It is not unheard of for the collective value of the UK pension industry to oscillate by £40 billion in a week. Trustees of most defined benefit (DB) schemes are also burdened by huge deficits and increasing longevity of their members. They want out.
Indeed the aggregate deficit of the 6,316 schemes in the Pension Protection Fund 7800 Index was £114.8 billion at the end of September with total assets of £1,118.7 billion and total liabilities of £1,233.5 billion. There is no end in sight to their pain. So trustees are looking at ways to cut their risk.
Simeon Willis, principal consultant, investment advisory at KPMG, explains: “This risk can be particularly troublesome if the pension scheme deficit has potential to impact credit rating and therefore ability to raise capital or simply result in large cash contributions which affect the ability of the firm to make money.”
Experts have come up with a myriad of ways of cutting risk both of assets and liabilities (the money due to pensioners). As Nick Flynn, divisional director – longevity at LEBC, warns: “By overfocusing and simply managing the investment risks, trustees have been caught out by events in other areas which mean that, despite good investment performance, deficits have widened.”
Buy-outs and buy-ins with insurance companies are popular choices. More than one million members of DB pension schemes will receive their pension from insurance firms by 2017. Also widespread is liability driven investment (LDI), longevity hedging techniques and pension increase exchanges where members forego future increases in their pension in return for a larger sum at outset.
Pension trustees are clamouring to buy-out. Indeed, 2013 is shaping up to be the biggest year for buy-ins and buy-outs since the banking crisis of 2008 with deals worth more than £5.5 billion, including the record £1.5-billion buy-out by EMI with Pension Insurance Corporation.
If a pension scheme has a large gilts holding, Emma Watkins, partner in consultants LCP, says it can use the holding “to pay the premium for a buy-in policy covering all or some of their pensioners”. “This locks down longevity risk on the liabilities covered, captures value from current high gilt prices and can often be done for little to no funding impact,” she says.
2013 is shaping up to be the biggest year for buy-ins and buy-outs since the 2008 banking crisis
The recent Rothesay Life £484-million pensioner buy-in from the Philips Pension Fund, where gilts and cash were exchanged for an insurance policy, gave the fund a secure, low-risk asset with cover against longevity risk and pension increase risk.
Buy-outs of smaller, closed pension funds can make sense for bigger companies so that management time can be focused on any remaining larger plans. Martyn Phillips, director at JLT Employee Benefits, points to overseas parent companies buying-out small UK schemes.
Mergers and acquisitions can be a useful catalyst. Dominic Grimley, principal consultant at Aon Hewitt, says “the sale of a company may trigger a substantial payment to the pension scheme, making buy-out affordable”.
Ian Aley, head of pension risk solutions at consultants Towers Watson, points to more non-pensioner members being covered. “Traditionally the pricing for these members has been a long way from the value of assets that the scheme has set aside to make payments to them, but our experience is that the gap has closed this year. This could make whole scheme buy-outs more affordable for scheme sponsors,” he says.
Schemes can also benefit from enhanced medically underwritten pensioner buy-ins from such firms as Partnership and Just Retirement, securing savings of 10 per cent or more on standard rates.
Will Hale, director of corporate partnerships at Partnership, an enhanced annuity specialist, enthuses: “Sophisticated underwriting techniques, which have made a significant impact in the individual annuity market by increasing retirement incomes for people with health or lifestyle conditions, can now provide a cost-effective way for certain defined benefit schemes to insure their liabilities.”
Another de-risking solution is LDI but timing is all. Tim Giles, partner of consultants Aon Hewitt, explains that LDI focuses on removing interest and inflation risk. “Interest rates drive the price of LDI,” he says. “If you expect interest rates to rise and the consequent price of LDI to fall, then you may want to delay buying to improve your funding position.”
What if all these options give trustees a headache? There is also fiduciary management from experts who, Sion Cole, also a partner at Aon Hewitt, claims “understand the complexities of the market, giving the ability to react quickly to changes in market conditions”.
