Pension Funds Online

The Current State of Play

The environment for pensions has gone through monumental changes over the last 30 years. If the past was a golden age, now apparently irretrievably lost, the present may represent the beginning of a new era. The future will remain unpredictable, but the risks inherent in pensions are now better understood, monitored and controlled. Most of the components necessary to allow this transformation to be realised now seem to have emerged, and new solutions are beginning to form.

Perhaps the most important of these is the move away from defined benefit solutions towards defined contribution solutions. While it is with regret that the security and utility of salary-linked income in old age is increasingly being withdrawn, the cost to many employers seems unaffordable in a world dominated by intense competition and the need for increasing returns on capital.

DB pension schemes are both complex in themselves and complex in relationship to their sponsors. There are few contracts in the financial sector that parallel the duration of DB pension benefits that extend commonly in excess of 50 years. And yet such exposures are not uncommon in the DB world. The Purple Book, issued by the Pensions Regulator and Pensions Protection Fund, indicates that the average age of active members is only 45.4 years – implying at least four decades of further life for the average scheme member. Current longevity estimates indicate that average life expectancy is increasing, with the rate of increase apparently accelerating. Even the British Government is proposing to address this issue by deferring the availability of State pensions from 65 to 68.

Increasing longevity and its cost implications is the single most important issue facing the DB sector. Many schemes are actively addressing this issue through a variety of approaches ranging from, in the extreme, closing schemes to future accruals through to restricting future benefits, increasing contributions or raising retirement ages. For those schemes that remain open, the principle issue is balancing the increasing real costs of DB provision against the overall cost of employment.

Even where schemes have been closed and alternative defined contribution pension arrangements introduced, scheme sponsors are faced with significant and persistent legacy problems. Running off existing pension obligations is likely to stretch over decades. The options for such schemes and their sponsors are relatively limited even for those schemes that are fully funded. Very many are not. As the Purple Book indicates the average funding level is currently only 80%.

For closed schemes, whether to new members or future accruals, the broad options comprise:

• Full or partial buyout: inevitably this is an expensive option but provides a complete exit strategy. While highly attractive in principle, it will generally represent a 'once and for all' deal that can only be judged with hindsight. Moreover the costs must be justified to shareholders against the other uses to which the money might be put. In many cases, maintaining and expanding the business will take higher priority.
• In practice, buyout is an unaffordable option for many sponsors – particularly where the scheme has a deficit that is required to be rectified before buyout can even be contemplated. Again, the Purple Book indicates that for those schemes captured in its database the full cost of buyout is £1,075.8 billion – some £440.4 billion in excess of current scheme assets.
• Work towards achieving and maintaining full FRS17 funding, or even a modest surplus. The achievement of full funding is a significant goal for scheme trustees and for the Pensions Regulator. Given the complex interactions between scheme liabilities, asset values, and yields, and inherent market volatilities, there is clear attraction in targeting a modest surplus of assets over liabilities to provide some degree of protection against market movements, further changes in longevity and, ultimately, sponsor insolvency.
• Many sponsors have taken the decision to accelerate contributions into DB schemes encouraged to some extent by the workings of the Pension Protection Fund risk based levy. But while full funding is a highly desirable goal, it does not, of itself, address the volatility that DB schemes can impose on the sponsor. This level of volatility can be considerable – we have seen schemes where liabilities are several times the scheme sponsors net equity. In this situation relatively small percentage changes in scheme asset or liability values can have a major impact on the net asset position of the sponsor.
• How supportable will pensions be in the future? In many cases in, say, 20 or 30 years time, the links between scheme sponsor and the members of long closed schemes are likely to have become remote. But sponsors will remain responsible for fulfilling pension promises made many years before, and will, in effect, be pledging their balance sheet to support a complex financial entity with little direct relationship with their core business.
• In this context, there has to be long-term pressure on trustees to seek to achieve a surplus of scheme assets over liabilities. This will appear desirable to provide a risk buffer against any faltering or diminution of the link between the scheme and the sponsor. From the trustees perspective, their position is not wholly dissimilar from that of the buyout underwriter. How much surplus is required to fully fund the schemes liabilities to extinction and reduce any further dependence on the sponsor?
• From a sponsors perspective, the challenge of funding a surplus of assets over scheme liabilities is an exposure to potentially stranded assets. The rules are such that any such excess cannot be returned to the sponsor until virtually all the pension liabilities have been extinguished. While the scheme surplus is accounted for as part of the sponsors net equity, it is unavailable in cash terms for use within the sponsors business to generate additional returns.
• Adopt a liability driven investment (LDI) strategy. Starting from a clear understanding of scheme liabilities, an LDI strategy can provide better – and longer – asset liability matching than can be achieved simply through bond based investments, while at the same time achieving protection against interest and inflation risk. There are diverse financial products available that can be broadly categorised as interest rate and inflation swaps and options. The broad intention is to stabilise asset values e.g. equity sale options or to fix the value of debt in terms of future interest or inflation rates. The advantage of using of derivatives rather than bonds to match scheme liabilities is, in part, that this can leave capital free for investment in higher yielding investments.
• While these approaches can stabilise the schemes balance position – they do so only in respect of particular drivers of change such as inflation or discount rates and are available at not insignificant cost. The main deficiency here is that there are currently no products to provide protection against the risk of increasing longevity. While it is thought such products may emerge in the future – there is no certainty that they will emerge in sufficient quantity to meet likely demand from the sector as a whole or that they will be of sufficient duration to provide a useful level of protection.

