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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: The long and winding road

Over the past four years pension schemes have made dramatic progress towards securing member benefits. This progress has been facilitated by moves in two areas: firstly, there have been improvements in funding as a result of stronger investment markets and accelerated contribution schedules subsequent to the introduction of the Pensions Act (2005); secondly, we have witnessed the deployment of better risk management techniques, the embracing of risk budgeting and liabilitydriven investment.

As a result of the improved understanding that has emerged over this period, trustees and sponsors are now focusing on the endgame. This is a decommissioning process that, in the private sector, is most likely to lead to the eventual transfer of liabilities to an insurance company. The motivation for this process will be as follows:

  • The scheme is closed to future members and accrual
  • The scheme is seen as a ‘no-win’ risk management task for trustees
  • The deficit becomes a less attractive and less durable form of company finance as trustees become more aware of their unsecured and undiversified creditor positions.

So what are the ideal components of a decommissioning plan and how should trustees and sponsors go about putting one in place? We do not expect this to be a big-bang solution achieved in weeks or months but rather a transformational journey achieved over a number of years, with trustees and sponsors working together to make this both attainable and affordable. For these aims to be achieved the following components need to be in place:

Navigators - Advisers > Driver - Asset manager > Destination - Annuity provider

Unless there are substantive cost-benefit reasons for doing so, trustees should rarely allow the navigator to attempt to map-read and drive at the same time.

The decommissioning process will seek to improve the funding efficiency of the scheme to a full buyout level using available sources of additional financing (see Figure 1). These sources are most likely to be a balance of sponsor contributions, investment returns and liability management.

The balance of these components will depend on a measure of the acceptable risk of failure to achieve the objective, taking into account the strength of the employer covenant.

Including annuities in the investment mix
In many ways annuities can be considered better bonds, not only providing guaranteed investment returns and inflation protection but also combining them with longevity, benefit options and administration expense protection. Indeed, annuities are the only asset class available at present that matches a pension scheme’s liability to pay a pension. As a result, in a manner similar to other asset classes, pension schemes should consider the role annuities have to play on the decommissioning roadmap journey and not just at the destination. Any credible ALM study should include them.

Figure 2 illustrates the investible efficient frontier for a typical pension scheme, representing the lowest level of risk that may be taken for a given return objective based on the underlying scheme liabilities and the available range of asset classes.

The graph illustrates the analysis both before and after annuities are included in this range, demonstrating the improvement in the portfolio efficiency of including annuities as the scheme risk appetite reduces and approaches the endgame.

To enable such an analysis to be undertaken, annuities for tranches of liabilities with similar pricing and risk characteristics are treated as scheme assets in the same way as other asset classes, with known returns and impacts on the risk budget. Using this knowledge, it can be determined when the scheme should annuitise each liability tranche along the decommissioning roadmap.

As a rule of thumb, for larger schemes our modelling shows that the effi ciency gain resulting from the inclusion of annuities in the investment portfolio becomes apparent when the equity-type investment content falls below 30%. This level increases as the scheme in question becomes smaller.

Benefits of an annuity lock
Ideally, an efficient decommissioning roadmap will have a destination with a location fixed by an annuity pricing basis lock; a pre-agreement with a provider as to the set of assumptions used to price future annuities purchased by the scheme. The advantages of this are:

  • The removal of unrewarded uncertainty around future annuity pricing, especially in relation to longevity pricing and insurance company profi t margins, allowing for the risk budget to be deployed more effi ciently by the asset manager
  • Immediate longevity risk transfer, avoiding the need to use expensive and/or ineffi cient longevity solutions
  • The nimble execution of annuity purchases by the asset manager during the decommissioning process, taking opportunities to de-risk the scheme as and when they arise
  • A smooth transition of member services to the annuity provider.

Of equal importance to having an annuity lock in place are the conditions applying to it. Preferably, the assets of the scheme should remain invested for as long as possible to enable them to be utilised fully in building the fi nances necessary to buy out the scheme in full. A commitment only to pass the assets on to the annuity provider when they are optimal within the overall investment risk budget achieves this by providing the annuity lock on non-onerous conditions.

In an efficient risk-management world, where no annuity lock is available, a scheme will annuitise earlier than would otherwise be the case to remove at least a portion of the annuity pricing risk. This results in either a requirement for higher returns on the smaller investible asset base or for higher contributions from the sponsor. Compared to the position where an annuity lock is in place, this either increases the risk that the overall objective is not attained or makes the process unaffordable to the sponsor.

The role of the asset manager
The final part of the decommissioning process is to have in place an asset manager acting on the instructions of the trustees and their advisers that manages the entire risk budget, de-risking the scheme and purchasing annuities as the scheme funding improves.

This is similar to the manner in which professional investment institutions use their asset managers. The asset manager becomes free to manage the assets within constraints prescribed by the trustees and their advisers on what risks can be taken, the level of individual and cumulative risk that can be taken and when to de-risk and annuitise.

This kind of mandate allows clear and accurate monitoring to be undertaken while not restricting the asset manager skill set. This will be to the overall benefi t of the scheme by way of enhanced returns and more effective and nimble risk management.

The future
For good reason, decommissioning is now coming onto the pension scheme agenda and it is important that actuaries, in the role of trusted advisers, work with trustees and sponsors to develop roadmaps against which progress and performance can be measured effectively.

It can be demonstrated that developing a decommissioning roadmap in this integrated manner, using a non-onerous annuity lock and empowered asset manager, improves the likelihood of success signifi cantly when compared to traditional, more piecemeal approaches.

David Hutchins is director of pension solutions within the risk advisory and capital solutions practice of UBS Investment Bank.