Is reducing risk too costly?

Soaring deficits on defined benefit pensions may have made offloading liabilities more expensive, but there are still ways schemes can reduce risk, writes John Greenwood

Schemes holding gilt-edged UK government bonds will be more able to afford to pay insurers to take on risk, while new industry standards on incentivising members to leave schemes should make offloading liabilities easier.

On the negative side, however, the spectre of an increase in the cost of buying out liabilities lurks on the horizon in the form of planned new European Union regulations.

Even though asset values have been rising for the last 12 months, the combined deficit of UK defined benefit schemes soared to £157 billion by the end of July 2012, under standard accounting measure IAS19/FRS17, a rise of 41 per cent on its level of £111 billion a year previously, according to JLT Pension Capital Strategies.

Raj Mody, head of pensions at PwC, says: “It is counterintuitive that liabilities on schemes have gone up over the last year when asset values have been rising. But this is because the liability values, which are measured in the cost of buying them out with gilts, have been rising even faster than equity values.”

In July 2011 the yield or payout on 15-year gilts was 3.56 per cent, but a surge in demand for the assets pushed up their price, squeezing their yield down to just 2.25 per cent by July 2012. This increase in the cost of gilts pushed total liabilities to £1,196 billion from £1,089 billion over the period, while assets rose to £1,039 billion from £987 billion.

Pension experts recommend putting in place strategies that trigger de-risking action if and when certain asset valuations are reached

That means, for most schemes, the finance director’s Holy Grail of full buyout through a bulk annuity purchase, where the obligation to pay pensions is handed over to an insurance company in return for a premium, is now more expensive.

Paul McGlone, principal and actuary at Aon Hewitt, says: “There will still probably be £5 billion of bulk annuity purchases this year, but not the £8 billion of previous years.”

Where schemes do hold gilts, however, bulk buyout or pension buy-in, where a scheme trades its gilts in return for a promise from an insurer to cover liabilities, can be attractive.”

Mr Mody says: “The prolonged pressure on gilts caused by the eurozone crisis and quantitative easing (QE) has left a situation where those with gilt holdings can buy out their liabilities for no extra cost. The scheme no longer has any longevity risk and the company gets the liability off its balance sheet.”

While today’s market indices point to de-risking opportunities for schemes holding large amounts of gilts, the current volatility means nobody knows what opportunities tomorrow holds. For this reason pension experts recommend putting in place strategies that trigger de-risking action if and when certain asset valuations are reached.

“If you have planned the opportunities you want to accept through trigger-based de-risking, then the extreme volatility of today’s markets can be your friend because it will help you find opportunities when they come along,” says Mr Mody. “That said, this is not applicable to everyone as there is a whole tranche of schemes out there that are not sufficiently funded to be able to afford buyouts, whatever way the market goes.”

A solution to the eurozone crisis and a significant improvement in the global economy would potentially reduce demand for gilts, but opinions are divided as to how this could play out. If yields did rise, however, deficits would narrow, making de-risking more attractive.

Mr McGlone says: “One school of thought says, if gilt yields rise, then money from pension funds will jump on them and push them back down again. Others say there is not enough money in pension schemes to have a substantial impact. In my view, £300 billion of QE is sufficient to affect gilt prices, but the amount of gilts pensions will buy over the next 18 months probably will not be.”

Another alternative for schemes looking to take risk off the books is longevity hedging. James Walsh, senior policy adviser, European Union and international affairs at the National Association of Pension Funds (NAPF), says: “Longevity swaps are where a scheme does a deal with an insurance company whereby, if increased longevity in the scheme ends up proving more costly in the future, the insurer picks up the extra cost.”

However, longevity hedging is expensive and is only usually an option for very big schemes, with only 12 transactions ever having taken place in the UK.

Less expensive, and with the potential to offload at least some risk, are enhanced transfer value programmes (ETVs), which are predicted to become more prevalent since a code of practice governing how they should operate was launched in June.

Under these arrangements, non-retired members, typically those who have already left the company, are offered a cash transfer into a personal pension plan, usually on enhanced terms in return for surrendering their defined benefit entitlement.

Because defined benefit pensions are valued on the basis of somebody with a spouse or partner who is expected to live for an average lifespan, these transfers can be attractive to single people or those who have medical conditions that could shorten their life expectancy, because they may be able to buy an annuity with a higher income as a result. Schemes meanwhile offload liabilities at a reduced price.

Retired members can be offered pension increase exchange (PIE) deals where they are offered an increase in pension now in return for forgoing some or all their inflation-linked pension increases in the future.

The pensions industry has come in for criticism for offering poor value enhanced transfers and pension increase exchange deals that tempted hard-pushed scheme members to accept with cash incentives. The new industry code of practice bans employers from offering cash incentives, and requires employers to provide and fund financial advice to scheme members offered transfers into personal pensions.

Mr Walsh says: “Enhanced transfer exercises have been quiet over the last year or so because of the uncertainty of how the industry’s code of practice will address the issues Pensions Minister Steve Webb has been rightly concerned about. Now the new rules are in place, there is a renewed interest in using enhanced transfers to reduce scheme liabilities.”

Another potential risk to defined benefit pensions is the European Commission’s review of the Institutions for Occupational Retirement Provision (IORP) directive. This proposes to make occupational pension schemes meet similar capital requirements to the stringent Solvency II requirements placed on insurance companies.

The NAPF estimates the IORP directive could add a further £300 billion in costs to UK defined benefit pension schemes as they would be forced to dramatically increase the capital held within funds.

Mr Walsh adds: “It is still at the policy-making stage and we are lobbying hard but, if we get the wrong outcome, it could make the cost of funding schemes rise above the level of buying them out. That could trigger a rush to buyout.

“We will see the outcome of the IORP negotiations within the next couple of years. The risk is major. We think it could increase liabilities by as much as 27 per cent, although there would be changes on the valuation of assets that could reduce that somewhat. But it would still be a major cost for schemes.”

Whether or not IORP prompts a rush to de-risking, schemes that can afford to take risk off the books are advised to be prepared. That means ensuring data on schemes is accurate so deals can be done quickly and putting in place a trigger strategy so opportunities can be grabbed when the markets present them. De-risking opportunities can come and go within a matter of weeks. Missing them through lack of preparedness can prove an expensive mistake.