As an addition to these broad options, we have developed an innovative, insurance based, approach. PensionsRisk Insurance (PRI) provides stability for DB schemes on a medium term basis (e.g. 10 years). It uses well-established non-life reinsurance techniques, which, coupled with pre-determined risk sharing arrangements, align the interests of trustees, scheme sponsor and insurer.

The main features of this approach are:

• An insurance contract between the trustees, sponsor and a regulated insurer. Usually for a 10-year term, the contract is designed to align with the Pensions Regulators guidelines for deficit rectification, but could be for a greater or shorter period.
• The insurer funds all payments that fall due during the period of the contract, and at the end of the period passes back to the scheme assets equal to an agreed and predetermined percentage of those liabilities as valued at that time.
• Subject to limits, the scheme is protected against all causes of liability deterioration including decreased discount rates, changes in longevity assumptions during the period and movements in asset values and yields.
• In the event of sponsor insolvency, the insurer provides not less than 104% of the protected liabilities to the Pension Protection Fund.

In return for this insurance cover:

• The sponsor pays the insurer an annual risk premium throughout the period of the contract, together with any amounts agreed with the trustees as appropriate to make good any scheme deficit.
• The schemes existing assets are transferred to the underwriter who manages them, together with any deficit rectification contributions and the PRI premium, for the duration of the policy.

The arrangement is fully flexible. While the insurer has no right to cancel, where the trustees and sponsor so agree they can cancel, at any annual anniversary. Such cancellation is likely to involve some predetermined penalty charge to compensate for loss of premium.

At the end of the contract sponsor and trustees are entirely free to revert to direct operation of the fully funded scheme, consider a buyout at that time or renew the PRI protection for a further period.

PRI provides numerous benefits:

• Both scheme sponsor and trustees have protection from adverse developments for the scheme and its impact on the sponsor over a realistic time scale and on a predetermined basis. This should free the sponsor in particular to concentrate fully on the management of the core business without distraction.
• The sponsors reported FRS17 balance is fully stabilised and will reduce in line with the deficit rectification payments.
• Subject to limits, the scheme is fully protected from all sources of deterioration including increasing longevity.
• The danger of stranded assets is avoided for the sponsor without diminishing the level of security received by the trustees.
• The cover is consistent with the ethos of pensions regulation and underpins the link between employers and their DB schemes.
• The sponsor and trustees acting in full agreement maintain complete flexibility both throughout and at the end of the policy.

PRI is affordable, particularly in relation to the costs of a full buy out. The Purple Book indicates that, on average, full buyout costs are 49% greater than the FRS17 liabilities. Our understanding is that this estimate of the buyout premium may be somewhat overstated and current market pricing indicates that a buyout premium of 30-35% might be more usual. While each scheme is unique our modelling indicates that a much lower equivalent cost applies to PRI cover – probably in the region 5.0 - 7.5 % spread over 10 years. Where sponsors and trustees are prepared to meet a stated first loss or to accept lower limits on underwriters total liability this premium range can be further reduced, albeit at the expense of the resilience of the cover being purchased. The actual costs will depend on the circumstances of each case.

In fact, discussion with sponsors and trustees indicates that there is significant appetite for what, in general insurance business, might be termed excess of loss cover rather than 100% protection. That is, within certain boundaries sponsors and trustees can tolerate a degree of scheme volatility but beyond that tolerance full cover is required. This risk based approach fully complements the risk analysis that trustees are required to assess of the probability of the scheme sponsors default in the event of outstanding contributions to the scheme and the risk characteristics of the schemes investment principles.

Overall, we believe that insured solutions for DB schemes are a powerful and useful development for tackling the challenges of the future. Clearly, they will not be possible in every situation and their cost versus benefit will not appeal to all sponsors and trustees. But as a new and cost effective solution, we believe that PRI should be considered by all sponsors and trustees alongside the existing approaches set out above.