different regimes that may have the effect of promoting or undermining the future of DB, depending on the impact of regulation on the fund's flexibility to use the optimal liability driven investment (LDI) strategy described below. The findings also imply that estimates of aggregate deficits depend to some extent on the way regulation measures liabilities. Such estimates, therefore, are arbitrary, as is the perception of a pensions ‘crisis'. The research also identified changes to the DB scheme structure that could share longevity and inflation risk between the sponsor and the members, which could enable the employer to continue the DB arrangement into the future with greater funding flexibility.

The study was commissioned by Allianz Global Investors (AllianzGI) and formed the basis for a new policy report, ‘Pension Fund Regulation and Risk Management: Results from an ALM Optimisation Exercise', published by the Organisation for OECD in collaboration with risklab germany GmbH and the Institute for Financial and Actuarial Science (IFA).

To assess the impact of regulation on investment strategies, the study constructed a synthetic DB scheme and quantified the way liabilities are measured under the different regimes. It examined the way that the methodology of discounting, as applied to the calculation of the liabilities, influences the scheme's risk characteristics, which in turn may influence investment strategy

The study found evidence that regulations influence the optimal choice of an investment policy by setting asset restrictions or minimum solvency requirements that affect the sponsor's liquidity constraints. Where full funding is required at all time and fixed discount rates are used to measure liabilities, the scheme is more likely to invest in lower risk instruments with correspondingly lower yields, thereby raising the net funding cost over the longer term. Strict solvency rules combined with very short recovery periods, as applied in Germany and in the Netherlands, can impose significant additional cash demands on the sponsor that could adversely affect the company's liquidity position and corporate policy decisions.

The comparative study used two typically (synthetic) pension fund liability profiles based on an accrual of 1% of relevant salary per annum (final pay and career average) with and without indexation of benefits. Taking a simplified version of the national regulatory factors into account, the study measured the impact of the five different regimes on the optimal investment strategy that can be established in each country for a typical scheme.

International Financial Reporting Standards (IFRS) - the international accounting rules - were also taken into account to model the corporate sponsor's position with regard to the way pension liabilities are shown on the balance sheet. The IFRS rules for pension schemes (IAS19) present a very different picture of the liabilities and risk position compared with the regulatory rules. This discrepancy makes it impossible for schemes to optimise the investment strategy in relation to both regulatory and accounting rules, creating serious dilemmas for employers.

The modelling assumed an active LDI approach unique to this study. The approach considered the development of both assets and liabilities simultaneously and used a surplus orientated concept, looking at the relative difference between these two factors. This extends the basic LDI approach, which only aims to immunise liabilities through the use of a bond-like asset strategy, as it also incorporates asset-liability modelling (ALM) to optimise the surplus-risk-efficient asset allocation. This allocation is broadly diversified and invests also in alternative asset classes (including, for example, absolute return positions or inflation linked instruments) and uses active risk management to enhance returns relative to liabilities. This approach can reduce funding costs and at the same time control the inherent investment risks for the pension fund and the corporate sponsor. So, a comprehensive assessment of risk-return trade-offs is achieved by applying a fully integrated ALM projection mechanism.

The study, using this active LDI approach, identified the optimal asset allocation for each regulatory framework based on the same integrated asset-liability modelling (ALM) concept, the same rational behaviour, and the same risk tolerance. Where applicable the strategy took account of local quantitative asset allocation limits, such as a cap on the maximum allocation to equities, and also incorporated respective solvency requirements. Using Monte Carlo modelling, the effects of these regulatory rules were studied by applying a simulation analysis with 10,000 capital market scenarios over an investment horizon of 30 years.

Due to the complex range of factors that can affect a pension scheme, however, the study does not attempt to identify the most favourable or cost-effective national regulatory framework. Instead, the study takes a quantitative approach that highlights the impact of selected elements of national regulation on a rational pension investment strategy.

While the study does not take any position on policy, it noted that the choice of DB scheme structure has a significant impact on the employer's ability to control future funding costs. Using demographic and economic data from OECD countries, the liabilities of a final salary plan with indexation were found to be up to double those of a career average plan without indexation, assuming a common accrual rate. Such cost savings can explain the reforms in plan design observed in occupational pension systems in recent years. The career average structure (all other factors in the modelling being unchanged) reduces the value of the liability to be reported under IFRS rules on the sponsor's balance sheet, while conditional (discretionary) indexation confers greater funding flexibility, as the experience in the Netherlands demonstrates.

A move on the part of regulators to minimise discrepancies in regulation and accounting - both internally and on a cross-border basis - could help stabilise DB schemes for the future by enabling funds to implement risk-efficient investment strategies suited to the real nature of the underlying liabilities. Adding more flexibility to the DB structure and using risk-based solvency requirements in line with modern investment strategies might also improve the prognosis for DB schemes.

Within the current regulatory environment the unique scheme-specific characteristics need to be taken into account fully to derive an optimal active LDI strategy that manages funding costs more effectively. Given the complexity of the regulatory and accounting framework and the individual nature of DB schemes, there is no ‘one size fits it all' pension finance solution. Together with their financial advisers each pension fund needs to develop its own individual and, hopefully, advanced solution.

Gerhard Scheuenstuhl is managing director of risklab germany GmbH

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