How does new entrant affect pension plan risk tolerance?

CFA Level III
#1

If a plan is closed to new entrants, will the risk tolerance increase or decrease?

I can think from both ways:

a). the ratio of inactive to active members will go up, risk tolerance goes down.

b). less number of people in the plan-> less payments, risk tolerance goes up. (question: if a new entrant to the plan, will the plan asset base increase or not?)

any comments? Thank you.

#2

Future participants are excluded from the investment benchmark (Volume 2 Page 462). They should not influence risk tolerance and thus asset allocation (same from future service costs). The relevant liabilities to consider are all accrued benefits and the future wage liability.

But to answer your question, I agree that risk tolerance would go down if we consider new entrants because they create the most liability “noise” and are the hardest to estimate (to start, you’d have to make an assumption about how many people the firm will be hiring in the future before you even get to estimating their pension liabilities). Due to the high uncertainty, it would make sense to decrease risk tolerance based on these expectations - but the normally are not considered.

If a new entrant joins the plan, then the plan asset base should increase because as he works -> he accrues benefits + is entitled to future wage increases -> increases firm liabilities -> asset base must grow either from new contributions from the firm or higher returns on assets.

#3

Closing a plan decreases risk tolerance.

  • No new entrants means age of plan members keeps increasing (decreasing time until retirement) and ratio of inactive : active workers increases with time. This means fewer contributions and looming pension payment liquidity requirements.
  • Contributions from workers are generally used in the first instance to cover pension payments, offsetting liquidity requirements from the assets. Therefore risk tolerance is increased with higher contributions and decreased with lower contributions. Your logic is awry on the second point but I can see where you are coming from.

A new entrant will typically increase risk tolerance. Don’t forget that PBO only takes into account service to date (not future service), inflated for projected salary increases. Each year of service typically adds a % to a worker’s final salary entitlement – a common example is that every year you work for the company, you receive 2.5% of final salary as a pension to a max of 40 years. A person who has 1 year of service is a lesser liability than someone of the same age with 10 years of service.

#4

I see. Thank you guys for the thorough explanations!