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Working Paper

Modeling Risk-based Pension Insurance Premiums

Martin G. Clarke
WP2013-14

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Abstract — This paper describes how the Pension Protection Fund (PPF) in the U.K. quantifies and prices the risks it carries. It also discusses how the PPF interprets these outcomes in terms of a levy or premium to be charged to the pension plans that it protects. PPF has existed since 2005: it has experienced rapid growth as a consequence of the failure of U.K. pension scheme sponsors and the persistent underfunding of their plans, and it has withstood the global financial crisis, partly due to the Fund's ability to charge a levy consistent with the risks it faces and its skill in securing stakeholder acceptance of its process. Considering the example of the U.S. Pension Benefit Guaranty Corporation (PBGC), the PPF was able to introduce the world's first risk-based pension protection levy, a key step in winning stakeholder support for the pricing mechanism; the components of the levy-setting process are described in this paper. We examine the PPF's goal to be self-sufficient by 2030. We also review the framework whereby investment and levy strategies can be evaluated in the context of the PPF's long-term objectives, and we describe the internal model at high level to compute measures of success of different strategies. The Board has been able to use this framework to assess the impact of a change to the basis of indexation of PPF compensation, the cost of removing its compensation cap, and the effect of a potential change in pension scheme funding valuations to permit smoothing of discount rates.