De-risking has been the watchword for defined benefit (DB) pension schemes since at least 2008. But you’d never know it by looking at the numbers.
“At the end of 2012, the total liability in UK DB schemes was in excess of £1 trillion, with a deficit around £100 billion,” says Kelvin Wilson, associate director at Grant Thornton. “That deficit has grown by about £30 billion in the past five years.”
Trustees have been taking one step forward, but two steps back amid a perfect storm of falling gilt yields, low equity returns, increasing inflation, greater longevity and more stringent regulatory requirements.
“The vast majority of trustees have embarked on a journey to get rid of all the risks,” says Kevin Wesbroom, partner and UK lead, global risk services, at Aon Hewitt. “But in the past four years, instead of getting closer, those targets have got further away.”
Aon Hewitt’s Global Pension Risk Survey 2013 found the average timescale to reach long-term objectives – typically the buyout of benefits with an insurance policy or self-sufficiency – had risen from 11.3 years in 2009 to 12.8 years in 2013.
… a perfect storm of falling gilt yields, low equity returns, increasing inflation, greater longevity and more stringent regulatory requirements
Despite the best efforts of all concerned – the 12 months to the end of December saw £4.8 billion of risk taken out of the market, according to Grant Thornton – the death throes of the DB pension scheme are proving undeniably tricky to manage.
“We are not far off a world where DB schemes are legacy plans,” says Mr Wesbroom. “Some 44 per cent of respondents have frozen their plans as part of initial liability efforts, up from 21 per cent in 2009. It’s a case of working through both the big picture and the fine details.”
Efforts in the past few years have been squarely focused on the asset side of the problem. Liability-driven investment (LDI) – where management aims to match assets and liabilities – has been all the rage, according to Boris Mikhailov, investment principal at Mercer financial strategy group.
“Each scheme is unique, but it’s about using levers, such as derivatives or investment triggers, to change the sensitivity of the assets,” says Mr Mikhailov. “The key is to keep it under review all the time because it changes quickly.”
That has prompted innovation in analysis, with products now available that will provide monthly or even daily valuations for trustees – a very different scenario to the traditional, once-every-three-years valuations.
Asset management has got much more sophisticated. But, while the UK’s more than 6,000 DB schemes have crossed the line and are now holding more bonds than equities, (on average 43 per cent of assets are in bonds with only 38 per cent in equities, according to the UK Pensions Regulator), there is a more fundamental problem, says Alasdair MacDonald, head of investment strategy at Towers Watson: there simply aren’t enough low or no-risk investments around to soak up the liabilities.
Chipping away at the deficit from a number of different angles is how most companies must tackle the problem
“Improving solvency can’t be done overnight, even if companies had the money [to buy government bonds],” he says. “We have calculated that, given the size of UK pension liabilities, it would be 30 years before the supply of bonds is adequate to meet demand.”
It means trustees must box clever with their assets, looking instead perhaps to low-risk property, such as a building let on a long lease to government or non-UK index-linked bonds. “You can’t just make one change, you have to make three or four to move the dial,” he says.
But, while managing the assets is still a big part of de-risking a scheme, it is the flip side that is now taking centre stage. Mr Wesbroom says liability management will be the buzzwords for the next year.
“It’s a nasty phrase that has had some very bad press, but has not been used as much as it will have to be if the UK pension industry is to become risk-free,” he says.
Solutions, such as pension increase exchange (where an index-linked annual sum is exchanged for a higher flat-rate pension) or enhanced transfer values (where members are offered incentives to transfer to DC schemes), were abused to the point where last year the industry and regulators produced a code of conduct to eliminate bad practice. Such offers can still be made, but will now cost more to implement, as they must be accompanied by financial advice.
Other liability side-measures involve the undeniably dull business of data cleansing or correction, making sure that you know, for example, the date of birth of all members’ spouses or, in more advanced cases, determining whether medical annuities, which pay higher sums to those with reduced life expectancy, can be used to cut average liabilities.
“What is important is that the schemes’ sponsors and trustees understand the profile of and risks associated with their assets and liabilities,” says Mr Wilson. This will enable them to understand the future direction of scheme funding, leading to much better value for money on de-risking strategies, while ensuring they fully understand the benefits profile. This can be particularly time-consuming for fast-growing companies that have taken over a series of businesses, but will secure the company against nasty shocks in the future.
There are even simpler steps that can be taken, says Neil Lalley of Punter Southall. “It’s always worth reminding employees that they can take retirement at 55 and take a tax-free lump sum or paying out so-called ‘trivial’ pensions with a value of £18,000 or less,” he says. “It all helps to reduce the liabilities and administrative cost of running the scheme.”
Chipping away at the deficit from a number of different angles is how most companies must tackle the problem, since few have the money to plug the hole in one go. But the trend is towards full exit, says Guy Freeman, co-head of business development at Rothesay Life.
“What do we mean by de-risking? It has evolved from LDI strategies through liability management to just mean insurance,” he says. “A full buy-out [where a pension scheme’s liabilities are transferred to an insurer] is quite complex due to its finality and usually takes a very big cheque, but it’s where the industry is heading. What people are doing is educating themselves about bulk annuities and building relationships to get to full buy-outs.”
Jay Shah, co-head of business origination at Pension Insurance Corporation, agrees. “Where bulk annuity purchase drives you is into a ‘safety-first’ approach and what drives companies to write a cheque is often a demerger or sale of a subsidiary,” he says.
“But the bulk annuity market is running at between £3.5 billion to £10 billion a year and £10 billion represents less than 1 per cent of the entire UK final-salary liabilities in the private sector. If conditions suddenly come right, would the insurance sector be able to cope with demand? Some trustees are thinking it would be better to do it now, rather than in a few years when there will be more constraints.”
And, by implication, the costs will be even higher than is currently the case. Though many sponsors are limited by costs at the moment, the sheer quantity of DB schemes that will be dissolving into legacy plans over the next decade means the price of de-risking can only increase. It will pay to be ready for action sooner rather than later.
De-risking has been the watchword for defined benefit (DB) pension schemes since at least 2008. But you’d never know it by looking at the numbers.
