Gyrating stock markets and increased lifespans have caused defined benefit (DB) pension scheme deficits to soar in recent years, while ever more stringent accounting standards have made the effect on companies’ balance sheets increasingly apparent.
Recent extreme market fluctuations have focused the minds of trustees and sponsoring employers to find ways of stabilising their exposure to the combined £1.2-trillion deficit in UK pension schemes, a process known as de-risking.
There are several strategies for de-risking a DB pension scheme, with buy-outs, buy-ins, longevity and interest rate hedging, and liability-driven investment the key options. Deciding which one is right for a particular scheme will depend on a range of issues including its financial position, its membership profile, and the size and resources of the sponsoring employer.
A buy-out, where a scheme pays an insurance company to take over the responsibility to pay pensions directly to the members of the scheme, is the most expensive option. Unfortunately for scheme sponsors, the fall in value of schemes’ assets caused by the financial crisis means that, for all but the richest companies or schemes, the moment for taking this option has now passed.
David Norgrove, chairman of analytics firm PensionsFirst, says: “There was a time in 2007, when equity markets were high, that the cost of doing a buy-out was more affordable. But a lot of people felt it was too expensive then and missed the boat.”
Depressed stock markets may have left most schemes unable to fully insure their entire workforce, but unexpected forces in the economy have created some opportunities for fleet-footed employers and trustees to reduce the risk on their scheme.
Today’s near-historic low gilt yields, caused by the historic high price of the gilts themselves, have created an opportunity for schemes holding a lot of gilts to opt for pension scheme buy-ins, which are insurance policies that will cover the risk of the pensioners in the scheme living longer than expected.
These policies are known as buy-ins because they are held within the scheme, rather than the insurer paying the pensioners direct, as in buy-outs.
Trustees and employers should get their de-risking strategy in place early
When a scheme opts for a buy-in, it typically trades the gilts it has been holding to cover its liabilities for an insurance company’s promise to pay the liabilities, taking longevity risk out of the equation for the scheme. As gilts are perceived as valuable at the moment, because they are more secure than other assets, schemes holding lots of them are in a position to trade them for buy-in policies.
David Stewart, partner at consultants LCP, says: “This happened in 2008 when the financial crisis kicked in. And it happened again in 2011 when the Eurozone crisis was at its peak, because the UK’s safe-haven status meant investors rushed to buy UK gilts.
“Buy-ins do not cost much from a trustee point of view because the reserves they are handing over are very similar to the cost of the annuities they are buying. This means companies can take advantage of the current environment to take risk off the balance sheet.”
Inflation is another risk factor that can seriously hit pension scheme funding, but its effect can be reduced by rearranging the assets in the scheme.
Paul Phillips, partner at law firm Sackers, says: “For schemes that have promised uncapped inflation protection to members, the risk of inflation taking off is high. These schemes may want to take away that inflation risk through some liability-driven investment solution. This may be as simple as buying gilts at the right price, but may be a case of buying swaps from banks, and using these to improve the match between their cashflow and the liabilities they will have to pay out.”
Swaps can also be used to reduce longevity and interest rate risk, although with interest rates at such low levels that they have little further to fall before hitting zero, some experts question the value of this latter strategy.
But whatever specific challenge a pension scheme faces, experts recommend trustees and employers get their de-risking strategy in place early, to avoid losing the opportunity that an optimum set of economic conditions might bring.
Mr Norgrove adds: “It makes sense having your de-risking strategy in place so you are ready to strike a deal if markets go in a particular direction.”
Regulating Ofcom’s liabilities
Ofcom has undertaken two buy-in transactions to reduce the risk that an increase in longevity would pose to one of its two defined benefit pension schemes. The scheme, called “The Plan”, was becoming quite mature, with a substantial proportion of the membership and liabilities relating to legacy pensioners from prior organisations which had been merged into Ofcom. The Plan was closed to new members when Ofcom was created and has subsequently closed to accrual so the membership consists of deferred and pensioner members only. Currently there are around 700 pensioners and 450 deferred members.
The deals have seen all the pensioner liabilities de-risked, initially with a £160-million pensioner buy-in transaction with Legal & General in 2008. Ofcom subsequently completed an extra £25-million transaction with the same company at the end of 2011 to insure the liabilities for those members who had retired since the first transaction.
Alastair Smith, finance director of Ofcom, says: “The trustees had largely de-risked the investments backing The Plan’s pensioner liabilities, through investing in UK Government gilts with a matching duration and inflation-matching profile. But there was concern, within both the trustees and Ofcom, about whether increasing longevity would mean that these backing assets would not prove adequate, alongside the continuing funding uncertainty due to the longevity risk.
“The de-risking exercise has been successful in that the amount of The Plan’s overall liabilities which are uninsured, and hence subject to investment, inflation and longevity risk, has been reduced substantially. Once transacted, we have found the buy-in policies very easy to work with – the trustees simply receive a lump sum each month from Legal & General equal to the pensions that need to be paid to our pensioners. The scheme administrator then divides this lump sum between our pensioners in line with their entitlements from The Plan. From our pensioner members’ perspective they have seen no change, as they still get their pension paid each month by our payroll providers.
James Staveley-Wadham, senior consultant at Towers Watson, who advised Ofcom, says: “The success of this transaction was due to all parties working together with a common goal, coupled with efficient decision-making and project management. By moving quickly and efficiently, we were able to take advantage of favourable market conditions.”