Pension Risk: Tackling the Three Main Challenges

Planning for an uncertain future is a key part of pension
scheme management. There is now an increasing desire from both corporate
sponsors and trustees to remove or reduce some of the risks of running a defined
benefit pension scheme -also known as ‘pensions de-risking’. Pensions de-risking
is becoming an increasingly common strategic priority for sponsors.

The economic and regulatory environment for pensions has become ever more
challenging and it has become increasingly difficult for sponsors to continue to
support schemes on an ongoing basis, leading to the continued trend of scheme
closures. 

However, existing assets and liabilities still need to be
dealt with and there are a number of well-known companies where the value of
pension scheme assets, and in some cases the deficit, is greater than the value
of the company itself.

It is, therefore, important for sponsors to
have a clear understanding of the relationship between both the funding and
accounting impacts of a pension scheme on the financial performance of the
company’s business. How companies manage their pension scheme risks in this
environment is, therefore, extremely significant, and can have an impact on the
share price. Corporate treasury is increasingly involved in the careful decision
making that takes place when devising strategy.

What are the Key
Risks Faced by Companies and their Pension Schemes?   

There are
many types of pension scheme risk.  The main ones can be categorised under three
headings: liability, asset and regulatory, as detailed below:
Buck Consultants three main pension risks
Many
companies are not pro-active in managing these risks and rely on their trustee
boards to drive any de-risking activity. Companies and their treasury
departments should look to actively engage with the trustees to work on a joint
de-risking plan.

Historically, the management of risk has focussed
on the assets, with strategies looking at asset allocation and liability-driven
investment (LDI). There has been an increasing appreciation that assets cannot
be managed in isolation of the liabilities. Underfunding of liabilities and
asset, and liability mismatch are generally rated as among the highest risks. Consideration should be given to each risk, and a decision made whether to
retain, manage or remove it.

Which strategies for Mitigating those
Risks are Proving to be the Most Successful?

Each scheme is
different as regards the liabilities, the sponsor covenant and the attitude to
risk, which means that a tailored approach should be employed to meet the
individual needs of each scheme. 

Sponsors and trustees can employ a
number of actions together, or may look to structure a flightpath involving a
number of actions over a period of time. Any plans need to be flexible to
accommodate changes over time.

Legislation, market opportunity and
affordability will ultimately determine how quickly objectives can be met.

There are a number of options to consider, as detailed in Figure 1
below, including a range of liability management exercises. Many are now driven
by ‘the code of good practice’ established for incentive exercises.

Figure1: Options for Reducing Pension Risk.
Buck Consultants Pension Risk Figure 1
Source: Buck
Consultants.

Pensioner buy-ins: These provide the opportunity for
scheme sponsors and trustees to remove longevity, interest and inflation risks
for sections of their scheme membership at a potentially affordable cost. Such
arrangements can provide members with increased protection while removing key
elements of risk for both sponsors and trustees.  Enhanced annuity buy-ins,
allowing for medical and lifestyle information, are now also available, leading
to reduced costs for some schemes.

Pensioner buy-ins have been very
popular and provided beneficial results over the last year, with a number of
transactions involving swapping their gilt assets for a buy-in policy. Removing
risks and in some cases improving the funding position.

Enhanced
Transfer Values (ETV):
ETVs provide the opportunity for scheme sponsors to
remove some liabilities and costs for sections of their scheme membership. Such
arrangements can provide members with increased flexibility and can lead to
improvements in funding levels.

Current market conditions of low gilt
yields have made ETVs less attractive, but there are still situations in which
they are used in a targeted way, or as a prelude to a buy-out.

Pension increase exchange (PIE): These provide the opportunity and flexibility
for scheme sponsors and scheme members to come to a mutually beneficial
arrangement. Such arrangements can provide members with a pension income better
matching their needs, leaving the sponsor less exposed to longevity and
inflation risks.

PIEs have the benefit of removing inflation and
longer term risks, without the need for initial cash injections.  Last month BT
announced a PIE exercise for 120,000 of its pensioners.

Flexible
retirement exercises (TPIE):
These provide an option for members to take a
transfer payment into an immediate annuity with an insurer as an alternative to
the normal position of a pension within the scheme.  The main benefits are
additional choices for members and a reduction in the pension scheme risk.

TPIEs are likely to become more common as practices at retirement change
to give employees more flexibility, whilst at the same time removing liabilities
from the scheme.

Figure 2: Example of a de-risking plan (the order
and timing of de-risking measures may vary).

Buck Consultants Pension risk Figure 2
Source: Buck
Consultants.

Which Countries have been Most Proactive in Adopting New
Thinking on the Challenges?

In recent years, corporate sponsors in
the UK and the US have been leading the charge on pension de-risking. This has
been a significant part of pensions strategy in the UK for at least five years,
and the US, whilst starting later, has the potential to be a huge market, with
Canada not far behind.

UK: The transfer of risk through buy-in/outs
and longevity swaps is now well established, with over £50nn of risk transferred
to date. Insurers have developed solutions to balance affordability and risk
reduction, through partial buy-ins, deferred payment options and risk sharing. 

USA: Recent de-risking moves by several high profile US corporations
are paving the way for additional companies to consider similar approaches. A
recent study found that sponsors were showing signs of differentiating among the
risk factors, focusing on a smaller number of risk factors and paying greater
attention to them.

Canada: Legislation is being changed to provide
both employers with a framework to establish shared risk plans, as well as to
convert existing defined benefit (DB) plans to shared risk arrangements.
Canadian employers are also engaging in lump sum transfer and annuity ‘buy-out’
programmes, following suit from the UK and US.

What Should Companies
be Looking to Do Now?

Awareness of de-risking has progressed to a
greater understanding, planning and getting ready. For those companies that have
not yet embarked on their de-risking plans, there are a number of options they
can consider when preparing:

  1. Set Objectives: Sponsors and trustees
    should work together to agree the objectives for their scheme. The agreed
    objectives will help determine what steps should be taken next and in what
    order. Many sponsors will see buy-out as the ultimate target, but for most it
    may not be immediately affordable. What is realistically achievable in terms of
    budgets and timescales?
  2. Understand your risks: Consideration should be
    given to each risk, and a decision made whether to: retain, manage or remove.
  3. Cost Control: A review of the costs associated with the scheme should be
    carried out, including options to reduce the costs of benefit design and, for UK
    companies, the applicable Pension Protection Fund (PPF) levies.
  4. Governance: Understanding of the risks associated with the scheme, coupled
    with knowledge of the range of solutions available and well established
    procedures for making decisions quickly, will aid future de-risking
    exercises.
  5. Data cleanse: Ensuring data is accurate can save both time
    and money.  It is essential that a scheme’s data is of the highest standard if a
    de-risking exercise is being considered. 

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