UNLOCKING THE JARGON
A pensioner buy-in is an insurance contract held by the trustees as an investment of the pension plan. It pays a monthly income to the trustees, typically equal to the benefit payments that the trustees are due to make to a specified group of members, for example current pensioners. In doing so, it hedges underlying interest rates, inflation and longevity risks, so providing a perfect match according to consultants LCP.
Under a buy-in, members are treated equitably, both on an ongoing approach and on wind-up; for example the payments under a buy-in can be restructured to comply with the statutory priority order if required, which is a key trustee concern. Administration is typically retained by the trustees, so members see no change in the way their pensions are paid. The pension liabilities remain in the pension plan until the trustees ask the insurance company to transfer the policy into the names of individual members (at buy-out).
A benefit of buy-in is that the insurance framework in the UK provides a high level of certainty that pensions will be paid. In addition, back-up from the sponsoring company remains as an additional protection until the policy is converted to buy-out.
A buy-out is a two-stage process – the initial buy-in followed by buy-out once the trustees are happy with the benefits secured under the buy-in. At this point individual policies are issued to each member in the pension plan. This signals completion of the buy-out and the plan can wind up.
The buy-out passes responsibility for paying benefits to members from the trustees to an insurance company. In turn, it removes the pension liabilities from the plan and the company balance sheet in full. Once the premium is paid in total, no further fees or levies are payable.
On buy-out, members become insurance company policyholders, allowing them to benefit directly from the strong insurance framework in the UK, including the Financial Services Compensation Scheme, and trustees are discharged from any liability to meet future pension benefits for all insured members.
Aside from smaller pension plans and plans with de-risked investment strategies, consultants LCP say the amount of cash required to support a full buy-out can be too high for some companies to justify it to their shareholders, not least because cash top-up would lock into the record low long-term interest rates.
LIABILITY DRIVEN INVESTMENT
The Bank of England’s efforts to boost the economy with quantitative easing has been nightmarish for defined benefit pension schemes, driving down bond yields. Schemes which have not hedged against this possibility have seen their deficits and recovery times lengthen despite strong asset growth. They face a familiar predicament of seemingly opposed options of wanting to reduce risk, but not lock in at such low yields.
Liability driven investment (LDI) can help. It is an investment strategy which aims to control risks stemming from both liabilities and assets. LDI could involve just increasing the duration of a gilt portfolio or may, for example, hedge interest rates and inflation risk using swaps, (derivative contracts). Inflation hedging has proved more popular than interest rate hedging recently.
LDI now covers £446 billion of liabilities in the UK, according to KPMG, with both pooled and segregated products available. Seventeen firms offer LDI in Britain, although the sector is dominated by Legal & General Investment Management, Insight and BlackRock. These three firms control some 90 per cent of the market with Legal & General having a huge 43 per cent share. LDI should be treated holistically alongside longevity hedging, insurance solutions, benefit changes/liability management, funding strategies and volatility controlled growth strategies.
Two thirds of trustees spend no more than five hours on investment each quarter, according to consultants Aon Hewitt. Waiting for a quarterly trustee meeting for decisions may mean losing out on investment opportunities, such as de-risking at a favourable price. So, in addition to accountants, lawyers and consultants, there is a new breed of expert on the scene – fiduciary managers. As third parties, they take the main responsibility for some or all of a pension scheme’s investment decisions, but the trustees retain ultimate responsibility for their investments, focusing on strategic allocations.
Fiduciary management, also known as delegated consulting, implemented consulting and solvency management, was virtually unknown in the UK a few years ago. Now it is beginning to take off, particularly among smaller schemes with limited resources. In the UK, the fiduciary management market is approaching £60 billion. Full delegation accounts for £28.7 billion with 211 mandates, around 2.5 per cent of total UK pension assets, with just under £30 billion managed on a partly delegated basis across 135 mandates, according to KPMG.
Investment consultants hold 90 per cent of the appointments, so there could be a danger of conflict of interests and extra spend in yet another tier of advisers. Look for a proven long track record and transparent fees.