Pension Funds Online

Living with the Risks Is Your Pension Deficit What it Seems?

Despite growing interest in investment strategies such as Liability Driven Investment, there is still one key risk to Defined Benefit pension schemes that none of these can guarantee to solve mortality!

The volatility of investment markets means the reported pension deficits can vary drastically from one month to the next. As a result, even the best investment strategies cannot provide absolute certainty to cover all the liabilities - especially when Pensioners across all social groups are living longer. For the individuals in question, increased longevity expectations may seem like great news, especially if he or she is in a Defined Benefit (DB) pension scheme. For DB scheme sponsors on the other hand, this news may well be received with mixed feelings. The harsh reality is that, as the membership of a DB scheme matures, so does the financial burden on that pension fund.

Indeed the impact of mortality upon pension funds has long been underestimated and represents a huge gamble for DB scheme sponsors. Now with the adoption of international accounting standard IAS19 more companies are starting to report their mortality assumptions, which has helped moved this issue from a footnote in the business press to become front-page news.

What if your mortality assumptions are wrong?

Consider your own workforce. If, for example, the assumptions that underpin your financial statements prove to be unrealistic, especially in relation to increasing life expectancy, you could be underestimating the likely duration of the scheme liabilities. Longevity assumptions are affected by a number of factors, including gender, social background, occupation and geographical location. Other factors include the proportion of members having spouses or dependants. And with an increased focus on healthier living and medical advancements, mortality assumptions need to be continually reviewed.

A survey by Lane Clarke & Peacock highlighted that within the 33 FTSE 100 companies who provided longevity assumptions there was a considerable variation in assumed life expectancy, as shown in the following chart.

Life expectancy assumption in 2005
Males retiring at age 60 on the accounting date

Unless your DB scheme uses the most up-to-date information in calculating the very specific life expectancy of an individual workforce, the impact on the schemes liabilities could be catastrophic for your company, no matter how carefully planned your current pension fund investment strategy may be.

Calculating longevity successfully is a difficult science. Having a robust understanding of the mortality risk being taken on gives scheme sponsors the opportunity to manage this over time. On the other hand, if those assumptions are proved wrong, each year of extra life adds about 3% to pension scheme liabilities, see table below. So getting your mortality assumptions wrong could leave your pension scheme facing unforeseen liabilities and increasing pressure to justify low longevity assumptions by pension analysts and the pension regulator. The key question is what to do?

Source: Prudential internal calculations 2007. In this table we have assumed that the base case is for a level annual annuity payable in advance. Mortality as per 100% PMA92c2004 with 100% of medium cohort improvements thereafter, discounting at 5% per annum. Figures shown are an increase in reverse commensurate with reducing the flat, all- age mortality percentage from 100% to al level yielding 1,3 or 5 years of extra life expectancy relative to base case.

Investment versus risk

There is an argument that continued economic growth and smarter fund investment strategies could counteract the negative effects of miscalculated longevity assumptions in the long term. A large rise in equities could, in theory, eliminate much of the deficit or even all of it but who would be prepared to predict with any certainty whether the recent strong performance of equities will persist for long enough? Obviously, the more a fund relies on equity performance the greater the volatility risk. Inflation and salary increases, the prospect of future legislation, added to the ongoing costs of administering a fund, create a further drain on a schemes assets.

Whilst exposing the fund to investment risk can provide the prospect of increased returns, there is a trade-off that has to be made between protecting the scheme members interests and minimising future contributions to the scheme. Clearly these risks should be managed. At the very least, managing risk - whether part of the risk or all of it - represents a significant challenge - at most, a real burden.

Risking it all?

Schemes cannot rely on investment returns alone to bridge the gap. Lane Clark & Peacock LLP (LCP) estimates that the aggregate FTSE 100 deficit for UK defined benefit schemes was 36 billion in July 2006, compared to 37 billion in July 2005 broadly unchanged. However owing to volatile equity and bond markets, the aggregate deficit hit a high of 54 billion in January 20061. Many experts suggest that for the deficits of the FTSE 100 group of companies to be removed, the FTSE 100 index would need to increase to around 7,200. This is a big ask, especially if many schemes have reduced their equity proportion and therefore may not see the full benefit of market improvements anyway. This backdrop of instability, falling bond yields and updated mortality assumptions places an uncertain risk on company accounts.

Managing risk is clearly a highly specialised area, so it pays to talk to experts who can provide the required combination of investment and longevity expertise - as well as the necessary service and administrative back up - to provide an effective Risk Management Solution. This is where Prudential can play a key role.

The role of Prudential

Our specialist Mortality Research Team has access to one of the largest private data sets in the UK, in addition to all of the publicly available statistics. Whenever we review a scheme from a risk management perspective, we create bespoke assessments of mortality risk for each member of the workforce. This information allows us to design a tailored solution for the scheme, which meets the unique problem facing the sponsors. Prudentials Risk Management for DB Solutions are not just limited to a full Scheme buy-out. We recognise that different clients have different attitudes to risk. That is why weve developed a full suite of solutions, which can be adapted to fit specific needs. In addition, we can conduct a specific review of mortality for an individual scheme illustrating the key risk areas.

Our Structured Buyout Plan removes longevity risks immediately, and investment risks Progressively, but allows for premiums being paid over an agreed term. Prudential will then guarantee to pay employees their agreed pension benefits when they become due without the need for a significant up-front cash investment. The Refundable Buyout Plan also guarantees pension benefits but offers potential for refunds to the pension fund. These approaches differ to LDI, which seeks to remove risk however fails to address the longevity risk.

Aggregate Pension

If you would like more information on our range of solutions for managing defined benefit risk, or would like a free first analysis meeting with one of our experts, please contact either Ted Clack directly on ted.clack@prudential.co.uk or your Employee Benefits Consultant or adviser. Alternatively you can visit our website to find out about our wider range of corporate solutions.