Lucida PLC

DB Pension schemes – making ends meet. PMI news

Jan 01 2010

View all News Articles

Trustees face two enormous challenges as we enter the new decade.  Firstly, how to ensure their investment performance delivers the funds needed to match the scheme’s liabilities and secondly, how much they can rely on their sponsoring company to meet the gap if things do not work to plan. 

These twin concerns of investment performance and employer covenant reflect the “Catch 22” of 2009; funding positions look precarious at the same time that sponsoring companies struggle to keep afloat in the credit crunch and recession.

Lucida recently asked1 a cross section of trustees to rank their current concerns. By far their greatest worry was matching investment performance to liabilities, with 43% of respondents citing this as their number one issue (see Fig. 1).

Investment
Scheme asset values fell sharply in late 2008, but as bond yields were rising, the damage to pension schemes was less apparent.  During 2009, as interests rates fell, deficits increased significantly. UK pension schemes of FTSE 100 companies showed a very large net deficit of £96 billion2 by July 2009 – all now reflected clearly in their balance sheets. 

Despite these huge numbers, many commentators argue that the true liabilities of DB pension funds remain understated.  What is true is that each pension scheme will cost what it takes to provide the benefits for members and beneficiaries for as long as they live. 

Investment management can help match assets and liabilities through structures like LDI or more complex derivatives programmes.  All such solutions are relatively expensive and long term. They also rely on specialists for construction and delivery. It may take time to effect a change if either the strategy or the implementation proves to be wrong.

Relying on investment strategy is unlikely to give trustees the peace of mind they crave, especially in the short to medium term. They take comfort from the fact that DB pension schemes are for the long term.  If assumptions and reality do not marry up in the short term, it is comforting to know that there are many years ahead to allow corrections to catch up.  Unfortunately for many the horizon is much closer than they think and this shortening of the end point seriously limits the possibility of the investment strategy alone being able to help make ends meet.

Fig. 1   What are your concerns for the future?

 

Employer covenant
The second factor to cause loss of sleep amongst trustees is the strength of the employer covenant.  In Lucida’s survey, there was a significant decline in trustee comfort with the financial well-being of their sponsoring company between 2008 and 2009 (see Fig.2). This point is reinforced by the increase in employer covenant reviews being commissioned currently.

Fig. 2   How comfortable are you with the financial strength of your employer?

 

The unfortunate reality is that employers who are faced with the increasing challenge and uncertainty surrounding the provision of DB pension schemes are neither prepared to meet higher funding costs nor the volatility and the impact on their shareprice.  Closures started in earnest five years ago but have accelerated more recently, to the extent that almost 90%3 of DB schemes in the UK are closed to new entrants.  Many are now also closed to new accrual and this trend looks likely to continue. 

However, even closing final salary pension schemes to accrual does not solve the problem.  The challenge of legacy schemes will continue to concern employers and trustees alike. 

 

Many ways to reduce risk
If investment management alone cannot help and trustees are uncertain of the long term viability of their employer, the trustees need to find other ways to reduce the risks in the scheme.

Buyout (in its many guises) is one option, but a more phased approach may be more practical.   Options for liability management are many and varied and range from full buyout of all or part of a scheme to attractive cash commutation terms.  While finances are tight, buy-in of a section or proportion of the membership may be the most attractive of the total risk removal options.

2009 also saw an increasing interest in longevity only solutions (see Fig.3). This is not really a buyout in that only one risk is removed, and often only for a limited period of time.  Longevity risk is addressed through the payment of premiums to (usually) a regulated insurer in exchange for an agreed future income stream to pay benefits as they fall due.  The trustees retain the assets and responsibility for the scheme.

A longevity swap is generally regarded as a stepping stone to future buyout, but care needs to be taken to ensure that the arrangement does not preclude later buyout.  It may prove expensive and requires considerable management time and expertise, so may not be suitable for most schemes.

Fig.3 Managing liabilities

 

Buyout insurance companies are actually in the business of preserving accrued final salary benefits. They take on the promise to pay and are financed to ensure that the promised benefits are actually paid.    Of course there is a cost for this present and future security, but what is often not clear is that the final reckoning will differ little whether you pay up front to buy out now or continue to endure significant running costs for many years.

Despite the adverse effects of the financial crisis, the appetite for buyout has not gone away and in fact many trustees and companies regret not proceeding with buyout before the credit crunch. The buyout market remains competitive with a number of insurers and financial institutions willing to take on the investment and longevity risks of a pension scheme in exchange for a premium.    Most trustee boards have buyout on their agenda and discussions are likely to grow with the completion of the 2008/9 round of triennial valuations and funding negotiations. 

Margaret Snowdon, Operations Director, Lucida 

 

Lucida plc is authorised and regulated by the Financial Services Authority

1.  Lucida Pensions Pulse Survey October 2009

2.  Lane Clark & Peacock, 2009

3.  PriceWaterhouseCoopers, June 2009