On 8 December, the Pensions Regulator published new guidance for defined benefit (DB) scheme trustees and employers on the development and implementation of an integrated risk management (IRM) framework.
IRM is a tool for managing the risks associated with scheme funding. It means, broadly, understanding and managing the three key risks in this area – employer covenant, funding assumptions and investment strategy – with an emphasis on the interaction between them.
For details of the five key steps the Regulator considers necessary for effective IRM, please see below.
Step 1: Initial considerations for putting an IRM framework in place
There is no one set formula for what IRM should look like. It will be determined by, and should be proportionate to, the trustees’ and employer’s objectives, in light of their needs and circumstances.
Trustees should consider introducing IRM wherever the scheme lies within its actuarial valuation cycle. This does not have to wait until the next valuation is due. Trustees may wish to ask their advisers with more experience in this area to take the lead in putting the IRM framework in place initially.
Advisers who work well together should be better able to help trustees make good decisions. Trustees should therefore consider taking steps to build relationships between their advisers.
Step 2: Risk identification and the initial risk assessment
Trustees should start from the scheme’s current position and examine the scheme’s current risks. IRM risk assessment is then developed from this point.
This analysis is likely to focus on each element (funding assumptions, investment strategy and employer covenant) separately. The IRM approach takes this further by examining how the risks identified as significant for each element individually also affect the other two.
Risk identification is not a one off exercise. Trustees and employers should consider repeating the risk assessment at intervals proportionate to the size and circumstances of the scheme.
Step 3: Risk management and contingency planning
IRM does not stop with initial assessment of risk. Working with the employer, the trustees need to develop their IRM approach by applying risk management strategies and developing contingency plans for how to deal with material risks as they emerge in future.
Step 4: Documenting the decisions
Clear documentation of trustee decisions is part of good scheme governance but documenting the agreed IRM framework should not involve trustees spending disproportionate time and resources.
Trustees should retain and the advice they have received in putting in place the IRM framework. For example, they might keep a short summary of this advice which includes a reminder that the decisions are recorded in the statement of investment principles, the statement of funding principles or in trustee meeting minutes.
Step 5: Risk monitoring
Treating the assessment of risk as a triennial, valuation related hurdle will limit the benefits of the IRM framework. Frequency of monitoring depends on the materiality of risks and on scheme resources. As a minimum, trustees should consider conducting high level monitoring at least once a year. In many situations it should be possible to base the monitoring on information already being produced.
Where trustees have agreed to higher levels of scheme risk to facilitate the employer’s growth plans, it is important to put a comprehensive monitoring framework in place with agreed actions if the risks and opportunities materialise.
The guidance includes a list of key possible risk indicators and describes various approaches to risk assessment that trustees may find useful – everything from simple stress testing to complex stochastic modelling and reverse stress testing.
IRM is a concept first introduced by the Pensions Regulator in its July 2014 code of practice on funding defined benefits. This IRM guidance builds on that code, as well as its employer covenant and internal controls guidance. In addition, the Regulator plans to publish investment guidance in 2016. This means that there will be considerable Regulator material for trustees and employers to digest on the theme of scheme funding.
The IRM guidance is a clear and well laid out document, which includes plenty of examples. Trustees and employers, particularly those unfamiliar with IRM type analysis, should find it helpful.
The extent of the initial investment in IRM will vary between schemes. When trustees consider an IRM approach, they should bear in mind the principles of proportionality. Many schemes, particularly larger schemes, already have a risk assessment and management process in place. It may not currently be labelled as IRM but its steps and results may be similar.