Pension De-risking Should be the Priority for Corporate Sponsors

Rising longevity, poor investment returns and increased regulation have seen the costs of providing defined benefit (DB) pension schemes soar, threatening the financial viability of more and more businesses and leaving corporate sponsors facing increasingly difficult decisions about the future of their employee benefit plans. In response to these increasing pressures, many scheme sponsors have opted to go down the road of benefit re-design, and in some cases have closed the scheme completely.

Indeed, manufacturing giant Unilever became the latest corporate sponsor to decide to close its final salary scheme to its existing members in April – following in the footsteps of Asda, Northern Rock, Aviva, Taylor Wimpey and Tate & Lyle. What is more, National Association of Pension Funds figures show that as many as 17% of DB schemes were closed to existing members as at the end of 2010 (up from 7% in 2009), with a third of those remaining seriously considering reforms.

Yet with so many other potential projects on the table for scheme sponsors, is scheme closure really the best way to achieve cost savings and reduce risk? Undoubtedly the cost savings derived from closing a scheme to future accrual are far easier to quantify than the financial benefits of a hedging exercise, for example. However, this alone should not mean that de-risking is overlooked in favour of scheme closure. Indeed, further analysis shows that, for many individual companies, de-risking should be the priority.

Cost Analysis: Closure Versus De-risking

To compare the cost savings that can be achieved from these two exercises – closure to future accrual and de-risking – let us consider the DB pension schemes sponsored by the FTSE 100 as an example.

The cost of providing ongoing DB pensions to members of FTSE 100 pension schemes is around £6bn per year. Were all these pension schemes to close to future accrual and be replaced by defined contribution arrangements, the cost would fall to around £2bn per year – a total saving of £4bn.

Putting a figure on the cost saving that can be achieved from a de-risking transaction is not quite so simple, however. Indeed, many pension professionals would have you believe that rather than reduce costs, de-risking actually increases them. But is this really the case? Despite pension schemes – for the moment anyway – not being subject to capital requirements, any risk that a corporate runs does have an economic capital impact. And capital has a cost.

The latest PF Risk Report – a monthly report on the risk being run by the DB pension schemes of the FTSE 100 – suggests that the one-month 95% value-at-risk (VaR) level for the FTSE schemes on an IAS 19 basis is around £25bn (this means that there is a 5% chance that the pension deficit will increase by £25bn or more over a one-month period). If you were to extrapolate this figure out for a one-year period and increase the confidence level to 99.5% (which is more consistent with an economic capital assessment of FTSE 100 companies), the VaR figure would increase beyond £100bn.

The cost of capital for the FTSE 100 may be in the region of 8% – the cost of running this level of risk is therefore around £8bn a year. In turn, this means that a hedging exercise that successfully reduced pension risk by half would save the FTSE100 £4bn per year – the same cost saving achieved from closing the schemes to future accrual.

And what is more, there are also the intangible benefits that come from continuing to run a DB scheme, in terms of staff morale and the ability to hire top-quality employees in the future. Certainly, DB arrangements reward employee dedication and the benefits reflect the value added by staff over the full term of their careers. As such, final salary schemes are still considered by most to be the best social safety net – providing individuals with the comfort they will be adequately provided for upon retirement. The protests by workers in response to any company’s plans to close its DB scheme are testament to this.

Accurate and Timely Information is Critical

Clearly, with numerous cost saving options competing for time and resources, pension schemes need timely and accurate scheme information to be able to prioritise which solution gives them the maximum ‘bang for their buck’.

It is challenging to make effective decisions based on poor quality information yet, historically, this is exactly what pension schemes have been forced to do. Pension scheme liabilities have traditionally not been valued as frequently, or to the same level of accuracy, as market instruments or insurance liabilities. In the main, pension liabilities are fully investigated and valued only once every three years – with the results only becoming available several months after the valuation date.

And while this liability information may be updated for changes in membership and economic conditions in between full valuations, such ‘roll-forwards’ remain mere approximations. In many situations approximate figures are unsuitable for decision-making purposes.

Furthermore, accurately assessing the benefits that may be achieved through de-risking requires a detailed understanding – at a very granular level – of the sensitivity of the assets and liabilities to demographic and economic changes. Many pension schemes simply don’t have this level of information.

Without detailed information, sponsors and trustees are unable to design an effective hedge, resulting in strategies that do not always fully address the mismatch between assets and liabilities. And the costs of not getting it right can be material. A recent PensionsFirst case study illustrates a pension scheme – which was designing an inflation hedge on £1bn of liabilities using summarised liability cash flow information – significantly over-hedged its inflation risk, incurring unnecessary transaction costs equating to around £2m.

Fingers are often pointed at both trustees and corporates for slow and ineffective decision-making, but when information is not accurate or transparent and is out-of-date, who can blame them?

A Platform for Change

To this end, technology may provide the answer, with new business intelligence platforms allowing sponsors and trustees to access up-to-date and accurate valuation information that enables them to more accurately examine and measure the complex risks associated with their pension schemes. Furthermore, such technology enables sponsors and trustees to perform extremely fast valuations and cash flow modelling on assets and liabilities down to the individual member/security level. By using these platforms, users can perform instant sensitivity analysis, stress testing both assets and liabilities within a meaningful timeframe to see the true impact of scheme closure, a hedging exercise or many other strategies.

By providing sponsors and trustees with the same, transparent, consistent, and most important of all, accurate, scheme information, both parties are on the same page when it comes to understanding pension issues. In turn, this should then facilitate a more forward-looking discussion on which pension initiatives to prioritise. In many cases, such detailed analysis will show that de-risking – rather than scheme closure – is the most attractive option.

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