24 March 2014

IOPS working paper: Stress-testing and scenario analysis of pension plans

Stress-testing – using the broadest term, referring to factor sensitivity testing and scenario analysis – has become more important for the financial sector generally and also for pension funds since the financial crisis. However, this is still a relatively new tool and there is a growing consensus that better design and implementation of stress-testing is needed.

In the case of pensions, there are still only a few jurisdictions where supervisors use them regularly. There is also ongoing concern over their relevance and applicability to DC pension systems. In the case of DC plans, supervisors do not have to have a "tangible" outcome to stress-test. For example, the Mexican authority tests a short-term measure of risk, the VaR, while the supervisory authority in Israel stress-tests portfolios’ resilience to various risks scenarios. In Australia, APRA has recently started carrying out stress tests of liquidity risk.

It is worth remembering that even though stress-testing for DC schemes is performed to analyse the impact of various risk factors (such as liquidity, market risk, foreign exchange risk etc.) on the current or projected situation of the pension funds, this procedure should take into account the ultimate long-term goal of the pension funds, i.e. their ability to deliver adequate retirement income for its members.

The take-up of stress-testing is also limited by lack of understanding among senior management, both within supervisory authorities and pension institutions.

As this report has highlighted, stress tests are still not widely used in the pensions sector covered by IOPS jurisdictions. Only 40 per cent of supervisory authorities use stress tests, mainly in DB plans, and as part of a risk-based solvency assessment. Pension supervisors still have some way to go before they catch up with their banking and insurance peers.

Supervisors need to be sure what stress tests are for and what supervisory authorities are trying to achieve – particularly when it comes to testing DC pensions. Stress-testing is a relatively straightforward task for DB pension systems, where supervisors and funds are used to test solvency and funding levels against adverse conditions. However, the challenge is greater for DC funds. Testing the impact on portfolios of market downturns and other risk factors, though a useful part of portfolio risk management, only gives half the story. What supervisors and members of DC funds really need to know is whether this accumulated pension pot will deliver them an adequate pension. Some supervisors (and indeed funds) are therefore looking at how to introduce ‘artificial’ income targets for DC funds, which can be stress-tested. Further work on these targets and their measurement will be undertaken by the IOPS in 2014.

As most experts attest, the key to getting stress-testing right is not so much the algorithms and mathematics of the tests themselves, but rather coming up with a plausible scenario to test against. Any stress test is only as good as the scenario on which it is based. As an exercise of the imagination, the stress test is limited by the imaginative capacities of those designing the stress test scenarios. As the IAIS (2003) points out: "Straightforward tests, with simple assumptions that cover the major risks, may be more useful than complex modelling that is difficult to understand or to validate".

Ultimately, the effectiveness of stress tests does not depend on just a few parameters, but on the context within which they are conducted. This requires a clear ex ante understanding of the stress tests’ objectives; knowledge of the key individual financial institutions in the system, their business models, principal sources of risk, and main channels of risk transmission; appropriate decisions on the tests’ perimeters and coverage; the use of other complementary assessment tools; a communications strategy tailored to the circumstances and purpose of the tests; and a credible commitment to take the measures that may be required to address the vulnerabilities uncovered by the tests. Lastly, the principles also emphasise that, regardless of technical refinements and improvements, stress tests will always remain hypothetical statements and cannot, by themselves, predict or prevent crises.

Full article

© IOPS - International Organisation of Pension Supervisors