Risk management attitudes and aptitudes in the UK defined benefit market
The UK private pension system is undergoing profound change. The past decade has seen the tide swing firmly against defined benefit (DB) schemes, but despite the emerging shift to defined contribution, an estimated £1 trillion of DB liabilities still need to be managed. As scheme sponsors, in partnership with the schemes’ trustees, determine whether to retain long-term DB pension liabilities on their balance sheets, the need to effectively assess and manage pension scheme risks remains acute.
Risk study
In order to gain a better understanding of how scheme sponsors and trustees view the different risks faced by their DB schemes and to determine how well the individual factors are being managed, MetLife Assurance Limited designed and fielded the first UK Pension Risk Behaviour Index[1] (PRBI). The findings of this study paint a reassuring picture of an industry which takes a broad view of risk and is aware of the potential impact of all the risk factors it faces. That said, more detailed analysis highlights a distinct divergence between the concerns of trustees, who ascribed more importance to investment risks, and scheme sponsors, who were more focused on liability and business related risks. This demonstrates that the respective parties are most likely to focus on the factors they are primarily responsible for managing. However, this can lead to a divergence, with neither side viewing the spectrum of risks in a complete context.
Employer covenant risk
The risks of divergence are underlined by the Pensions Regulator’s recent statement on the importance of the employer covenant – “Understanding employer support for DB schemes”. It outlines the importance for trustees to fully understand the employer covenant and stresses that some schemes need to improve. Our PRBI demonstrated that trustees do not rank employer covenant risk as highly as scheme sponsors. It is worth noting that ‘employer covenant’ can cover both the sponsor’s financial strength as well as its commitment to support the scheme.
The link that the Pensions Regulator has placed between the demographic and financial risks being run by the scheme and the employer covenant should also be noted. Any framework for assessing covenant needs to be grounded in an understanding of the risks of adverse consequences to existing scheme financing as, ultimately, the scheme sponsor backs those risks. This may not be important for schemes that are over funded on a wind-up basis as they can seek the security of an insured arrangement. However, given that this is not the case for the majority of UK DB schemes, it can be argued that trustees need to ensure that processes are in place to monitor employer covenant risk closely.
This and other examples highlighted within the PRBI demonstrate clearly that the key to tackling the possible impacts from differences in priorities and alignment on risk management is increased communication. A “divide and conquer” approach is not the way ahead for trustees or scheme sponsors. More frequent communications between the two parties could help align thinking and encourage a more coordinated plan of action. A Pension Chief Risk Officer who can help trustees and sponsors with this communication, incorporating a risk-based view, could be beneficial for larger schemes, with professional trustees potentially being able to play this role in smaller schemes. This should prevent scheme sponsors and trustees from walking down separate and disjointed paths whilst still enabling them to carry out their respective responsibilities in a more integrated context.
Longevity risk
Another key consideration for scheme sponsors and trustees is the degree to which they believe they are successful in managing the most important risks facing their scheme. Ideally the PRBI should reflect consistency between the importance ascribed to a risk and the success with which it is managed. However of the 18 risks, only 8 demonstrated consistency, with longevity risk being the most extreme example.
Our study showed that longevity risk was regarded as the second most important risk factor affecting pension schemes. However, when asked to rate how well they were managing longevity risk, scheme sponsors rated their success as 18th out of 18 factors, while trustees rated themselves as 16th out of 18 factors.
Longevity is of course an issue that trustees and scheme sponsors have been grappling with for a considerable time. Part of the problem is that no one knows how long people will live and whether the trend of increased longevity will continue. Mercer’s Longevity Bulletin states that over the past hundred years, life expectancy in the UK has increased by four months every 10 years, but in the past 10 years alone, the improvement rate has been five times greater at 20 months. Moreover, those born between 1925 and 1940 have experienced even greater life expectancy, with a faster rate of improvement than for any generation born before or after.
Whilst further improvements in longevity are expected, the extent to which mortality rates will continue to fall and which age groups will experience the most significant changes are uncertain. One possibility is that longevity will continue to improve indefinitely through medical advances, improved nutrition and a better lifestyle. Conversely pandemics, war and adverse lifestyle choices will limit longevity improvements.
So it is apparent that scheme sponsors and trustees show a good understanding of the impact that longevity risk poses to their schemes and their organisations as a whole, but they believe they are not managing longevity risk effectively. This may be in part due to a lack of understanding of the range of options available to better manage this risk.
Although scheme sponsors typically have the power to close their scheme to new members and / or future accrual and manage the longevity risk through cessation of benefits, trustees and sponsors could explore potential ‘third way’ options that might help better spread longevity and investment risk between employees and shareholders. Cap and pay arrangements that allow for greater cost sharing with the scheme members is one example. In the UK, scheme benefit amendments including changing the definition of final salary, limiting salary increases for pension purposes and reducing the rate of future accrual have been commonplace. In the Netherlands, conditional indexing already allows greater flexibility for scheme sponsors and trustees to balance funding needs against a company’s financial constraints. A paper from the Department for Work and Pensions – Risk Sharing: information for employers considering making changes to Defined Benefit pension schemes – also considers other risk sharing options including longevity adjusted DB schemes. In addition, there are third party insurance products available such as buyouts, buy-ins and longevity swaps in the market that already provide the potential for trustees and scheme sponsors to transfer or mitigate the longevity risk inherent in their schemes.
