Lucida PLC

Running pension schemes as Britain bounces back

Feb 17 2010

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The last few years have seen all in Britain suffer that famous Chinese curse - “May you live in interesting times”.  An unprecedented global banking crisis causing widespread economic turmoil, falling markets, plummeting interest rates and a deep and lengthy recession.  The stuff of disaster movies really; expect the Hollywood version soon.

The good news of course is that the dust is settling, markets have bounced back to an extent, stability is returning – slowly but surely.  And finally and officially, the UK is out of recession and is starting its recovery.  

For those running defined benefit pensions, recent times have pushed in two different directions. On the one hand, the turmoil has highlighted just how hard it is becoming to cope with the risks faced by these schemes, with struggling sponsors, volatile markets and falling interest rates adding to the challenges of increasing longevity and evolving regulation.  Never has the desire to de-risk been so heightened.  However on the other hand, that same economic upheaval has made it harder for schemes and their sponsors to take the steps to reduce risk they want to.

But now that the economic dust is settling and stability and growth is returning, trustees and sponsors have a renewed opportunity to get to grips with the risks they face and to explore the practical measures they can take to reduce it.  Indeed, a number of schemes have already taken advantage of this opening window as evidenced by the significant upturn recently in de-risking market activity.     

So what are the risks that trustees and sponsoring employers need to consider?

They are in fact many, varied and often interlinked, making the first essential step one of risk assessment and analysis. 

Perhaps the most fundamental risk is that of the employer sponsoring the scheme no longer being able to support it. As the impact of the recent financial crises and recession takes its toll, sadly this is risk that increasing numbers of trustees must face.

The more common risks - faced by all trustees to one degree or another and very much in the spotlight recently - include the risks that market and investment volatility leave a ‘black hole’ in the scheme, and that falling interest rates, higher than expected inflation or ongoing improvement in longevity push up the costs the scheme has to meet.  

While these are the high profile risks hitting newspaper headlines, there are additional risks that must be taken just as seriously. These include the operational risks associated with running the scheme, the legal risk that the regulatory environment changes to the detriment of the scheme, and finally ‘counterparty risk’ - the risk that one or more of the partners in the management of the scheme fails.

It is crucial that trustees allocate the right amount of time and energy to a full and proper assessment of the risks the scheme faces. Once they understand the risks that they are faced with running, then they can start to develop a risk management plan to address them. 

Given the technically challenging nature of these issues and the state of flux in which most of them exist, it is not at all surprising that developing such a plan may feel daunting .  The good news is that organisations like the Pensions Regulator and the ABI have produced very helpful education material to assist trustees, and of course pension scheme advisers and buyout companies are also more than happy to provide support.

Turning to the actions that can be taken to reduce risk, there is a wide and growing range of options available to trustees now - a highly useful and continually improving ‘tool kit’ to turn to when seeking to address the risks inherent in running a defined benefit pension scheme.  From universally useful data cleansing exercises, to more bespoke liability driven investment strategies, from insuring against longevity risk, to taking the first steps towards a full buy out of the scheme. 

The latest tool to be added to the de-risking kit is the longevity swap.  Although these have been carried out for years in the insurer to reinsurer world, last year saw the first use of a longevity swap to reduce risk in a pension scheme.  

The recent upturn in de-risking activity across Defined Benefit pensions has seen a number of schemes follow this first arrangement to embrace this ‘latest fashion’ in risk reduction. Under a longevity swap, in exchange for a known series of payments, the counterparty will pay the actual pension payments.

This approach has the advantage of requiring no major outlay up front, but instead the payment of an ongoing premium over time for the swap.  These cost advantages clearly have appeal, especially when memories of the recent financial crises and its effects are so fresh in people’s minds. 

These arrangements are currently one of the most talked-about de-risking solutions and whilst longevity swaps do offer a useful additional tool in the pensions de-risking kit, they need to be approached and evaluated with caution as they may not represent the risk reduction panacea some of the hype might suggest.  Trustees and sponsors need to be careful to recognise the important limitations of using longevity swaps.

The fundamental limitation should be obvious; a longevity swap can only only address one of the risks faced by a pension scheme, that of increasing longevity.  This is rarely the only or even the most significant risk faced by a scheme, as the essential initial step of a thorough review of all risks faced by the scheme will confirm.  The other key risks - interest rate, inflation, market and operational risk - are left largely untouched by a longevity swap. In fact, use of a longevity swap can actually increase operational risk, through added complexity and the interaction between benefits that will occur. 

In contrast to the narrow risk reduction achievable through a longevity swap, a ‘buy-in’ provides a significantly more holistic approach to risk reduction - covering interest rate, inflation, longevity, market and operational risk for the members or portion of members covered by the buy-in policy.

It is true that the cost of a full buy-in or buy-out may seem prohibitive in the current climate for many schemes, but there is an excellent first step available through a partial buy-in.  This offers a lower cost option, but with far wider and more comprehensive benefits than can be delivered through a longevity swap.

The accompanying diagram provides a useful visual explanation of the relative risk reduction delivered through longevity swaps and partial buy-ins.

Whilst a longevity swap can be visualised as removing one layer of the risk ‘cake’, a partial buy-in can actually cut through all the layers and remove part of each risk completely and permanently.

A good example of a partial buy-in was the arrangement Lucida wrote with the Merchant Navy Officers Pension Fund last year. This was a partial buy-in, securing approximately half of the benefits of all pensioners.  The partial buy-in made communication with members easier – this was an investment decision for the scheme and not a decision to insure specific individuals. It gave the scheme added security by protecting against the longevity of every pensioner, thereby reducing the risk of the ‘wrong members dying’.     

Without careful thought, a partial buy-in, like a longevity swap, could potentially restrict future opportunities for further risk reduction activity.  However with careful structuring there are a number of alternative ‘next steps’ that a scheme can take on the path to full de-risking: 

• The partial buy-in could be left in place and the unprotected liabilities could be covered with a further partial buy-in with the same or a different provider.  The providers could then work together to share administration functions.
• The partial buy-in could be converted to a reinsurance policy to be transferred to a different provider as part of measures to de-risk more of the scheme. 
• And finally, the existing buy-in could be restructured, for example by moving from covering say half of the benefits of all members to all of the benefits of half of the members.

So there is no reason to fear that opting for a partial buy-in as a first step in risk reduction will restrict the availability of the full range of potential solutions for further de-risking measures in the future and every reason to think that a partial buy-in will significantly reduce risk across all risk categories.

The “interesting times” of the last two years have added considerably to the already extensive challenges involved in running a defined benefit pension scheme. Sadly, many schemes are underfunded, facing deficits of varying extent. 

But despite the Chinese curse, there is an impressive array of effective and flexible solutions on offer to help trustees and sponsoring employers deal with the need to reduce the risks they face.  As economic conditions stabilise and the country continues its climb out of recession, the time is right to look hard now at what can be done to reduce the risks involved in providing these schemes going forward. 

John Smitherman-Cairns is Corporate Development Director at Lucida and can be contacted on 020 7647 1600 or at john.scairns@lucidaplc.com