Pension Funds Online

De-risking UK pensions

There has been rapid growth in the range of de-risking solutions available to UK pension plans. In this article, Clive Wellsteed of Lane Clark & Peacock explores the main de-risking options being used by UK pension plans and also identifies examples of where the same ideas are being used in other countries

1. Investment - setting a strategic framework

A variety of factors have contributed to a sharp reduction in risk appetite amongst UK pension plan trustees and sponsors.  These include:

• a diminishing investment horizon as pension plan membership profiles mature;
• mark to market valuations for plan funding and financial reporting, which means funding level volatility can have a direct impact on financial results; and
• the experience of the financial crisis which highlighted the scale of investment risk many pension plans were running.

The problem that many pension plans face is that they are closed, underfunded, rapidly maturing and have limited appetite for risk. Therefore, many remain minded to take investment risk to help mitigate the deficit.  The challenge is therefore how to de-risk affordably, without sacrificing the potential to close deficits through investment returns.

We believe that pension plan trustees should plan ahead and be in a position to capitalise on any favourable changes in market conditions.  We expect to continue to see volatility in financial markets going forwards, which may present attractive opportunities to de-risk. 

However, the typical trustee decision-making framework makes it difficult in some cases to capture opportunities in volatile markets.  These challenges can be overcome by thinking ahead and knowing the answers to questions such as:

• What would we do if equity markets went up by 30%?
• What would we do if interest rates went up by 1%?

Both of these scenarios would likely result in a substantial improvement in the funding position and may offer opportunities to de-risk on attractive terms.  Exactly what you would do in each scenario depends on many factors (including liability profile, current investment strategy, funding position, strength of sponsor covenant, etc), but by agreeing those actions today trustees have a much better chance of actually seizing an opportunity and taking action when it arises.

Two examples when trustees have been successful in capturing opportunities to de-risk are provided below.  In both cases, the trustees considered in advance what they would do in certain market conditions and agreed market-based triggers for implementing specific changes to their strategy. 

Equity triggers

In this example, the trustees determined what levels of equity returns were required to close the deficit and set market-based triggers for selling equities when specific performance targets had been achieved.

Source: Bloomberg

The chart shows that the trustees were able to significantly reduce their equity exposure in the rising equity markets of 2007 and thereby avoided some of the potential losses when markets turned with the onset of the financial crisis.  Note that returns are measured relative to a proxy for the change in the assessed value of the liabilities.

Liability hedging

In this example, the trustees determined what levels they believed were attractive for hedging interest rates and inflation and set separate market-based triggers for hedging these risks independently.

The chart shows that by setting separate triggers in anticipation of market volatility, the trustees were able to lock into an effective real yield (ie the yield net of inflation) of 1.7% which was much greater than the real yield which could have been achieved at any single point in time.

Even if pension plans can’t afford to de-risk today, there will be opportunities to de-risk in the future.  A trigger based approach provides a pre-defined road-map between the current position and a better funded, lower risk position in the future.  With careful planning and preparation, in anticipation of market volatility, pension plans should be able to capitalise on these opportunities when they arise rather than reflect on what might have been. 

In summary, market volatility can be a good thing, but only if you are organised.

2. Transferring risk to insurance companies
 

The market in the UK for transferring defined benefit pension obligations to insurance companies (the “buyout market”) has matured since its rapid growth over 2007 and 2008.  It is now four years since the market was shaken-up by the entry of new specialist insurance companies such as Paternoster and Pension Insurance Corporation. 

What types of transaction characterise the market?

The pension buyout market in the UK is currently characterised by two main types of transaction:

• Full pension buyouts where a legacy pension plan is terminated and wound-up by the sponsoring company with all assets and pension obligations transferring to an insurance company.  Any funding shortfall would need to be met immediately by the company, so given current low funding levels, such transactions have occurred only where the pension plan is relatively small in the context of the company.  Recent examples include deals by the pension plans of Liberty International for £60m and Denso for £140m.
• Pension buy-ins where a pension plan transfers assets to an insurance company and in return the insurance company takes on responsibility for meeting the pension payments for a group of members.  2009 saw large buy-ins covering pensioner members (where pricing has looked most attractive).  These are often used as a stepping stone towards a full buyout when funding permits.  Recent examples include deals by the pension plans of Cadbury for £500m and the Merchant Navy Officers Pension Fund for £500m.

A number of the larger pension buy-ins, such as MNOPF and CDC, have included additional features to protect against the possibility of insolvency of the insurance company – typically through designated pools of ring-fenced assets.

What is the current state of the market?

In 2009, £3.7 billion of pension buyout business was completed in the UK, down from the record levels of £7.9 billion in 2008.  This reduction was partly driven by concerns over the solvency of financial institutions. However, these fears largely receded with volume levels picking up later in the year.  Around £4 billion of longevity swaps were also written so overall liability risk transfer volumes remained similar to 2008 levels.

The following chart shows the key transactions in the UK pension buyout market over 2009 and the market share by volume for the insurance companies.

Overall, eight insurance companies were active in 2009 with an increasing focus on different segments of the market.  Prudential chose to stay out of the market during 2009 and Paternoster withdrew from writing additional pension buyout business until they had raised further capital. 

What does the future hold for the UK market?

