Delay could be the biggest risk

De-risk­ing has been the watch­word for defined ben­e­fit (DB) pen­sion schemes since at least 2008. But you’d nev­er know it by look­ing at the num­bers.

“At the end of 2012, the total lia­bil­i­ty in UK DB schemes was in excess of £1 tril­lion, with a deficit around £100 bil­lion,” says Kelvin Wil­son, asso­ciate direc­tor at Grant Thorn­ton. “That deficit has grown by about £30 bil­lion in the past five years.”

Trustees have been tak­ing one step for­ward, but two steps back amid a per­fect storm of falling gilt yields, low equi­ty returns, increas­ing infla­tion, greater longevi­ty and more strin­gent reg­u­la­to­ry require­ments.

“The vast major­i­ty of trustees have embarked on a jour­ney to get rid of all the risks,” says Kevin Wes­b­room, part­ner and UK lead, glob­al risk ser­vices, at Aon Hewitt. “But in the past four years, instead of get­ting clos­er, those tar­gets have got fur­ther away.”

Aon Hewitt’s Glob­al Pen­sion Risk Sur­vey 2013 found the aver­age timescale to reach long-term objec­tives – typ­i­cal­ly the buy­out of ben­e­fits with an insur­ance pol­i­cy or self-suf­fi­cien­cy – had risen from 11.3 years in 2009 to 12.8 years in 2013.

… a per­fect storm of falling gilt yields, low equi­ty returns, increas­ing infla­tion, greater longevi­ty and more strin­gent reg­u­la­to­ry require­ments

Despite the best efforts of all con­cerned – the 12 months to the end of Decem­ber saw £4.8 bil­lion of risk tak­en out of the mar­ket, accord­ing to Grant Thorn­ton – the death throes of the DB pen­sion scheme are prov­ing unde­ni­ably tricky to man­age.

“We are not far off a world where DB schemes are lega­cy plans,” says Mr Wes­b­room. “Some 44 per cent of respon­dents have frozen their plans as part of ini­tial lia­bil­i­ty efforts, up from 21 per cent in 2009. It’s a case of work­ing through both the big pic­ture and the fine details.”

Efforts in the past few years have been square­ly focused on the asset side of the prob­lem. Lia­bil­i­ty-dri­ven invest­ment (LDI) – where man­age­ment aims to match assets and lia­bil­i­ties – has been all the rage, accord­ing to Boris Mikhailov, invest­ment prin­ci­pal at Mer­cer finan­cial strat­e­gy group.

“Each scheme is unique, but it’s about using levers, such as deriv­a­tives or invest­ment trig­gers, to change the sen­si­tiv­i­ty of the assets,” says Mr Mikhailov. “The key is to keep it under review all the time because it changes quick­ly.”

That has prompt­ed inno­va­tion in analy­sis, with prod­ucts now avail­able that will pro­vide month­ly or even dai­ly val­u­a­tions for trustees – a very dif­fer­ent sce­nario to the tra­di­tion­al, once-every-three-years val­u­a­tions.

Asset man­age­ment has got much more sophis­ti­cat­ed. But, while the UK’s more than 6,000 DB schemes have crossed the line and are now hold­ing more bonds than equi­ties, (on aver­age 43 per cent of assets are in bonds with only 38 per cent in equi­ties, accord­ing to the UK Pen­sions Reg­u­la­tor), there is a more fun­da­men­tal prob­lem, says Alas­dair Mac­Don­ald, head of invest­ment strat­e­gy at Tow­ers Wat­son: there sim­ply aren’t enough low or no-risk invest­ments around to soak up the lia­bil­i­ties.

Chip­ping away at the deficit from a num­ber of dif­fer­ent angles is how most com­pa­nies must tack­le the prob­lem

“Improv­ing sol­ven­cy can’t be done overnight, even if com­pa­nies had the mon­ey [to buy gov­ern­ment bonds],” he says. “We have cal­cu­lat­ed that, giv­en the size of UK pen­sion lia­bil­i­ties, it would be 30 years before the sup­ply of bonds is ade­quate to meet demand.”

It means trustees must box clever with their assets, look­ing instead per­haps to low-risk prop­er­ty, such as a build­ing let on a long lease to gov­ern­ment or non-UK index-linked bonds. “You can’t just make one change, you have to make three or four to move the dial,” he says.

