Pension Plan Solvency and Extreme Market Movements: A Regime Switching Approach – Funding Report for the Actuarial Profession

• Published in: British Actuarial Journal Vol. 18; no. 3; pp. 676 - 680
• Main Authors: Abourashchi, Niloufar, Clacher, Iain, Hillier, David, Freeman, Mark, Kemp, Malcolm, Zhang, Qi
• Format: Journal Article
• Language: English
• Published: Cambridge, UK Cambridge University Press 01.09.2013
• Subjects: Actuaries; Decision making; Defined benefit plans; Discount rates; Economic policy; Equity; Insolvency; Interest rates; Monte Carlo simulation; Multivariate analysis; Pension funds; Pension plans; Present value; Probability; Rates of return; Sessional meetings: papers and abstracts of discussions; Solvency; Studies; United Kingdom > UK
• ISSN: 1357-3217; 2044-0456; 1748-5002
• DOI: 10.1017/S1357321713000287

The aim of this research is to analyse the impact of extreme market movements on future pension plan solvency by applying a regime switching approach. The motivation for undertaking the analysis came from the financial crisis and the collapse of Lehman Brothers in September 2008 and the subsequent policy response in March 2009 of quantitative easing (QE). According to the Pension Protection Fund (PPF), between June 2007 and March 2009, the overall asset values of defined benefit plans fell by nearly 8% (as a combination of a severe fall in equity values but an offsetting rise in bond prices), while the present value of future liabilities rose by almost 40% as Gilt yields fell. Since then, the aggregate funding position has worsened despite a recovery in asset values as further declines in Gilt yields have driven the present value of liabilities even higher. This situation highlighted two key issues when considering future pension fund solvency. First, traditional 'one state' models of asset returns and discount rates assume that the statistical drivers of these factors remain constant through time. As a consequence, these models underestimate the severity, frequency and duration of extreme market movements. Second, it is essential to capture the correlation between pension assets and interest rate processes in different market conditions. As a result, the current piece addresses these issues by applying a 'multi state' approach. To do so we employ a multivariate Gaussian Markov regime switching model.