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The Actuary The magazine of the Institute & Faculty of Actuaries
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Made simple: Pensions de-risking - The £1 trillion question

The BBC is just one of the latest employers to announce plans to close its defined benefit scheme (DB) to new employees. Office for National Statistics figures show that it is not alone. In 2008, around 1.1 million private sector workers were members of open DB schemes compared with 4.9 million in 1995. Research from PricewaterhouseCoopers shows the rate of closure to existing staff has doubled from 14% last year to 32% this year, with a further 30% planning to do so in the future.

Financial market volatility is partially to blame. Accounting rules, including FRS 17 and IAS 19, require companies to declare pension scheme assets and liabilities in their annual accounts. As pension scheme liabilities change with movements in interest rates and stock markets, company results can be materially affected when these are volatile. However, it is not the whole story — increasing life expectancy means schemes have to pay out for longer to retirees, while increased regulation has added to the costs.

While reports of the demise of DB schemes are not exaggerated, there remain £1 trillion liabilities to be managed long into the future. This has driven interest in de-risking which, in the context of DB schemes, involves removing elements of risk from the pension scheme in order to reduce the possibility of an adverse change in future contributions, diminish the impact of financial market volatility on the employer’s balance sheet and to better protect members’ benefits. There are a variety of strategies available, a selection of which are detailed below:

Liability reduction exercises include the use of enhanced transfer values (ETV) as an incentive for members to leave their DB scheme. Scheme members have a statutory right to request a transfer payment from a scheme in which they have built up benefits into another pension scheme. An ETV is an enhanced payment that is above the value of the transfer payment yet below the full cost of insuring the member’s pension. The enhancement can be offered in the form of a cash sum or as an increase to the member’s transfer payment.

They provide schemes with a cost-effective solution for reducing risk relating to members who still have a benefit in the scheme but are no longer working for the employer and offer such members choice. However, the Pensions Regulator has been critical. Other methods available to schemes include pension increase conversion exercises, which involve exchanging non-statutory pension increases for a higher flat pension, or caps on pensionable pay.

Investment de-risking typically focuses on tightening the link between assets and liabilities. At the highest level, trustees can consider their allocation to assets, such as bonds and swaps, which broadly match movements in liabilities. Alternatively, assets can be diversified, across geographies and/or asset classes. Potentially more sophisticated strategies include employing a swap programme to hedge more effectively against adverse movements in interest rates and inflation. While swaps and derivatives can be effective risk management tools, they do introduce complexity and the extra risk of counterparty default.

Longevity swaps or longevity insurance look to mitigate longevity risk, ie. the risk of people living longer than expected. A scheme makes regular payments based on agreed mortality assumptions to an insurer, which in turn pays regular amounts based either on the scheme’s actual mortality rates or an index of UK population longevity. They come with a high monitoring requirement, the time and cost implications of which mean they are only really suitable for large schemes. Furthermore, unless schemes are looking to buy and hold the swap for its full term, which could be in excess of 50 years, obtaining clear contractual terms that define the swap valuation on exit and identifying the circumstances under which the scheme can novate the contact is critical.

Bulk annuities involve the partial or full transfer of investment, inflation, interest rate and longevity risk to an insurer in exchange for a premium. Effectively, the scheme purchases an insurance policy to cover the pension payments. These come in two forms.

A buy-in is the purchase of a single insurance policy held in the trustee’s name as an asset of the scheme. The trustees remain responsible to the members to provide their benefits. They obtain a matching asset that produces an income stream equal to the benefits they have specified for the insurer, usually those the trustees expect to pay out, thus achieving their goal of risk transfer.

A buyout involves the purchase of separate insurance policies in the individuals’ names, ie. they become policyholders of the insurer and cease to be members of the scheme. Where the scheme is in deficit this would require the employer to make a contribution to meet the funding gap. Once bought out, the trustees obtain a full discharge of liability in respect of the bought-out benefits.

DB pension schemes have a long way to run despite the accelerating trend of closures. With more than £1 trillion of scheme liabilities it is in the interests of members, trustees and employers to develop strategies that ensure the interests of all are protected. De-risking has a vital role to play in that process and understanding de-risking is crucial in developing strategies that deliver for all parties.

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Emma Watkins is head of relationship management at MetLife Assurance Limited