Dick Kamp: Why no pension fund can operate responsibly without scenario analyses
This column was originally written in Dutch. This is an English translation.
By Dick Kamp, Director of Pensions, Investment and Risk, Milliman Pensions
Managing a pension fund under the new pension contract (Wtp) requires a constant balance between achieving the agreed pension ambition and managing risks within the set risk budget. Scenario analyses are an indispensable tool in this regard, both in terms of content and process. They not only provide board members with insight into the feasibility of the mandate, but also form the foundation for proactive, transparent and responsible governance in a new Wtp world. By making systematic use of scenario analysis, the board is enabled to anticipate changing circumstances in good time and to provide adequate accountability to stakeholders, such as members, social partners and regulators.
Objectives of scenario analyses
Scenario analyses serve several objectives:
- Substantive: They periodically assess whether the execution of the pension mandate remains feasible, given current market and fund developments. They also provide insight into optimisation opportunities within the risk budget, for example through adjustments to the lifecycle allocation.
- Process-related: Scenario analyses serve as management training (‘wargaming’), ensuring that the board remains alert to emerging risks, maintains a clear view of its own scope for action, and is prepared for situations in which actual action becomes necessary.
Methodology and scope
Scenario analyses are embedded in the governance framework and are carried out systematically and cyclically, for example on a quarterly basis, and include an assessment of the feasibility of the mandate.
Based on current portfolio information, lifecycle allocations, premium contributions, the participant base, technical provisions and costs, and relevant scenarios such as DNB quarterly scenario sets and, where relevant, fund-specific scenarios, an assessment is made as to whether the pension ambition for all age cohorts remains realistic within the agreed risk budget in relation to the agreed ambition. Combining stochastic analyses (thousands of economic paths based on probability distributions) with deterministic analyses (specific ‘what-if’ scenarios, such as an interest rate crisis or inflation shock), to provide insight into both the distribution and impact of extremes.
Input for scenario analyses further elaborated
The input for scenario analyses is broad and systematic, and directly reflects the fund’s current situation. Central to this are the key data: the composition of the portfolio, lifecycle allocations, premium contributions, the membership base, technical provisions and the cost structure. Based on this input, various relevant economic scenarios are developed, in which factors such as interest rates, inflation, share prices and property prices vary. By linking these scenarios to the current fund data, a clear picture emerges of the expected pension outcomes, the development of the funding ratio and the indexation potential per cohort.
Scenario analyses are generally carried out on a quarterly basis as part of risk management, to enable an adequate response to market developments or significant events. In stress situations, such as market crises or significant changes in interest rates, additional ad hoc analyses are carried out. The scenarios utilise the DNB quarterly scenario sets, which align with supervisory practice and ensure comparability between funds. In addition, it is also possible to opt for the fund’s own scenario sets, which may be more appropriate for the pension fund.
Both stochastic and deterministic methods are used when preparing scenario analyses. Stochastic analyses simulate thousands of possible economic paths and provide insight into the distribution of pension outcomes, the likelihood of failing to meet the agreed target – including the potential to keep pace with inflation – and are quantitative in nature. Deterministic analyses focus on the impact of specific events and show what happens in ‘worst-case’ or ‘best-case’ scenarios, and may also be more qualitative in nature.
Interpretation and application of results
The results of scenario analyses are analysed and discussed in full:
- Ambition versus reality: An assessment is made as to whether the expected pension outcomes per cohort are still in line with the agreed ambition and fall within acceptable ranges.
- Risks and recovery potential: The likelihood of failing to meet the ambition is made explicit, as is the potential for recovery through returns or contribution adjustments.
- Management actions: Based on the analyses, the board can make targeted adjustments, for example through allocation changes within the lifecycles, and communication and escalation procedures are activated where necessary.
- Accountability: Scenario analyses form the basis for transparent communication with and accountability to stakeholders, with clear explanations of choices and risks.
- Management wargaming: By involving the management as a whole in the discussion of the scenario outcomes, decision-making and communication under pressure are practised, thereby increasing management agility and readiness.
Administrative course of action
Scenario analyses give concrete form to the board’s perspective on action (course correction):
- Allocation adjustments within project lifecycles: Optimising implementation within the agreed risk budget.
