Identifying and managing business risks – defined benefit pensions
May 2014 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
The phrase ‘elephant in the room’ couldn’t be more apt than in relation to the business risk posed by defined benefit pensions. The total liabilities of a scheme are often comparable in size to the capital value of the sponsoring employer; contribution requirements can exceed free cashflow; and the company’s balance sheet is exposed to significant gains or losses stemming from investment market conditions that may have little or no direct impact on the company’s actual business.
Funded pension arrangements are built on the premise that the sponsoring employer accepts risk in order to provide a certain level of retirement benefits at an acceptable cost. If the employer reduces the amount of risk in this equation, then the expected costs of provision increase (as benefits already earned cannot be reduced). Finance Directors (FDs) therefore face a real challenge in deciding how much resource to allocate to the mitigation of pensions risk. The trick is to monitor the position closely and look for opportunities to remove further risks at an acceptable price.
In recent years, funding negotiations have tended to focus on the maximum amount that companies can afford to contribute to repair scheme deficits over a reasonable period of time. For example, in 2012, the deficit contributions paid by FTSE350 companies averaged a substantial 12 percent of operating profit. This equated to some £11bn in total and yet the aggregate deficit still worsened over the year. Having paid in large contributions, FDs faced a dilemma at that time between locking into market conditions to mitigate risk, or keeping risk on the table in the hope of achieving gains.
Over the course of 2013 and early 2014, many schemes have seen improvements in funding level. Bond yields (often used to measure pension liabilities) have improved from their low point in early March 2013 and equity market returns have been favourable. Nobody can be sure when is the best time to reduce risk levels, but developments in the pensions market mean that products are available to do this more efficiently than in the past.
Bulk annuities are probably the most common tool for de-risking, as the mortality, inflation and investment risks are all passed to the insurer. There has been an increase recently in the number of buyout transactions that have taken place on an ‘all-risks’ basis. This means that, in addition to mitigating the risks associated with a standard bulk annuity purchase, the employer and trustees are also able to cover risks relating to incorrect data, or missing beneficiaries.
These types of policy help to close the door to any future claims that members could have against the scheme. Some insurers are even providing packages that will cover the costs and additional liabilities likely to materialise when Guaranteed Minimum Pensions (GMPs) are equalised. These packages can help employers and pension scheme trustees overcome the time consuming hurdle of data cleansing prior to a standard bulk annuity purchase, as the insurer will take on this responsibility. This can really help progress a liability transfer exercise but the trustees and employer need to assess the extra costs they are actually paying for this additional insurance.
In some cases, the insurer can also accept a deferral of some of the premium. In effect, this is a loan from the insurer and allows the annuity pricing terms to be guaranteed at outset. The amount that can be deferred and the period allowed to pay the rest of the premium varies – some insurers are more flexible than others. It is also likely that the deferred premium will have to be paid in stages unless the time period is fairly short. It is important to be aware of what will happen if the ‘loan’ is not repaid – the benefits paid by the insurer will be reduced.
Longevity swaps are also becoming more accessible. They are contracts between the pension scheme and an insurer that reduce the risk to the sponsoring employer of members living longer than expected (if all members lived just one extra year than expected, this could increase the total cost of the scheme by around 4 percent). In some regards the longevity swap is very similar to an inflation or interest rate swap, where a fixed coupon is paid each year in exchange for variable receipts. Under the longevity swap the scheme makes payments based on an agreed mortality assumption. Then, if fewer deaths occur during the period than under the mortality assumption underlying the contract, the insurer makes a net payment to the pension scheme. Alternatively, if more deaths occur than expected, the insurer makes a profit and receives a net payment. Essentially, the swap reduces the risk and uncertainty of payments associated with longevity.
Some of the attraction of a longevity swap compared to buying out member liabilities through bulk annuities relates to the control of assets. Paying a regular coupon under the longevity swap, as opposed to handing all assets over to an insurer, means the scheme is able to maintain control of the assets and investment strategy (pursuing any growth strategies that may have been agreed).
Liability Driven Investment (LDI) products are another example of market developments. Pension schemes have always invested in assets with the nature and duration of liabilities in mind. But purpose built LDI products have become increasingly popular as employers and trustees have realised the significance of interest rate and inflation risks within schemes. Investment managers have introduced funds that can provide better matches to the liabilities through the use of derivatives in ‘buckets’ of different durations. The strategy does not seek high asset returns, but instead to reduce volatility in the scheme’s funding position and the corresponding impact on the employer’s balance sheet.
If risks need to be taken to keep the cost of a defined benefit scheme at an acceptable level the most important point for company directors is that opportunities to remove risk at an acceptable price do not hang around. Employers need to be very clear (in their own minds and in collaboration with the pension trustees) on their objectives and strategy for the scheme. They should consider having triggers for action in place, so that when a suitable opportunity arises, it is identified quickly and can be acted upon without delay. As modelling capabilities have improved, it is now common for trustees and employers to have access to funding trackers that monitor the scheme’s changing assets and liabilities on a variety of measures and can be used to set triggers for action. For example, this could include a defined switch from equities to bonds on achieving a certain level on the scheme’s funding basis, or purchasing bulk annuities in respect of a tranche of members when the estimated price looks favourable compared to current asset values. This approach also helps to provide focus for ongoing discussions between the employer and the scheme trustees.
Nick Griggs is Head of Corporate Consulting at Barnett Waddingham LLP. He can be contacted on +44 (0)20 7776 2200 or by email: firstname.lastname@example.org.
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