Pension Risk (as a corporate liability) is the risk that the firm must make unexpected additional contributions to employee pension funds where the fund cannot disburse its promised payments from its own assets and the firm it is either contractually or for reputation reasons obliged to make up the difference
Employees and Firms make ongoing contributions to employee pension funds and employees are entitled to pension after retirement. Pension payments are funded by future contributions and accumulated pension fund assets. Management and regulation of the employee pension funds is typically separate from the firm itself.
The risk to the firm arises when its associated pension funds cannot fulfil their obligations (which may be expressed as formal coverage ratio threshold) for whatever underlying reason (asset under-performance or any other risk factor). More explicitly: pension risk arises from the potential for a deficit in a defined benefit plan due to e.g.,
- pension fund investments delivering a return below that required to provide the plan benefits. This could arise when there is a fall in the market value of equities, or when increases in long-term interest rates cause a fall in the value of fixed income securities held;
- corporate failures, thus triggering write-downs in asset (both equity and debt) values;
- a change in either interest rates or inflation which causes an increase in the value of the scheme liabilities; and
- scheme members living longer than expected (Longevity Risk).