- Communication and stakeholder management: Proactive and transparent communication with participants, social partners, regulators, contractors and consultants.
- Escalation and decision-making: Identifying in good time when the assignment is no longer feasible and initiating consultation or returning the assignment as a last resort.
From theory to practice: success factors for implementation
Embedding scenario analyses structurally within the management cycle requires more than just good intentions. Successful implementation requires concrete agreements on metrics, governance, scenario design and decision-making rules. The following elements are essential in this regard:
Explicit goals and metrics
Define measurable KPIs for each cohort that make progress towards the pension ambition objectively assessable. Consider the likelihood of achieving the ambition (e.g. ≥70% over a 10-year horizon), the ability to keep pace with inflation (probability of indexation ≥ CPI of, for example, ≥60%), and projections of the funding ratio across different scenarios. Linking these metrics to the available risk budget creates a clear dashboard that enables the board to monitor progress.
Clear governance and roles
Embedding scenario analyses requires clear responsibilities. A RACI matrix explicitly sets out who is responsible for scenario design (risk/ALM lead), assessing the ambition (actuary), implementation implications (asset manager), advising on optimisations (investment committee) and final decision-making and communication (board). In addition, an independent validator is needed to critically challenge assumptions and models. Link this to a fixed cadence: quarterly analyses with a decision agenda, monthly monitoring of risk indicators and ad hoc analyses when pre-defined triggers are exceeded.
Standardised scenario library
Develop a fixed set of scenarios that includes both DNB scenario sets (for comparability and supervision) and fund-specific stress scenarios. Consider interest rate shocks (±200 basis points), inflation shocks (+3% over 2 years), equity market crashes (-30%), property market corrections (-20%), liquidity stress and combination scenarios. Document methodological choices: rebalancing rules, indexation regime under the Wtp, premium policy and transaction costs. Validate the models annually through independent review and test them by backtesting against historical crises.
Decision rules and communication/escalation triggers
Make concrete agreements in advance regarding when the board must communicate or escalate. For example: if the probability of achieving the target falls below 70% for two consecutive quarters for a cohort, communication to the relevant participants follows. If the probability falls structurally below 60% for multiple cohorts, formal communication to social partners follows. Such triggers make decision-making more objective, faster and more accountable, whilst respecting the board’s limited scope for action.
Administrative wargaming in practice
Organise two to three wargaming sessions annually in which the full board discusses realistic scenario outcomes: for example, a situation in which the target for multiple cohorts is under pressure due to an inflation shock, or in which liquidity stress requires rapid decision-making.
In these sessions, the board practises:
- Interpreting scenario outcomes and assessing whether the pension mandate is still achievable
- Exploring the limited scope for action under the Wtp: optimising the investment policy within the agreed risk appetite (on the advice of the investment committee), communicating with members and social partners, and escalating matters if necessary
- Formulating clear messages to stakeholders regarding the situation and any measures
- Making decisions under time pressure and uncertainty
The investment committee prepares concrete optimisation options for these sessions within the agreed frameworks. The board assesses these recommendations and takes the final decision. These exercises increase managerial agility, clarify the limits of the scope for action and strengthen confidence in crisis situations.
Standardised reporting
Ensure a concise scenario report (maximum 15 pages) with an executive summary, cohort overviews, a risk budget dashboard, stress test results and concrete recommendations. Link this to a communication schedule for the board, regulator and participants. Record all assumptions, scenario versions and decisions in an audit trail for reproducibility and accountability.
Stakeholder-focused governance
By structurally integrating scenario analyses into the board’s work, the fund remains continuously aligned with its objective, the interests of stakeholders and relevant internal and external developments. This strengthens the board’s capacity for learning and anticipation and contributes to confidence in a new Wtp environment.
Conclusion
Scenario analyses are an essential part of modern pension fund governance. They enhance the board’s ability to learn and anticipate, strengthen governance and contribute to the trust of stakeholders such as members, social partners and regulators. By structurally embedding scenario analyses into governance, the board lays a solid foundation for transparent, proactive and forward-looking governance. Investing in knowledge development and the sharing of best practices ensures that the fund continues to operate in an agile and responsible manner. In this way, the pension fund is well equipped to meet the challenges of tomorrow.
This is the forty-nineth column in a series on risk management. The series aims to encourage readers to view risk management as an integral part of business.