5 top tips when de-risking
1. Make sure your scheme data and administration are in good shape. If they are not, this will cost you money and slow you down.
2. Consider what the end-game looks like. If you don’t know, think about it now or how else will you be able to get there?
3. Good governance is essential. When thinking about where you want to get to, consider whether you have the right governance framework in place.
4. Careful planning to achieve run-off in an orderly way takes planning, but it requires taking decisions, such as spending money, when you are ready.
5. Remember – it’s a marathon, not a sprint. There may be a number of options you need to use and it may take longer than you think. Use that time to prepare.
How to get pensions off the books
Auto-enrolment has ushered in a new era of workplace pension provision for thousands of employers tied into final salary or defined benefit (DB) plans which are becoming more expensive to maintain each year. So what can employers do to rid themselves of these turbulent schemes?
The good news is there really is a silver bullet to make this all go away. It’s a bulk buy-out annuity, which is a transfer of the plan’s assets, plus a premium, and each member’s benefits are converted into an individual insurance policy. It’s then off the balance sheet and no longer your problem.
The bad news is very few schemes have sufficient capital to secure one as the benefits must be secured in full. There are exceptions, but they would require the business to become insolvent, which is not a palatable alternative.
There is also a buy-in, another arrangement with an insurance company that guarantees certain members of the plan will have their pensions guaranteed. The benefit is the assets remain with the scheme, but some claim it discriminates against those who are not covered should the employer go bust.
It’s hard enough for well-funded schemes with strong employers behind them to find enough cash to get through such a de-risking process, but apparently there’s quite a lot of it going on.
It has become much more affordable and is now within the cheque-writing distance of the chief financial officer, allowing them to get the plan off the balance sheet as cheaply as possible
“We have clients of all sizes looking to de-risk with a buyout or buy-in and this is being driven as much by the corporates as the plan trustees,” says Martin Bird, senior partner and head of the risk settlement practice at Aon Hewitt.
“Corporates are tired of the hassle of running them and, in order to get it off the balance sheet, sponsors are prepared to stump up additional cash.”
For large plans, this focuses minds on either no risk (buy-out) or low risk (buy-in or a liability-driven investment strategy), but where does that leave small schemes? Actually, as insurers write more business, they understand the risk better. It doesn’t make it any less complex, but the process becomes more standardised as a result.
“Insurance companies know how it works now and there is an appetite for writing business at the smaller end of the market,” says Mr Bird. “It has become much more affordable and is now within the cheque-writing distance of the chief financial officer, allowing them to get the plan off the balance sheet as cheaply as possible.”
CETVs and PIEs
An alternative approach to reducing liabilities is to get people to leave the plan. This involves using cash equivalent transfer values (CETVs), where you show the member how much their benefits are worth in cold, hard cash, or an enhanced cash transfer value, which is the same with a bit on top as a sweetener.
Another method is to offer a member a PIE or pension increase exchange, which gives them a cash lump sum if they agree to give up some or all of their index-linked annual increase, which even in this day and age could be as much as 5 per cent.
Finally, if the sum is small, you may be able to pay it out – commute it – as cash.
CETVs have been difficult as many trustees are wary of offering inducements and so take-up has been low, says Marian Elliott, a director at Deloitte. “PIEs and flexible retirement options have been useful as something other than the standard lump sum and some plans have been successful in reducing liabilities with these,” she says.
Trustees are becoming more comfortable with this as the Pensions Regulator has issued guidance on liability management and how to protect members in the process.
Ms Elliott recommends small and medium plans are more systematic about trying to work out what the future looks like, and if the current strategy is likely to get them there. “Pension plans always have plans, but what if there they go wrong?” asks Ms Elliott. She recommends putting technology to work. Modelling is straightforward and allows you to test different scenarios very easily.
But even if you can’t afford buy-out or convince people to leave, there is still much every plan can do.
One of the most important steps any plan can take is to get its databank up to scratch as very few have accurate data. This not only causes duplications and errors in processing, but it costs money, especially if you are approaching a major de-risking event like a buy-out, says Monica Cope, chief operating officer at Veratta, a financial services technology company.
“Big insurers will weight a premium by 5 to 10 per cent if they’re not totally sure about your data,” says Ms Cope. She says it’s the trustees’ duty to get the members’ benefits right, so sorting out your data quality once and for all is a sensible step to take. “Even if you don’t use it straight away, it is a step in the right direction and a box that can be ticked,” she adds.
Data is indeed a crucial stage of any de-risking, says Andrew Waring, chief executive of the Merchant Navy Officers’ Pension Fund, the new section of which is in the process of a four-year programme to clean the data.
Mr Waring’s plan is large, with around £2.7 billion of liabilities, and he is well versed in the application of liability-driven investment, interest rate and inflation hedging; he even oversaw a buy-in of some of the liabilities in the last couple of years.
The latest strategy was to hedge some of the longevity risk of pensioners through an innovative structure the plan developed. While the average liabilities of most DB plans increased by 10 per cent in 2014, Mr Waring’s increased by around 21 per cent. However, the hedges in place to de-risk the scheme saw the assets increase by 23 per cent in the 15 months to March 2015.
“Without our strategies in place, that would have been a £300-million deficit,” he says.
Small plans cannot hope to access those structures, but through Mr Waring’s plan’s innovation and those highlighted by Aon Hewitt’s Mr Bird, de-risking strategies are cascading down.
However, it requires planning and quite a lot of it, says Mr Waring. “De-risking is often built around a long and bumpy road. You need to be able to cope with the shocks – and you won’t get them all – but in the end you must protect the plan,” he concludes.