 By Emma Watkins, Director of Business Development, MetLife Assurance Limited
Traditional defined benefit (DB) pension schemes are being closed to new members and future accrual, and defined contribution schemes are growing in number as employers seek to control the volatility of their costs. However, there are still an estimated £1 trillion of private sector DB liabilities which will need to be managed for many decades*.
Continued economic volatility and an ever-changing regulatory environment have sharpened DB pension scheme sponsors’ and trustees’ focus on the significant risks facing their schemes today. Determining how best to manage these risks is critical and it is therefore no surprise that these factors weigh on the minds of trustees and sponsors alike. MetLife Assurance Limited’s 2011 UK Pension Risk Behaviour Index (2011 PRBI) identified the top three risks among sponsors and trustees as Funding Deficits, Employer Covenant and Asset and Liability Mismatch.
The focus on Funding Deficits reflects sponsors’ and trustees’ reactions to continued volatility within their schemes and just how pivotal managing funding deficits is to pension risk management. In this year’s 2011 PRBI, Funding Deficits moved up in importance to first place from fifth place last year, with the number of times it was selected as important increasing from 27% in 2010 to 58% this year. Whilst funding status may be improving, the volatility of funding ratios, which can change from day-to-day and year-to-year, is playing a major role in how sponsors and trustees view the risk attached to Funding Deficits.
With regard to Employer Covenant risk, defined as the assessment of the sponsor’s willingness and ability to fund the scheme, this was ranked second in importance among sponsors and trustees. This risk was also ranked second in 2010, but the number of times it was selected as important by respondents jumped from 28% in 2010 to 49% in 2011, indicating that sponsors and trustees are paying more attention to this risk. Trustees, in particular, need to be confident that an employer can meet its obligations to scheme members over the long-term and especially during times of economic volatility.
Turning to Asset and Liability Mismatch, this risk factor was ranked sixth last year, increasing from a selection rate of 26% in 2010 to a selection rate of 48% in 2011. This significant change indicates that both sponsors and trustees are concerned about their scheme’s ability to meet long-term liabilities, which extend far into the future. They are also interested in taking steps to change their investment strategy, if necessary with a view to de-risking.
In this context, de-risking can be used to reduce the impact of economic fluctuations on funding status and the reliance on the employer covenant. Activities that have been employed over the last decade range from increasing employee contributions, benefit modifications, through to liability management and transfer.
Focusing on the latter, there are a number of risk transfer options available depending on where or to whom the trustees or sponsor wish to pass the risk.
Increasingly enhanced transfer value exercises have been undertaken to pass the risks to the individual members. Activity in this area has increased over the last few years, with predictions for this year alone suggesting that offers affecting 70,000 members are in the pipeline**.
For those schemes looking to secure the liabilities with an insurance company, bulk annuities in the form of a buy-in or buyout may be of interest. Although both involve the transfer of a scheme’s full or partial liabilities in exchange for a premium there are some fundamental differences between the two approaches:
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A buyout insures members’ benefits through the purchase of individual annuity policies. Under a full buyout all liabilities and associated risks (investment, inflation, interest rate, longevity and employer covenant risk) along with operating costs are removed completely.
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A buy-in is the use of an annuity to hedge or protect the liabilities of a scheme as part of a strategy to reduce risk. The policy is held in the name of the trustees, with the scheme obtaining a matching asset that produces an income stream equal to benefits specified to the insurer.
This market remains buoyant in this area with a recent report stating that the combined value of buy-outs and buy-ins in the UK reached £5.2bn in 2010*** and has already hit the £1.7bn mark in the first two quarters of 2011.
The long-term aim of many sponsors and trustees is to wind-up their pension scheme in order to transfer the liabilities off the company’s balance sheet and protect the long-term interests of the members. For those schemes that cannot or do not yet wish to consider a buyout, a partial buy-in is an increasingly popular alternative. Trustees and employers should focus on working together now to identify their key risks and prepare for the long-term by agreeing what action needs to be undertaken in the short and medium term.
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