Institute of Actuaries paper backs climate scenario analysis at DB pension funds

Uncertainty “should not be used as an excuse for not considering climate risks”, according to a new working paper by the Institute and Faculty of Actuaries (IFoA), which is calling on UK trust- based defined benefit pension schemes and their advisors to utilise scenario analysis to address such risks.

Resource and Environment Issues for Pensions Actuaries: Considerations for Setting Financial Assumptions is the latest working paper by the London-based global actuarial body on the topic of climate change.

It aims to start to address the “knowledge gaps and uncertainties” that exist around climate risks and offers guidance to actuaries advising UK trust-based DB schemes on the issue.

The report, which is not formal guidance, seeks to broaden the consideration of climate risks to include their impact on a “wider range of financial parameters” relevant to pension schemes, such as bond yields, inflation and annuity pricing.

Studies on climate risks, the IFoA argues, have tended to focus on the risk to investments in equities, neglecting other “macroeconomic risks” important to pension schemes.

But this gap in knowledge, it is argued, far from excusing inaction, “emphasises the need to consider a range of possible scenarios and the resilience of a pension scheme’s funding position under these different scenarios”.

The IFoA regards such “narrative scenarios and stress tests”, which were endorsed by the Taskforce on Climate-related Financial Disclosures (TCFD), as a “helpful tool” in anticipating the “macroeconomic impacts” of climate change on pension schemes.

Ideally, these scenarios, it argues, would incorporate the “impacts on covenant strength [the relationship between sponsor and pension fund] and demographic assumptions”, as well as the “impacts on asset values and financial assumptions”.The report goes on to give actuaries guidance on how the insights of scenario analysis can be harnessed, in addition to a host of other “action points” for actuaries to explore generally in relation to climate change risk due diligence.

“Consider a range of possible scenarios and the resilience of a pension scheme’s funding position”

Another gap in research, identified in the report, is the impact of climate change on annuity pricing – the cost of offloading liabilities on to an insurer – which is something the report claims an increasing proportion of UK DB schemes have funding objectives linked to.

The importance of considering climate risks is such that the IFoA paper states that pension actuaries should be considering them “regardless of whether their client explicitly requests them to do so”.

The IFoA has taken an increasingly prominent stance on climate change in its communications with members, following the issuance of its first-ever climate-focused risk alert in May 2017. The alert drew members’ attention to the “material risk” that climate change poses, and stressed their responsibility to “consider how climate-related risks affect the advice they are providing”.

In March 2018, IFoA issued guidance to defined contributions (DC) pension scheme advisors that warned of the “spectre” of legal action for those that did not take account of climate change in their advice.

That risk is again reiterated in this report for DB pension scheme advisors. The report also highlights the growing prominence climate change has been given in UK and European pension law and regulation – it cites both the 2017 Investment Guidance by The Pension Regulator and the revised EU Directive for Institutions for Occupational Retirement Provision (IORPs) as examples.