Pension Funds Online

Strategic Planning for Pension Schemes

Looking at the turmoil in financial markets of the last two years, it is no surprise that many companies are keen to reduce the amount of risk they bear through their pension schemes.

An increasing number of companies have taken action on defined benefit pension commitments by moving to other scheme designs which leave them far less exposed to the unexpected. Such activity has, through necessity, been directed mainly at future benefits that have yet to be earned; pension rights already earned have been left largely untouched. However, these past liabilities are the main source of risk for corporates, and with almost £1trn of defined benefit pension liabilities spread across the UK private sector, companies have their work cut out in bringing those risks to heel.

Given that full scheme buyout remains unaffordable for all but the very few, the majority of pension scheme sponsors and trustees looking to reduce risk have little choice but to edge their way to relative safety over a period of years. Helpfully, pension schemes can now draw upon an increasing array of new and innovative tools to manage risk. Pensioner buy-in contracts, longevity hedging and inflation swaps are just some of the options for schemes looking to design a risk reduction strategy that fits with corporate and trustee objectives and scheme-specific circumstances.

Setting a strategic plan

The challenge is how best to plan and execute that process. A successful and cost-effective journey to safety is far more likely where the corporate sponsor and trustee set out a detailed strategic plan at the outset.

A strategic plan involves setting clear and measurable objectives. For example, a top level objective could be to reduce overall scheme risk by 50% over a five year period. However, this is only the starting point. With so many ways to reduce risk, schemes will also need to set more specific objectives.

One approach is to put together a “shopping list” of measures, where each individual activity would allow the scheme to reduce risk by a similar level. Suitable examples of these measures will depend upon the specific circumstances of a scheme, but could include:

·                     A pensioner buy-in covering 50% of pensioner liabilities

·                     A longevity hedge covering 100% of pensioners

·                     Buying swaps to lock into a real yield of say, 1% on 50% of scheme liabilities

The scheme would then have a clear view of what opportunities to focus upon in looking to achieve the top level objective.

Measuring risk

In putting together that “shopping list”, we first need to address an important and highly topical issue; how can we measure the impact of each measure on scheme risk in a reliable way?

The risk metric in most common use is Value at Risk (VaR). Originally developed by an investment bank to provide a simple metric for measuring overall risk exposures at the end of each trading day, VaR has rapidly become the market-standard risk metric across the financial world, with a wide variety of applications.

VaR has the clear benefit of simplicity; it encapsulates risk for any given portfolio of assets into one single number which shows how much that portfolio could lose, as a minimum, in say its worst year in ten.

However, VaR has been heavily criticised of late, bearing much of the blame for the failure by banks and regulators to track overall levels of risk that built up inside many financial institutions in the years leading up to the financial crisis.

Our view is that there are justifiable concerns around certain applications of VaR, in particular, when measuring absolute levels of risk, e.g. as used in the banking world. This is because VaR can only produce numbers which are reliable measures of absolute levels of risk when the assumptions behind the VaR model generally hold true. So, where reality proves to be very different from that assumed (for example, during the financial crisis), VaR output can be highly misleading. However, when looking at relative levels of risk (e.g. comparing the riskiness of two portfolios, or looking at how overall risks break down into the individual sources) VaR is a far more robust measure, as the output is less sensitive to the assumptions in the model. As an example of this, consider that whilst we may not be sure how risky it is to invest in equities, we can be confident that it is significantly more risky, over the longer term, than investing in index-linked bonds.

Returning to our “shopping list” of risk reduction measures, we can use VaR to tailor a list of measures where each would offer a similar reduction in overall scheme risk. This is using VaR in a robust way, i.e. to consider relative levels of risk.

Executing a strategic plan

Armed with the “shopping list”, a scheme is then in a position to monitor the market for opportunities to execute any of the measures, when conditions are favourable, (including available attractive pricing terms from an acceptable counter-party).

Before stepping into the execution phase, there are two other considerations for schemes, which will – if dealt with at the planning stage – help to increase the prospects of a successful outcome:

Agree up-front on what measures are acceptable and on what terms

It is essential to get prior agreement on what risk-reduction measures are acceptable, at what price and with which types of counter-party. Without advance planning and agreement the scheme may miss opportunities to reduce risk when the cost of protection is attractive. For example, schemes can reduce inflation risk in several ways through index-linked gilts, pooled LDI funds or inflation swaps. It would be better to be clear at the start of the de-risking process which of these options are acceptable to the trustees – for example, are the trustees willing to hold swaps directly given the complexities surrounding contractual terms and the need to post collateral?

Delegate and automate

Once the big decisions have been made, set up a sub-committee to work closely with scheme advisers to complete the process. Where appropriate, set market-related triggers for entering into financial contracts in advance, with automated instructions given to the investment manager. This enables swift action to be taken when the opportunity arises. With recent high levels of market volatility, schemes that wait for the next trustee or investment sub-committee meeting to rubber-stamp a transaction may miss out.

Steps for pension schemes looking to reduce risk:

Overall, we see the following steps as important steps for schemes looking to reduce risk.

·                     Create and agree a clear strategic plan, with the objective of moving to a “comfort zone” in terms of the overall level of risk.

·                     To be effective, a strategy needs to be clearly laid out at the outset, with agreement up-front between company and trustees on key issues. This minimises the risk of missing valuable market opportunities, which would otherwise help by shortening the journey to that “comfort zone”.

·                     Once drawn up, a detailed strategic plan to reduce risk will help protect the scheme against a loss of focus over time. A scheme can then move forward with a clear sense of purpose.

Biography of Jerome Melcer

Jerome Melcer is a Partner at Lane Clark & Peacock LLP, in the Investment department. He is the firm’s lead specialist in advising clients on the developing market for the transfer of longevity risk.

LCP is one of the leading firms of consulting actuaries in Europe, with a wide range of clients including some of the world’s largest companies, as well as a number of charities and unions.