Matthew Arends examines the popularity of liability management exercises

Undoubtedly, pension schemes have had a tough few years, with a challenging economic environment and rising deficits confounding attempts to reduce risk in the scheme. In fact, instead of the long-term reduced-risk objective getting closer over time, schemes have found that their long-term objectives seem to be more distant than ever before.

Our Global Pension Risk Survey 2013 shows that the expected time to reach the long-term objective has risen from an average of 11 years in 2009 to almost 13 years in 2013.

Against this backdrop, one of the surprising outcomes of the survey was the reluctance of schemes to implement liability management exercises in order to control pension risk.

The previous survey in 2011 showed that roughly 25 per cent of schemes were either somewhat likely or very likely to implement some sort of liability management exercise over the next 12-24 months (ie up to the time of the current survey). In practice, the percentage that had actually implemented something by the time of the 2013 survey had barely changed from 2011. Why was this? There seem to be two main reasons: the potential for adverse publicity and recent market conditions.

Liability management exercises have attracted a lot of negative attention in recent times, mainly due to some of the early exercises that were very poor value for members. These had often relied on members being unable to judge appropriately the value of the options with which they were presented. However, in the middle of last year, we saw the long-expected publication of the industry code of conduct on incentive exercises.

The uncertainty over the content of the code almost certainly meant that many exercises were put on hold pending its publication. The other factor counting against liability management exercises was market conditions. With gilt yields being at historic lows, some exercises simply did not make economic sense. For example, enhanced transfer value exercises ultimately rely on the transfer terms passing a test of whether the sum is expected to replicate the defined benefits being given up. This test is conducted using the FSA’s assumptions, which in turn relate to gilt yields. Under recent conditions, very substantial enhancements were required in order for the terms to meet the test.

So, liability management exercises have been less popular than pension schemes had predicted. Will this pattern change? We believe so. The fact remains that pension schemes are running large deficits and are carrying unwanted risks. De-risking of the scheme’s assets will help to manage this situation but this is only one part of the picture.

We believe that schemes will need to pursue all available de-risking opportunities, whether on the asset side or the liabilities side, in order to meet their de-risking objectives, so-called ‘full spectrum de-risking’. This means that many schemes will have liability management back on the agenda.

Along with this, we now have the code of conduct that very clearly sets out what a well-run liability management exercise needs to involve. The uncertainty in this area has now gone. Moreover, market conditions have changed since the middle of 2012, with gilt yields at the time of writing being (fractionally) higher, so the financial equation is shifting. All in all, we expect schemes now to be much more interested in pursuing an exercise.

And this is in fact what we have seen. Our survey has highlighted an increasing number of schemes that have adopted a pension increase exchange (PIE) option at retirement. This permits members at retirement age to exchange the part of their pension that attracts non-statutory pension increases for a larger, non-increasing pension. The survey shows that introducing this option for future retirees is proving more popular than conducting an exercise to introduce the option for existing pensioners. In fact, we expect this to become the template in future: schemes first introduce PIE at retirement and then later conduct an exercise for existing pensioners.

The environment for pension schemes continues to change and the indications are that this will facilitate liability-side de-risking. We believe schemes will need to pursue these options as part of their overall de-risking plans. It will be interesting to see whether our
2015 Global Pension Risk Survey records this trend.

Matthew Arends is a principal consultant at Aon Hewitt

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