Professional Pensions Bulk Annuities Panel 10/3/08 by Joseph Collins

Q1. The Accounting Standard Board recently proposed using "risk free" discount rates to measure pension liabilities in company accounts. For many companies this would recognise pension liabilities at close to the cost of buyout. Do you think the proposals a reasonable way to account for pension liabilities and would such a change push buyout higher up the corporate agenda?

A. From an accounting perspective the proposals do not seem unreasonable since use of “risk free” discount rates would enable direct comparison between different companies without adjustment and the accounting would be consistent with the way in which companies are required to value other assets and liabilities. However there is a risk that the apparent deterioration in funding position (from, an accounting perspective) has unintended consequences such as forcing companies to increase contribution rates. We do not believe that this is appropriate, since companies should be permitted to take account of the scheme’s investment strategy in determining future contribution rates. Whether this balance sheet impact will force buyout higher up the corporate agenda is debatable, as we believe that buyout is already high on the agenda of many companies.

Q2. How has the credit crunch, and the resulting turbulence in financial markets, affected schemes going through the buyout process?

A. Most pension schemes have been adversely impacted by the credit crunch and resulting turbulence in financial markets:

• Credit spreads have widened leading to a fall in bond values;
• Deteriorating market sentiment has led to a fall in equity values;
• A reduction in liquidity has made it difficult for schemes to sell or even value certain assets, in particular property and some infrequently traded bonds; and, generally,
• Asset valuations remain very volatile.

The turbulence in the markets has again highlighted the risks that pension schemes are running by having a mismatch between assets and liabilities. Schemes going through the buyout process are particularly exposed to changes in asset value between the point they decide to buyout and the time when liabilities are transferred. Not surprisingly, they are keen to identify mechanisms which allow them to lock in economic conditions to insulate them from subsequent turbulence. Lucida and other buyout companies are working with clients to achieve this.

Q3. The buyout market in 2008 is expected to be the industry's busiest year yet. How will you manage your resources to meet this demand? Will certain quotations be prioritised over others?

A. We certainly expect the buyout market to grow in size in 2008 and have planned accordingly. From a human resources perspective, we have been building significant in-house capability to meet projected demand. In the event that we need to call on additional resources we have agreements in place with external providers. In addition, before agreeing to provide quotations, we prioritise activity by considering the size of the potential transaction, the likelihood of the scheme transacting and the timescales proposed for the transaction. From a capital perspective, Lucida’s financial backer (Cerberus Capital Management) has already committed £1bn of capital to the business. In addition, Cerberus has indicated it is prepared to provide further capital as the market expands.

Q4. The regulator has proposed that schemes with an inadequate allowance for future improvements in life expectancy in their funding valuation will face increased scrutiny. How does the Regulator's focus on the "long cohort" projection, with an underpin on the level future improvements, compare to your own reserving assumptions?

A. When considering the strength of a scheme’s mortality assumptions, it is not sufficient to focus on future improvements alone. It is those improvements combined with the underlying base mortality table which drive life expectancy. When setting our reserving assumptions we consider both the appropriate base table and future improvements. These are tailored to individual schemes based on a range of factors including: socio-economic profile of the membership; industry data; occupation of the members; and an analysis of the scheme’s own mortality experience. That said, in general our assumptions are consistent with the Regulator’s focus on the “long cohort” projection with an underpin.