An employer’s guide to pension de-risking

It is not unheard of for the col­lec­tive val­ue of the UK pen­sion indus­try to oscil­late by £40 bil­lion in a week. Trustees of most defined ben­e­fit (DB) schemes are also bur­dened by huge deficits and increas­ing longevi­ty of their mem­bers. They want out.

Indeed the aggre­gate deficit of the 6,316 schemes in the Pen­sion Pro­tec­tion Fund 7800 Index was £114.8 bil­lion at the end of Sep­tem­ber with total assets of £1,118.7 bil­lion and total lia­bil­i­ties of £1,233.5 bil­lion. There is no end in sight to their pain. So trustees are look­ing at ways to cut their risk.

Sime­on Willis, prin­ci­pal con­sul­tant, invest­ment advi­so­ry at KPMG, explains: “This risk can be par­tic­u­lar­ly trou­ble­some if the pen­sion scheme deficit has poten­tial to impact cred­it rat­ing and there­fore abil­i­ty to raise cap­i­tal or sim­ply result in large cash con­tri­bu­tions which affect the abil­i­ty of the firm to make mon­ey.”

Experts have come up with a myr­i­ad of ways of cut­ting risk both of assets and lia­bil­i­ties (the mon­ey due to pen­sion­ers). As Nick Fly­nn, divi­sion­al direc­tor – longevi­ty at LEBC, warns: “By over­fo­cus­ing and sim­ply man­ag­ing the invest­ment risks, trustees have been caught out by events in oth­er areas which mean that, despite good invest­ment per­for­mance, deficits have widened.”

Buy-outs and buy-ins with insur­ance com­pa­nies are pop­u­lar choic­es. More than one mil­lion mem­bers of DB pen­sion schemes will receive their pen­sion from insur­ance firms by 2017. Also wide­spread is lia­bil­i­ty dri­ven invest­ment (LDI), longevi­ty hedg­ing tech­niques and pen­sion increase exchanges where mem­bers forego future increas­es in their pen­sion in return for a larg­er sum at out­set.

Pen­sion trustees are clam­our­ing to buy-out. Indeed, 2013 is shap­ing up to be the biggest year for buy-ins and buy-outs since the bank­ing cri­sis of 2008 with deals worth more than £5.5 bil­lion, includ­ing the record £1.5‑billion buy-out by EMI with Pen­sion Insur­ance Cor­po­ra­tion.

If a pen­sion scheme has a large gilts hold­ing, Emma Watkins, part­ner in con­sul­tants LCP, says it can use the hold­ing “to pay the pre­mi­um for a buy-in pol­i­cy cov­er­ing all or some of their pen­sion­ers”. “This locks down longevi­ty risk on the lia­bil­i­ties cov­ered, cap­tures val­ue from cur­rent high gilt prices and can often be done for lit­tle to no fund­ing impact,” she says.

2013 is shap­ing up to be the biggest year for buy-ins and buy-outs since the 2008 bank­ing cri­sis

The recent Rothe­say Life £484-mil­lion pen­sion­er buy-in from the Philips Pen­sion Fund, where gilts and cash were exchanged for an insur­ance pol­i­cy, gave the fund a secure, low-risk asset with cov­er against longevi­ty risk and pen­sion increase risk.

Buy-outs of small­er, closed pen­sion funds can make sense for big­ger com­pa­nies so that man­age­ment time can be focused on any remain­ing larg­er plans. Mar­tyn Phillips, direc­tor at JLT Employ­ee Ben­e­fits, points to over­seas par­ent com­pa­nies buy­ing-out small UK schemes.

Merg­ers and acqui­si­tions can be a use­ful cat­a­lyst. Dominic Grim­ley, prin­ci­pal con­sul­tant at Aon Hewitt, says “the sale of a com­pa­ny may trig­ger a sub­stan­tial pay­ment to the pen­sion scheme, mak­ing buy-out afford­able”.