But, while man­ag­ing the assets is still a big part of de-risk­ing a scheme, it is the flip side that is now tak­ing cen­tre stage. Mr Wes­b­room says lia­bil­i­ty man­age­ment will be the buzz­words for the next year.

“It’s a nasty phrase that has had some very bad press, but has not been used as much as it will have to be if the UK pen­sion indus­try is to become risk-free,” he says.

Solu­tions, such as pen­sion increase exchange (where an index-linked annu­al sum is exchanged for a high­er flat-rate pen­sion) or enhanced trans­fer val­ues (where mem­bers are offered incen­tives to trans­fer to DC schemes), were abused to the point where last year the indus­try and reg­u­la­tors pro­duced a code of con­duct to elim­i­nate bad prac­tice. Such offers can still be made, but will now cost more to imple­ment, as they must be accom­pa­nied by finan­cial advice.

Oth­er lia­bil­i­ty side-mea­sures involve the unde­ni­ably dull busi­ness of data cleans­ing or cor­rec­tion, mak­ing sure that you know, for exam­ple, the date of birth of all mem­bers’ spous­es or, in more advanced cas­es, deter­min­ing whether med­ical annu­ities, which pay high­er sums to those with reduced life expectan­cy, can be used to cut aver­age lia­bil­i­ties.

“What is impor­tant is that the schemes’ spon­sors and trustees under­stand the pro­file of and risks asso­ci­at­ed with their assets and lia­bil­i­ties,” says Mr Wil­son. This will enable them to under­stand the future direc­tion of scheme fund­ing, lead­ing to much bet­ter val­ue for mon­ey on de-risk­ing strate­gies, while ensur­ing they ful­ly under­stand the ben­e­fits pro­file. This can be par­tic­u­lar­ly time-con­sum­ing for fast-grow­ing com­pa­nies that have tak­en over a series of busi­ness­es, but will secure the com­pa­ny against nasty shocks in the future.

There are even sim­pler steps that can be tak­en, says Neil Lal­ley of Punter Southall. “It’s always worth remind­ing employ­ees that they can take retire­ment at 55 and take a tax-free lump sum or pay­ing out so-called ‘triv­ial’ pen­sions with a val­ue of £18,000 or less,” he says. “It all helps to reduce the lia­bil­i­ties and admin­is­tra­tive cost of run­ning the scheme.”

Chip­ping away at the deficit from a num­ber of dif­fer­ent angles is how most com­pa­nies must tack­le the prob­lem, since few have the mon­ey to plug the hole in one go. But the trend is towards full exit, says Guy Free­man, co-head of busi­ness devel­op­ment at Rothe­say Life.

“What do we mean by de-risk­ing? It has evolved from LDI strate­gies through lia­bil­i­ty man­age­ment to just mean insur­ance,” he says. “A full buy-out [where a pen­sion scheme’s lia­bil­i­ties are trans­ferred to an insur­er] is quite com­plex due to its final­i­ty and usu­al­ly takes a very big cheque, but it’s where the indus­try is head­ing. What peo­ple are doing is edu­cat­ing them­selves about bulk annu­ities and build­ing rela­tion­ships to get to full buy-outs.”

Jay Shah, co-head of busi­ness orig­i­na­tion at Pen­sion Insur­ance Cor­po­ra­tion, agrees. “Where bulk annu­ity pur­chase dri­ves you is into a ‘safe­ty-first’ approach and what dri­ves com­pa­nies to write a cheque is often a demerg­er or sale of a sub­sidiary,” he says.

“But the bulk annu­ity mar­ket is run­ning at between £3.5 bil­lion to £10 bil­lion a year and £10 bil­lion rep­re­sents less than 1 per cent of the entire UK final-salary lia­bil­i­ties in the pri­vate sec­tor. If con­di­tions sud­den­ly come right, would the insur­ance sec­tor be able to cope with demand? Some trustees are think­ing it would be bet­ter to do it now, rather than in a few years when there will be more con­straints.”

And, by impli­ca­tion, the costs will be even high­er than is cur­rent­ly the case. Though many spon­sors are lim­it­ed by costs at the moment, the sheer quan­ti­ty of DB schemes that will be dis­solv­ing into lega­cy plans over the next decade means the price of de-risk­ing can only increase. It will pay to be ready for action soon­er rather than lat­er.