Lucida PLC

Buyout and de-risking Q&A. Engaged Investor

Jan 26 2010

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How have trustees' derisking choices changed over the last year?

Although ‘longevity-only’ transactions have been a reality in the reinsurance sector for many years, it is only recently that the concept has been utilized in transactions undertaken by pension schemes. These have proved that the concept can be applied to pension schemes and have served to raise the profile of this ‘new’ derisking option.

Another relatively recent development is the partial buy-in concept, where a proportion of all benefits (or all pensioner benefits) is insured.  Partial buy-ins have the advantage of reducing

all risks in relation to the members covered by the insurance, rather than just their longevity risk.  Again this was possible over a year ago but very few such transactions have been undertaken through the turbulent times of the recent past.  Lucida’s recent £500m deal with the Merchant Navy Officers Pension scheme is a good example of a partial buy-in.

Perhaps the biggest change over the year has been the improvement in economic conditions since the end of 2008.  Bond and equity values have increased over the year and markets now appear to be more stable.  The improvement in economic conditions should increase the affordability of various derisking options for pension schemes and may mean that we see a significant growth in buyout activity in 2010.

Trustees may want to de-risk their scheme but not be sure where to start. What approach would you recommend?

The start point to de-risking would be to better understand the risks to which the scheme is exposed.  These include:

•  Market/investment risk – the risk that asset values fall and the risk that the pension fund does not deliver the required investment returns;
• Economic risk – the risk that interest rates fall or inflation is higher than expected.  For schemes that are still open to accrual this would also include the risk that salary increases are higher than expected;
• Longevity risk – the risk that members live longer than expected;
• Operational risk – the risks associated with running the scheme including the risk that expenses are higher than expected;
• Legal risk – the risk that the regulatory environment changes to the detriment of the scheme;
• Counterparty risk – the risk that one or more of the partners in the management of the scheme fails; and
• Sponsor risk – the risk that the sponsor is no longer able to support the scheme.

For each scheme, the trustees’ risk appetite and risk exposure will vary.  For example, a small, poorly funded scheme with a financially strong sponsor may be prepared to take significant market risk in the hope that investment returns will improve the scheme’s funding position and in the knowledge that if it doesn’t, the sponsor can provide additional contributions.

Once the trustees understand the risks that they are running then they can develop a risk management plan which begins to address the risks to which they are exposed.

Is it important for Trustees to have a de-risking 'roadmap' or is addressing specific risks in isolation a better approach? 

Although having a de-risking ‘roadmap’ is clearly a better approach, the absence of a detailed holistic plan should not be used as an excuse to delay or defer taking the first steps in risk reduction.

Certain de-risking actions are likely to be beneficial in all circumstances, for example if the scheme has poor quality data then data cleaning will reduce operational risk and may even be a pre-requisite for other de-risking actions.  Similarly anything which reduces the liabilities or transfers risk to an insurer is likely to result in reduced overall risk for the scheme. However, it is important to be aware that reducing one risk may lead to an increase in others (for example, increased counterparty risk if administration is out-sourced).

Once the de-risking roadmap has been developed, the first steps taken along the route may still be to address specific risks in isolation.  And such a map may leave some decisions about the longer term route open.

 

Andrew Stoker is Chief Actuary at Lucida and can be contacted on 020 7647 1696 or at andrew.stoker@lucidaplc.com