Shortfall Risks and Pension Funds

Investors who invest in financial assets face various kinds of risk. There is market risk, liquidity risk, and even currency risk which are talked about quite often. However, at the same time, market investors also face another kind of risk called the shortfall risk. This risk is faced by investors all over the world.

However, it does not receive its due attention. This is possible because of the fact that shortfall risks do lead to a decrease in the nominal value of a portfolio. Therefore, many novice investors do not consider it to be a risk at all. However, nominal wealth is not as important as real wealth to pension investors.

The whole objective of pension funds is to ensure that investors have sufficient real wealth when they retire from active employment.

In this article, we will have a closer look at what shortfall risks are as well as how they impact pension funds and their investors.

What are Shortfall Risks?

In simple words, shortfall risk is the risk that an investment will not be able to meet the returns provided by a benchmark. In most cases, the risk-free rate is considered to be the benchmark rate.

Hence, if an investor invests in pension funds and averages a return of 5% per annum whereas the risk-free return during the same period is 6%, the investor has faced a shortfall. It means that the investor has taken an unnecessary risk and has earned a lower return even though they could have just kept their money locked in treasury bills and earned a higher rate of return.

The shortfall risk becomes much more important in the context of a pension fund. This is because investors receive pensions when they are no longer earning. Hence, if there is a shortfall, these investors often have to reduce their standard of living in order to make up for it.

Why do Shortfall Risks Arise in Pension Funds?

Shortfall risks can arise in pension funds because of several reasons. These risks have been witnessed in both defined benefit as well as defined contribution plans. However, the likelihood of facing this risk is generally higher in a defined benefit plan.

This is because in a defined benefit plan, the plan sponsor i.e., the employer has to provide the pensioners with a minimum guarantee. This means that the pensioners will receive some minimum benefits regardless of the performance of the portfolio. This means that the employer has to bear 100% of the downside risks.

However, when it comes to upside potential, the sponsor can only benefit from obtaining a percentage of the benefits. As a result, the sponsors are more concerned about avoiding the downside potential than they are about increasing the returns of the fund. As a result, defined benefit plans tend to be ultra-conservative.

They lock all the money in fixed-income investments and very little money is invested in equities. This is seen as a safe approach. However, in such cases, if the value of the fixed-income securities starts going down, then the value of the pension funds also starts reducing beyond the shortfall limit.

Defined contribution plans can also provide returns below the shortfall limit. This may be because of the fact that the fund has invested a very small amount in equities. It could also be because of the fact that the fund has increased its allocation towards riskier equities. This could cause a huge downfall in the value of the portfolio fund dragging it below the shortfall benchmark.

Shortfall Risks and Time Frame

There have been many studies conducted that have concluded that shortfall risks and investment horizons are inversely related. This means that if the investment is made over a longer period of time, the risk of shortfall is greatly reduced. Pension funds must therefore take their mean age into account while making investments.

If a large percentage of their investors are young, then the allocation needs to be inclined towards equity. This is because even if there are losses in the short run, in the long run, stocks provide a higher return as compared to other benchmarks.

However, as the investor group ages, a more defensive approach must be adopted and the portfolio should be inclined towards debt. This is because, at this stage, the focus should be on the preservation of funds instead of on beating benchmark investments.

How Shortfall Risk is Measured?

Various quantitative mechanisms have been developed in order to measure the shortfall risk. The safety-first ratio is one of the most popular mechanisms which have been created to measure this risk.

The safety-first ratio is a mathematical formulation that allows investors to compare the probability that various portfolios will provide a return lower than the benchmark return.

This formulation uses the mean return and the standard deviation of portfolios as input parameters in order to derive the optimal portfolio which would avoid shortfall risk. It is common for pension funds to use the safety-first ratio as one of the parameters while making decisions.

It is important to realize that shortfall risk should be considered a very important factor while making investment decisions. This is because the fact that shortfall risks do not provide investors with a chance to recover. Failure to understand shortfall risks and incorporate them in the decision-making process can have far-reaching effects on pension fund investors.

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