Model risk - your five-point guide to avoid tripping on the pensions catwalk

Model risk - no, not the chance of a supermodel tripping up on the catwalk - but instead a serious issue for the pension industry and the bodies which oversee and regulate it.

The question is this: if you're a trustee or a pension plan sponsor making a decision based on input from an advisor, how do you and they know that any modelling or calculation work supporting that input is correct? And consequently that you have made the right decision?

What are the situations which could lead to "model risk"?

One might be where an advisor is relying on their own in-house model which hasn't been independently verified or externally tested to an appropriate standard. A compounding factor might be where that in-house model is outsourced to an offshore or other remote geographic centre which creates distance, literally and metaphorically, between the front-line individual advisor and the back-office engine where the calculations are carried out. To what extent is your advisor really kicking the tyres on the calculations he's relying on?

In contrast, a more robust approach would be where all parties and advisors are using one common platform for all their pension scheme valuations and analytics. With one third party system, accessible by all but with information showing private to that user's individual log-in, every user has an opportunity to check that the outputs are working appropriately. Even better when there is transparency from that system around what has gone into it - clear documentation summarising the benefits valued, the membership data used, and the assumptions made.

We expect that all pension scheme trustees and company sponsors will want to move to such a third party approach - a common data and information platform but where each user can access their bespoke requirements privately and securely - within the next 12 months. Not only does that solution address model risk, but it also reduces cost and speeds up decision-making, as you don't have each advisor duplicating work or talking at crossed purposes with other advisors.

Your five-point guide to reducing your exposure to model risk

In the meantime, until you get to that arrangement for your scheme, you need an urgent method for reducing your exposure to model risk. Here is a five-point guide. Ask these questions of all your pension scheme advisors and ensure you get meaningful responses, not just superficial answers:

  1. What modelling system do you use to calculate the numbers underlying your advice to us, and who runs it?
  2. Who has checked the system?
  3. What external or independent verification has been applied to our pension scheme's specific outputs?
  4. How do you personally know that the outputs you rely on each time you provide advice to us are correct?
  5. Please share the library of documentation which shows what pension liabilities you have valued, what membership data you have used, and what assumptions you have made?

Finally, if your actuarial advisor is still proving reticent, or you worry he or she is playing down the significance of the issue, then you can steer them to assistance designed to support their thinking through this. It's a Professional Support Service provided by the Institute and Faculty of Actuaries, and they can click here to find out more about it.

Raj Mody

Raj Mody

Raj advises corporates, trustees, regulators and government, specialising in helping major FTSE and multinational organisations deal with their pensions challenges. He is a partner at PwC, a Fellow of the Institute of Actuaries and a founding Director of Skyval. - 020 7804 0953 - @PensionsRaj