Ian Aley, head of pen­sion risk solu­tions at con­sul­tants Tow­ers Wat­son, points to more non-pen­sion­er mem­bers being cov­ered. “Tra­di­tion­al­ly the pric­ing for these mem­bers has been a long way from the val­ue of assets that the scheme has set aside to make pay­ments to them, but our expe­ri­ence is that the gap has closed this year. This could make whole scheme buy-outs more afford­able for scheme spon­sors,” he says.

Schemes can also ben­e­fit from enhanced med­ical­ly under­writ­ten pen­sion­er buy-ins from such firms as Part­ner­ship and Just Retire­ment, secur­ing sav­ings of 10 per cent or more on stan­dard rates.

Will Hale, direc­tor of cor­po­rate part­ner­ships at Part­ner­ship, an enhanced annu­ity spe­cial­ist, enthus­es: “Sophis­ti­cat­ed under­writ­ing tech­niques, which have made a sig­nif­i­cant impact in the indi­vid­ual annu­ity mar­ket by increas­ing retire­ment incomes for peo­ple with health or lifestyle con­di­tions, can now pro­vide a cost-effec­tive way for cer­tain defined ben­e­fit schemes to insure their lia­bil­i­ties.”

Anoth­er de-risk­ing solu­tion is LDI but tim­ing is all. Tim Giles, part­ner of con­sul­tants Aon Hewitt, explains that LDI focus­es on remov­ing inter­est and infla­tion risk. “Inter­est rates dri­ve the price of LDI,” he says. “If you expect inter­est rates to rise and the con­se­quent price of LDI to fall, then you may want to delay buy­ing to improve your fund­ing posi­tion.”

What if all these options give trustees a headache? There is also fidu­cia­ry man­age­ment from experts who, Sion Cole, also a part­ner at Aon Hewitt, claims “under­stand the com­plex­i­ties of the mar­ket, giv­ing the abil­i­ty to react quick­ly to changes in mar­ket con­di­tions”.

UNLOCKING THE JARGON

BUY-IN

A pen­sion­er buy-in is an insur­ance con­tract held by the trustees as an invest­ment of the pen­sion plan. It pays a month­ly income to the trustees, typ­i­cal­ly equal to the ben­e­fit pay­ments that the trustees are due to make to a spec­i­fied group of mem­bers, for exam­ple cur­rent pen­sion­ers. In doing so, it hedges under­ly­ing inter­est rates, infla­tion and longevi­ty risks, so pro­vid­ing a per­fect match accord­ing to con­sul­tants LCP.

Under a buy-in, mem­bers are treat­ed equi­tably, both on an ongo­ing approach and on wind-up; for exam­ple the pay­ments under a buy-in can be restruc­tured to com­ply with the statu­to­ry pri­or­i­ty order if required, which is a key trustee con­cern. Admin­is­tra­tion is typ­i­cal­ly retained by the trustees, so mem­bers see no change in the way their pen­sions are paid. The pen­sion lia­bil­i­ties remain in the pen­sion plan until the trustees ask the insur­ance com­pa­ny to trans­fer the pol­i­cy into the names of indi­vid­ual mem­bers (at buy-out).

A ben­e­fit of buy-in is that the insur­ance frame­work in the UK pro­vides a high lev­el of cer­tain­ty that pen­sions will be paid. In addi­tion, back-up from the spon­sor­ing com­pa­ny remains as an addi­tion­al pro­tec­tion until the pol­i­cy is con­vert­ed to buy-out.

BUY-OUT

A buy-out is a two-stage process – the ini­tial buy-in fol­lowed by buy-out once the trustees are hap­py with the ben­e­fits secured under the buy-in. At this point indi­vid­ual poli­cies are issued to each mem­ber in the pen­sion plan. This sig­nals com­ple­tion of the buy-out and the plan can wind up.

The buy-out pass­es respon­si­bil­i­ty for pay­ing ben­e­fits to mem­bers from the trustees to an insur­ance com­pa­ny. In turn, it removes the pen­sion lia­bil­i­ties from the plan and the com­pa­ny bal­ance sheet in full. Once the pre­mi­um is paid in total, no fur­ther fees or levies are payable.