The UK pension buyout market continues to be active, with Aggregate Industries completing a £300m transaction in February 2010.  There is no doubt that the demand for de-risking remains strong with many companies and pension plans in the process of reviewing risk transfer options. 

Recent gains in equity markets and increases in bond yields have helped to improve pension plan funding levels. Combined with improving corporate cashflow, buyouts and buy-ins are looking increasingly affordable.  We expect the market to continue to grow.

3. Longevity swaps

2009 saw the first longevity swaps written by UK pension plans.  In May, Babcock International announced that it had secured a deal with Credit Suisse to hedge out the longevity risk of one of its pension plans and by the end of the year six such deals had been completed. 2010 has so far continued the trend with BMW UK announcing a deal with Deutsche Bank for a £3bn longevity swap – the largest yet.

What are longevity swaps and why are pension plans using them?

A longevity swap is a contract between two parties who agree to exchange cash payments in the future.  Under the swap, the pension plan’s payments are fixed whilst payments by the counterparty (typically a bank or an insurance company) are dependent upon how long the members covered by the swap actually live. 

Once struck, a longevity swap removes from the pension plan any exposure to the risk that members (typically pensioners) covered by the swap live longer than assumed.  The swap counterparty takes any gains, or losses, that arise in future from pensioners dying earlier, or later, than expected. 
Given that life expectancy has been increasing significantly in the UK for several decades removing this risk has been seen as an attractive proposition. The key issue is the cost at which the risk is removed.

Are longevity swaps expensive?

The cost of a longevity swap can be thought of as the difference between the value of the payments the pension plan expects to receive from the counterparty and the value of the fixed payments that it must pay under the swap.  In practice, a key influence will be the pension plan’s actuary’s assumptions for life expectancy.  If the actuary’s view of life expectancy is relatively cautious, the swap might appear better value than if the actuary’s view of life expectancy is less cautious.  For example, if the actuary’s view of average life expectancy is two years less than assumed in the swap, then the swap will appear more expensive than if his view of average life expectancy were only one year less than assumed in the swap.  For this reason, it is important to compare to a best estimate view of mortality and to consider the impact of this best estimate changing in the future, both with and without the swap in place.

What risks are there?

There are several important risks to consider, including:

• The risk the counterparty becomes insolvent.  To mitigate this risk, longevity swaps are usually collateralised. For example, should actual death rates be lower than assumed in the swap (ie the pensioners are living longer), then assets will be passed from the counterparty to the pension plan reflecting the increased value of the swap.
• The risk that the swap cannot be unwound on acceptable terms in future.  This may be a particular concern where a pension plan is planning to move to full buyout at some later date.
• The risk that the swap does not provide a full hedge for the pension plan’s specific longevity risk.  It is for this reason that longevity swaps executed so far by pension plans have been structured on a bespoke basis, as this risk can be almost eliminated.

4. De-risking outside the UK

Increasingly, pension funds and companies around the world are using similar de-risking approaches to manage their pension liabilities.  Here are some examples:

• In Germany, medium-size companies are now following many of the DAX-30 and setting up funding vehicles to partially, or fully, fund previous their pension liabilities, and therefore reduce the level of apparent leverage in the company, as well as balance sheet volatility and protect against future cash flow strains.
• In the Netherlands there is increased interest in pension buyout transactions as, following improvements in funding levels since the end of 2008, plan assets in many cases [may] now exceed the cost of insuring guaranteed benefits.
• Some Swiss pension funds are looking at ways to use financial market instruments to protect against reductions in funding level (eg "cap and collar" strategies).  One innovative method being promoted by some banks is the use of Constant Proportion Portfolio Insurance ("CPPI").  CPPI involves the use of advanced mathematical models to frequently adjust the asset allocation in response to market movements and therefore provide downside protection against falls in asset values.  However CPPI does have some disadvantages (eg rebalancing costs, liquidity issues, allowance under pension fund investment guidelines) which would need to be minimised for this to become a viable option for most Swiss pension funds.
• Some of the longevity swap providers are now focussing on other European markets.  We may not see deals outside the UK in 2010 – but we probably will in 2011 as the understanding of these products improves and there is greater awareness of mortality risk in other countries.

Elsewhere, multinationals are applying techniques widely used in the UK in their foreign pension plans.  Examples of steps recently taken by UK FTSE 100 companies are:

• Diageo have used financial swaps to hedge approximately 40% of its £1.3 bn Irish pension liabilities against future movements in interest rates and inflation. 
• Invensys de-risked their £1.2 bn US plan investment portfolio and reduced their equity allocation to just 11%. 
• Unilever insured their pension liabilities in Denmark which also resulted in a €42 million cash refund to the business.

5. Conclusion

The basic principle of a successful de-risking programme is to plan in advance and set up mechanisms to lock in favourable investment performance when it occurs.  By doing this, pension sponsors and trustees in the UK and internationally can successfully capture future opportunities to reduce risk. 

Clive Wellsteed is a Partner at Lane Clark & Peacock LLP and Head of LCP Buyout Practice.
The views expressed in this article are those of the author and not necessarily those of LCP as a firm. The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities.

To download LCP's Pensions Buyouts 2010 report please see www.lcp.uk.com/buyouts