 “Not everything that is faced can be changed. But nothing can be changed until it is faced” (James Arthur Baldwin)
By Robert Hunt, director, Xafinity Corporate Solutions
Any sponsors or trustees who were not fully aware of the risks inherent in their pension schemes have had a sobering five years. Poor equity returns and falling gilt yields have meant that many scheme deficits have increased significantly despite record contributions being paid into the schemes during that same period. Sponsors are on the hook for any pension deficits that develop and therefore it is vital for them to take action now to ensure that the risks they face are understood and minimised as much as possible.
De-risking is a process, not an event; even if now is not the right time to fully de-risk, now is the time to plan the de-risking process so that any opportunities to de-risk can be exploited.
Understanding risks
Pensions should be simple: put sufficient money aside now to pay for members’ pensions when they retire. Unfortunately no-one knows how long members will live or what return will be achieved on invested assets, let alone what changes to legislation will affect the schemes finances. What is “sufficient” will only ever be known when all the benefits have been paid, but it is possible to manage and mitigate the risks so that this amount does not turn out greater than expected and hence does not cause a strain on company finances.
Risks need to be identified and understood before their potential impact can be quantified. Many trustees and sponsors are aware of the risks that they face such as investment returns being lower than expected, members living longer and having inaccurate or incomplete data. It is only when the risks are quantified that the importance of a coherent de-risking strategy can be appreciated.
Managing risks
There are various ways of managing these risks, some of which can cost money in the short term but will reduce the risk of greater costs in the longer term, while others are either cost-neutral or can achieve a gain while still reducing risk.
Investment allocation
Adopting an efficient investment portfolio is a must for all schemes - there is no point taking risks for which there is no corresponding reward. The exact risk/reward balance of the scheme’s investments can be investigated so that the scheme can pursue returns that will reduce the need for sponsor contributions while keeping within risk limits determined by the trustees and sponsors.
Deficit management exercises
Rather than just managing risks, it is possible to remove them altogether for some members. Enhanced transfer value exercises involve offering members the opportunity to transfer their benefit entitlement to a different pension arrangement. The trustees then pay a lump sum to this new arrangement and the liability is removed from the scheme. Some of these exercises have received poor press but when managed properly they can be valued by sponsors, trustees and members.
Other exercises involve members exchanging some future increases to their pensions for a larger initial pension. This can remove some inflation risk from the scheme while allowing members to enjoy a higher standard of living now.
Buy-out/Buy-in
The ultimate goal for all sponsors is to remove all of the risk they face. As schemes mature, many trustees and sponsors will secure the promised benefits by purchasing annuities from an insurance company. The risks then transfer to the insurer and the Finance Directors will have one less demand on their time. Unsurprisingly this tends to be one of the more expensive options in the short-term, but many schemes which purchased annuities ten years ago will be glad that they did. Despite the high cost for insuring an entire scheme, trustees and sponsors may be pleasantly surprised how much it costs to purchase annuities for certain groups of members. Advisors can also help trustees to investigate and monitor annuity rates so that they can take advantage of favourable conditions.
When is the right time to de-risk?
Unfortunately, as with most things related to pensions, no-one can know. Anyone who could tell for certain what will happen to gilt yields, equity values and future longevity trends would not be sharing that information, they would be busy making billions of pounds trading on that knowledge!
However, sponsors and trustees can identify the levels at which they would like to reduce risk. They can then take advantage of changes in market conditions to de-risk. Many schemes have based their de-risking “trigger points” on targets such as the scheme’s funding level, size of deficit, gilt yields and real gilt yields, among other targets. The most appropriate target varies from scheme to scheme and can be impacted by things such as sponsor covenant and attitude to risk.
The key to taking advantage of changes in market conditions is to have targets and processes agreed in advance. Getting trustees together and reaching agreement can take time and opportunities can be missed if the de-risking processes are not agreed in advance.
Pensions are complex and can pose significant risk to sponsors. Some risks can be eliminated immediately, while others are removed through a gradual de-risking process. Many sponsors have received a shock at how far their scheme’s funding position has deteriorated in recent years; the goal now is to ensure that there are no more nasty surprises.
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