DISCUSSION PAPER PI-9810
An Analysis of the Level of Security Provided by the Minimum Funding Requirement
Heriot-Watt University, Edinburgh
In this paper we investigate questions arising during the author's membership
of the Minimum Funding Requirement (MFR) Change of Conditions Working Party¹.
In particular, do the various liabilities calculated under the MRF deliver a suitable
level of security to pension scheme members.
The paper considers active (and deferred) members and current pensioners
For active members, Monte Carlo simulation is used to compare how the proceeds
arising from investment of the MFR liability in an equity-backed personal pension
would compare with the deferred pension promised by the scheme. It is found that
while there may be the intended 50% chance that the personal pension has a better
outcome there are very substantial downside risks for younger members. Investment strategies based upon index-linked gilts are found, inevitably, to result on average
in lower personal pensions but they provide an extremely effective means of limiting
the downside risks.
For pensioners, Monte Carlo simulation is used to find the distribution of
amount of assets required to pay off precisely the pensions liabilities as they arise.
This investigation considers the effectiveness of the 12-year rule and different
investment strategies. The 12-year rule in combination with an equivalent investment
strategy is shown to provide reasonable security for a typical group of pensioners.
However, if investments are restricted to an appropriate mixture of gilts then the level
of security for pensioners is much increased. In particular, we investigate the use
of value-at-risk reserves. It is found that 95% value-at-risk reserves are lower for
a mixed gilts strategy than a mixed gilts/equity strategy.
It is argued, because of the high degree of downside risk, that there is
no place in
MFR calculations for high, anticipated equity returns. Instead rates of interest should
be based solely upon fixed-interest and index-linked gilt yields.
¹ The opinions expressed in this paper are those of the author and not
those of the working party.