Examining these options in discussion with scheme sponsors could be part of the standard covenant review process that trustees will be expected to carry out under the Pension Regulator’s latest guidance.
Data quality risk
Our study also demonstrated the case of risks attributed as less important but with greater success in risk management, for example in the case of data quality. We found that scheme sponsors and trustees collectively ranked success in managing quality of data risk as 6th among the 18 risks monitored. However, when it came to ranking the importance of quality of data risk it sank to 16th out of 18 risks. So do trustees consider data quality to be a less important risk because they believe they are managing it well – and if so are they right to suppose this? It really depends on how they are measuring their success. If it is on the basis of the scheme not receiving complaints from its members then this might be the wrong measure. A better gauge of success would perhaps be the readiness of the scheme for completion of a Pension Protection Fund assessment period.
Indeed, the Pensions Regulator’s guidance on targets for member record-keeping reported “encouraging signs of progress” but stressed that it has yet to “see the significant improvements we expect”. It is clear that the Pensions Regulator is focused on improvements in data quality and it has underlined its determination to tackle the issue by setting a target deadline of December 2012 for the resolution of data issues. Whilst this should concentrate minds, it is clear that trustees and scheme sponsors should be taking action now to identify whether they face data issues and instituting a ‘Data Recovery Plan’ which sets realistic and achievable goals.
There are powerful motivations beyond the regulatory focus for trustees to improve the quality of member data in their schemes. Poor record-keeping can lead to significant additional costs in a number of areas including administration, inaccurate actuarial valuations and even claims from disgruntled members. In de-risking exercises it can affect the speed and effectiveness of the exercise. Taking buyout as an example, bad data can substantially lengthen the overall process from initial take-on of the members’ liabilities to full discharge of the trustees – in some cases in excess of a year.
Indeed, all the research from the Pensions Regulator and the industry indicates that many schemes do face data issues. The most important first step for trustees is to understand the data their scheme already holds and then to identify short, medium and long term targets for improving the data where necessary. Trustees also need to consider the Pensions Regulator’s timetable. Whilst the December 2012 deadline seems to be immovable, for some this will be too late and for others potentially unachievable. Those schemes considering de-risking for example should not wait to improve the quality of record keeping as it is so key to a successful process. For those whose data requires a significant amount of work the implementation of a Data Recovery Plan, even if it has not been completed by 2012, is a clear indication that trustees and scheme sponsors have taken responsibility for the quality of data in their scheme and demonstrates to regulators that record-keeping is taken seriously.
The importance of managing data quality will inevitably increase and trustees and scheme sponsors should be focusing on the issue irrespective of the Pension Regulator’s deadline. December 2012 may seem like a long way off, but there is no time to waste improving quality of data.
Summary
The full PRBI study can be found at www.metlife.co.uk/metlifeassurance - we believe it establishes a baseline for the current state of risk management within DB pension schemes and identifies emerging risk management gaps. Finally we hope that this inaugural study will serve as a benchmark against which future risk management attitudes and perceptions can be measured, and becomes a useful tool for scheme sponsors and trustees as they explore risk management strategies with one goal in mind, protecting member benefits.
[1] The MetLife Assurance Limited UK Pensions Risk Behaviour IndexSM surveyed 89 respondents (47 scheme sponsors and 42 trustees) between December 2009 and February 2010 on how they viewed 18 investment, liability and business risks impacting their schemes and how well they believe they are managing those risks.
Company Profile
MetLife Assurance Limited is an insurance company authorised and regulated by the FSA to provide bulk annuity solutions for occupational pension schemes. We take pride in developing the right pension risk management solution for each client. Our experienced team works closely with trustees, pension managers, employers, consultants and advisors to understand their unique needs and financial goals, and help them bridge the gap from pension risk to future security.
We replace the uncertainty of pension scheme risk with the security of an insurance contract, offering a range of full, partial and tailored pension risk management solutions. Our solutions are backed by our strong capital position (rated A+ by Standard & Poor's) and financial strength, and built upon over 85 years of pension risk management experience in the US. Clients of MetLife Assurance and their scheme members can feel secure in our dedication to providing their pension benefits with a high level of service and customer care.
For enquiries, please call Emma Watkins, Head of Relationship Management on 0207 557 4926 or 0207 557 4900, or email ewatkins1@metlife.com
For more information visit www.metlife.co.uk/metlifeassurance
Emma Watkins
Head of Relationship Management
MetLife Assurance Ltd.