RISK MODELLING SOFTWARE

14 August 2014

The recent wave of new online risk modelling software entering the pension market will eventually translate into a greater use among pension funds. But what do they really do and are they worth the cost? 

These online tools bring a range of functionality, allowing trustees and sponsors to assess the impact of different assumptions on pension scheme deficits and recovery plans; model value at risk measures from different investment strategies; and measure the probability of meeting a scheme’s objectives over the long term. 

These models will unlikely change the fundamental processes of running a pension scheme, but access to real-time data means they can provide flexibility in how information is communicated, particularly for reporting. However, the greatest benefit is undeniably the gain in time efficiency. 

It is useful to draw a parallel between these new tools and the first generation of online modelling tools which enable individuals to make projections in relation to their defined contribution pension plan. These models have a simple set of inputs: return assumptions, contribution rates, salary and expected retirement dates are most typical. Whether the actual outcome is close to that forecast depends on a number of highly fluctuating factors: annuity rates and investment returns being key offenders. 

Ready access to such models allows individuals to check whether they are on course to meet their targets and how to set their contributions and investments. There is a risk however, if appropriate advice has not been taken or there is a misunderstanding of the drivers of the change in projection, that an unintended decision could be taken. 

In the same way, the new generation of online modelling tools are helpful in providing trustees and companies with a tangible and meaningful output of the impact of changing assumptions, strategies and market movements. A company knows that increasing contributions will reduce either the time or the required return to meet its funding objectives, but understanding the magnitude of that change can support the decision-making process further.
Historically, this data would be regularly supplied by professional advisors during and between their meetings with companies and trustees. With online modelling, trustees and the company representatives can review a range of scenarios in advance, thus focusing the time with their advisors on the advice around evaluating scenarios and options. 

Online tools can also help trustees and the company representatives to revisit discussions and consolidate their understanding, as well as communicating the pension strategy to other key stakeholders, such as the management board, in a timelier manner. For example, many finance directors often wait with trepidation to see whether the deficit has increased or decreased. Near instant access to this data can help the company budgeting process.

Whilst the gain in time efficiency is obvious, we need to be conscious of what the software doesn’t offer. Online functionality and the results of the modelling are only the preparation step after which decisions need to be made and human advice at this stage cannot be substituted by a system. It is also important that the assumptions used are understood and that “risk” numbers are translated into real life outcomes. 

The appearance of such software can also raise the question of whether it could shift the focus on making short term decisions based on market movements instead of the traditional long term funding objective. However, it is improbable that trustees would abandon such a fundamental principle.

Overall, there are clear benefits to using online modelling tools, although trustees need to be aware of the pitfalls of relying on the inputs. The question is whether users really feel those benefits outweigh the costs.

Jignesh Sheth
Consultant jignesh_sheth@jltgroup.com 0161 253 1154