Ben Shaw discusses the different ways pension schemes can look to reduce risk

For most companies, pension schemes are essentially an unrewarded risk that they are carrying on the balance sheet. Every year, the vagaries of the investment markets, new mortality projections or PPF levies act to disrupt the profit and loss account and balance sheet of many UK companies. It is no great surprise therefore that finance directors and other senior executives look to de-risk their pension schemes.

Indeed, many company boards look to go further. It is usually the most senior management in the business which is drawn into defined benefit pension scheme issues – whether it is to look at de-risking proposals, suggest investments or become pension scheme trustees.

This activity is not rewarding the company’s profitability or helping it grow and therefore many senior executives are looking at ways to move the pension scheme off the company balance sheet completely. This article seeks to explore first the various options for de-risking a scheme in situ, and then turns to the options available for moving the pension scheme away from the company once and for all – a complete risk transfer.

To understand how to de-risk a scheme, let us first recap on the basics. A pension scheme is a promise to pay a set of payments to pensioners every month from when they retire to when they die, and then possibly another set of payments to their spouse and dependents. These payments can be calculated quite accurately, albeit with two elements of uncertainty: first how long the individuals will live and secondly the amount that their pensions will be uplifted each year to take account of inflation (the rate of indexation).

In order to be able to make these payments, the pension scheme collects sums of money and invests them such that this money should grow sufficiently to meet the payments as they fall due.

Following the logic above, there are thus two ways to address de-risking – one looking at the assets, the other looking at the liabilities. In terms of assets, a well-publicised method of de-risking is a liability driven investment strategy (LDI). As described above, the payments due from the scheme can be predicted with some accuracy, especially if inflation risk is removed. An LDI strategy incorporates a swap overlay to remove inflation risk and invests in a series of gilts, bonds or bond-like instruments that aim to repay interest and capital in a way which matches a scheme’s expected payments out to pensioners.

However, there are two key issues related to this strategy – first that the scheme is being locked into investments that only pay out a best guess of actual payments required. If people live longer, if more people take their tax-free lump sums, or if PPF levies go up, then the scheme could find itself short of cash. In addition, an LDI strategy is inherently costly – over the long term, gilts and bonds, especially inflation-linked, are not expected to grow as fast as equities and other risk-seeking assets. The pension scheme therefore needs to start with a greater pool of assets on day one in order to effectively implement an LDI strategy.

At the other end of the spectrum, the alternative is a ‘go for growth’ investment strategy, whereby the aim is for investments to grow as fast as possible without the scheme taking on too much risk. The theory behind this strategy is that the larger the pool of assets, the more likely the scheme is to be able to pay member benefits as they fall due.

Turning now to liabilities, there are a number of different risks a pension scheme runs. It has already been mentioned that buying inflation-linked securities or a swap overlay, although expensive, is a way to mitigate inflation risk. The next main risk a scheme faces in relation to its liabilities is how long people will live.

In recent years a new market has sprung up around longevity swaps. At their most desirable, a longevity swap is a contract where essentially the scheme pays a fixed set of payments to a counterparty (usually a bank), and the counterparty pays the scheme back a set of cashflows which exactly matches its payments to its pensioners. In practice, this kind of bespoke mortality swap is only available to very large schemes (£250 million plus). For smaller schemes, they would need to do a swap based on the national index – so the payments back to the scheme are based on a national average rather than being specific to the scheme’s membership. Surprisingly, mortality swaps may not be as expensive to implement as many might think – although there will be some structuring costs, many scheme actuaries already have very prudent longevity assumptions in place for schemes and thus the difference between a scheme’s current assumptions and the price of a swap may not be so large.

There are also a number of smaller ways to remove risk from a scheme. The first of these is to ensure your factors are appropriate. For example there is a factor at which a person’s pension entitlement is converted into a lump sum if they choose to take their 25 per cent cash-free lump sum on retirement. Particularly if a scheme is underfunded, one should ensure that a scheme is not paying out too much in cash in these tax-free lump sums. Other factors to consider include the uplift to a person’s pension if they retire late and the reduction in pension entitlement if they retire early.

Enhanced transfer values (ETV) exercises – giving members an enhanced cash value to take to buy a pension elsewhere – have received mixed press recently. However if done correctly, the take-up can be good, thus reducing your scheme’s assets and liabilities and they can benefit many members. For example, single members do not value the spouses and dependants pension and might well be able to receive a better single person’s pension if they were given a lump sum via an ETV. Some words of caution though: firstly, ensure an ETV is done in line with The Pensions Regulator’s guidance so that it does not come back to haunt you in the future as a mis-selling scandal. Secondly, ensure you understand the impact of all the single people moving out of your scheme – the actuary might well change the way he values your scheme and thus increase the liabilities to take into account the fact that most of the single people have left.

A similar exercise to ETV is PIE – pensions increase exchange. This is a way of offering members the option to take a higher initial pension but one that does not increase over time. It can be attractive to members as people often spend most in their early years of retirement. For the scheme, it reduces longevity and inflation risk.

A final small exercise relates to trivial commutation – giving cash to members with very small pension pots. This can be done tax-free and thus can be attractive to individuals. As well as reducing a scheme’s assets and liabilities, it reduces scheme administration costs which tend to be unduly high for people with small pension pots.

If a number of the above exercises are combined, a scheme can result in a virtual do-it-yourself buy-in. However full risk transfer traditionally has involved either passing all your assets and liabilities plus a top-up payment to an insurer (a buyout) or buying an insurance policy to cover just a segment of your members (a buy-in). These are inherently very expensive as an insurer is mandated to assume very low investment returns, is prudent with regards to mortality and needs to hold a capital buffer.

A final option is a full risk transfer to a non-insured provider – basically the trustees move all the assets and liabilities to a mirror of their own pension scheme that sits under a nominal sponsoring employer. The trustees of the outgoing scheme clearly need to ensure that such a transfer is in the best interests of their members, but if an underfunded scheme is offered a promise of cash and/or assets that takes them immediately to an overfunded position, this can be better for members who would otherwise be living in hope for many years that their current sponsoring employer continues to pay their recovery payments and does not become insolvent. This option is generally very significantly cheaper than the insurance route.

To conclude, this article has examined the main options pension scheme trustees have to de-risk their schemes – starting first with strategies on the asset side and then turning to individual mechanisms available on the liability side. Finally we turned to complete risk transfer solutions, including a cheaper alternative to the traditional insurance route.

Written by Ben Shaw, development director, Occupational Pensions Trusts

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