On buy-out, mem­bers become insur­ance com­pa­ny pol­i­cy­hold­ers, allow­ing them to ben­e­fit direct­ly from the strong insur­ance frame­work in the UK, includ­ing the Finan­cial Ser­vices Com­pen­sa­tion Scheme, and trustees are dis­charged from any lia­bil­i­ty to meet future pen­sion ben­e­fits for all insured mem­bers.

Aside from small­er pen­sion plans and plans with de-risked invest­ment strate­gies, con­sul­tants LCP say the amount of cash required to sup­port a full buy-out can be too high for some com­pa­nies to jus­ti­fy it to their share­hold­ers, not least because cash top-up would lock into the record low long-term inter­est rates.

LIABILITY DRIVEN INVESTMENT

The Bank of England’s efforts to boost the econ­o­my with quan­ti­ta­tive eas­ing has been night­mar­ish for defined ben­e­fit pen­sion schemes, dri­ving down bond yields. Schemes which have not hedged against this pos­si­bil­i­ty have seen their deficits and recov­ery times length­en despite strong asset growth. They face a famil­iar predica­ment of seem­ing­ly opposed options of want­i­ng to reduce risk, but not lock in at such low yields.

Lia­bil­i­ty dri­ven invest­ment (LDI) can help. It is an invest­ment strat­e­gy which aims to con­trol risks stem­ming from both lia­bil­i­ties and assets. LDI could involve just increas­ing the dura­tion of a gilt port­fo­lio or may, for exam­ple, hedge inter­est rates and infla­tion risk using swaps, (deriv­a­tive con­tracts). Infla­tion hedg­ing has proved more pop­u­lar than inter­est rate hedg­ing recent­ly.

LDI now cov­ers £446 bil­lion of lia­bil­i­ties in the UK, accord­ing to KPMG, with both pooled and seg­re­gat­ed prod­ucts avail­able. Sev­en­teen firms offer LDI in Britain, although the sec­tor is dom­i­nat­ed by Legal & Gen­er­al Invest­ment Man­age­ment, Insight and Black­Rock. These three firms con­trol some 90 per cent of the mar­ket with Legal & Gen­er­al hav­ing a huge 43 per cent share. LDI should be treat­ed holis­ti­cal­ly along­side longevi­ty hedg­ing, insur­ance solu­tions, ben­e­fit changes/liability man­age­ment, fund­ing strate­gies and volatil­i­ty con­trolled growth strate­gies.

FIDUCIARY MANAGEMENT

Two thirds of trustees spend no more than five hours on invest­ment each quar­ter, accord­ing to con­sul­tants Aon Hewitt. Wait­ing for a quar­ter­ly trustee meet­ing for deci­sions may mean los­ing out on invest­ment oppor­tu­ni­ties, such as de-risk­ing at a favourable price. So, in addi­tion to accoun­tants, lawyers and con­sul­tants, there is a new breed of expert on the scene – fidu­cia­ry man­agers. As third par­ties, they take the main respon­si­bil­i­ty for some or all of a pen­sion scheme’s invest­ment deci­sions, but the trustees retain ulti­mate respon­si­bil­i­ty for their invest­ments, focus­ing on strate­gic allo­ca­tions.

Fidu­cia­ry man­age­ment, also known as del­e­gat­ed con­sult­ing, imple­ment­ed con­sult­ing and sol­ven­cy man­age­ment, was vir­tu­al­ly unknown in the UK a few years ago. Now it is begin­ning to take off, par­tic­u­lar­ly among small­er schemes with lim­it­ed resources. In the UK, the fidu­cia­ry man­age­ment mar­ket is approach­ing £60 bil­lion. Full del­e­ga­tion accounts for £28.7 bil­lion with 211 man­dates, around 2.5 per cent of total UK pen­sion assets, with just under £30 bil­lion man­aged on a part­ly del­e­gat­ed basis across 135 man­dates, accord­ing to KPMG.

Invest­ment con­sul­tants hold 90 per cent of the appoint­ments, so there could be a dan­ger of con­flict of inter­ests and extra spend in yet anoth­er tier of advis­ers. Look for a proven long track record and trans­par­ent fees.