Innovation and technology in defined benefit pensions
August 2014 | EXPERT BRIEFING | BOARDROOM INTELLIGENCE
Many people associate defined benefit (DB) pensions with lengthy processes and unwieldy rules and practices – a far cry from the innovation and technology seen in some other areas of business. In truth, though, the pensions industry is developing at great pace to help sponsoring employers to set and achieve reasonable objectives in relation to their legacy pension arrangements.
The government is helping too, with new legislation being introduced to facilitate risk sharing arrangements. The potential for DB-lite arrangements (e.g., with no requirements for a minimum level of pension increases, or dependants’ pensions) was dropped due to lack of interest from employers in establishing such schemes. The idea of Collective Defined Contribution (CDC) arrangements on the other hand was more warmly embraced. It is anticipated that large employers, or groups of many individual employers from the same industries, will develop innovative benefit designs for future service provision using these arrangements. The advantages stem from the collective nature (resulting in economies of scale and beneficial cross-subsidies) and the ability to vary future pension payments in line with market conditions. The key to success is finding the right balance between complexity and a structure that can adapt to changes in economic circumstances over time.
Although this particular benefit structure is new, changing future service benefit provision has been done before and is only part of the solution. The real innovation in recent years has been in relation to liability management. For example, giving members the option to exchange increasing pension for a higher fixed-rate pension (a Pension Increase Exchange, or PIE), or helping them through the provision of independent financial advice to transfer out to an insured pension that might better suits their needs (a Retirement Transfer Option, or RTO).
In particular, increases in past service deficits over recent years have given rise to innovations to help reduce or remove liabilities from schemes. The key principle underlying any such exercises is to offer additional benefit flexibility for members whilst also helping to reduce liabilities and risks for the sponsoring employer. An industry code of good practice for pension incentive exercises was published in June 2012 and this has provided an accepted framework for such exercises, further increasing the appeal for employers who may previously have been worried about reputational risks. The most popular exercise recently has been to introduce an RTO both as a normal option for individual retirements and as a bulk offering to all members above the minimum retirement age.
The government will shortly be announcing whether or not it intends to ban DB to DC transfers, which would impact RTO exercises. The reason for the possible ban is the introduction of additional flexibility in DC pensions from April 2015, which the government is concerned could lead to mass transfers out of DB schemes, affecting DB schemes’ ability to invest for the long term.
If transfers are not banned, then RTOs can continue in their present form and the option should be expected to attract more members than currently, given the ability they will have to draw DC funds as they wish, rather than being limited to the insured pensions available on the open market.
If transfers are banned, there may be increased scope to encourage members to transfer across to DC provision for future service. Typically, employers wishing to close a DB scheme to future accrual will face opposition from members and possibly unions, which can harm employee relations. It has become common in recent years to offer enhanced contributions to the new DC arrangement for members who leave the DB scheme. Although this incurs higher employer contributions (which would typically phase down to the normal level over a period of a few years), this can be a small price to pay for improved employee relations. With the increased lure of DC flexibility, employers may find that a smaller enhancement to contributions is required to seal the deal.
In terms of technological advances, funding trackers are now quite commonly used to track the progress of assets and liabilities between formal valuations (which are completed every three years). These can continuously monitor risk transfer opportunities to help ensure that action is taken before any opportunities disappear. With competition in the bulk annuity market and volatility in bond yields both driving frequent price fluctuations, a funding tracker can easily make the difference between successfully securing tranches of pension liabilities at an acceptable price, or not.
Asset-liability modelling is another helpful tool from the point of view of assessing and understanding the risk of future investment strategies relative to liabilities. The modelling requires thousands of complex simulations, but increased computing power has made this more accessible as a standard tool. This helps employers to understand the risks they face and set objectives for the scheme. This is especially important in light of the Pensions Regulator’s new funding code, requiring an integrated approach to funding and investment strategies.
Finally, although formal valuations still take a long time (e.g., up to a year or more) to complete, valuation modellers (which are used during the valuation process to help set the assumptions to be adopted) can now more easily reflect the impact of a range of de-risking options to investigate the feasibility of post-valuation liability management exercises. This not only helps to reduce the time taken to get exercises underway, but can also enable the expected outcome to be reflected within the funding strategy agreed between the employer and the trustees.
The pensions industry might have lagged a little behind the changing economic and technological landscapes in the past. It appears to have caught up now, though, and engaged employers should seek to make full use of the innovations and technologies coming through to manage their pension obligations successfully.
Nick Griggs is head of Corporate Consulting at Barnett Waddingham LLP. He can be contacted on +44 (0)20 7776 2200 or by email: email@example.com.
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