Lucida PLC

Tackling pension scheme risks in the ‘Twenty Tens’. Engaged Investor

Jan 26 2010

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2010 looks set to be a pivotal year in the growth of the pension buy-out and risk reduction market.

On the supply side, the concluding years of the last decade have seen rapid evolution in the market.  New entrants arrived including established insurers, new insurers, reinsurers and investment banks.  The market also saw departures, particularly of those offering non-insured approaches.  In addition there is been considerable product innovation, including pension buy-in and partial buy-in, longevity-only insurance and most recently longevity swaps. 

Overall these developments have served to increase and invigorate the supply side of the risk reduction market, both in terms of products and the organisations providing them. 

Turning to the demand side, the changing fortunes of the economy over the last two years is also serving to drive market growth.  There is no doubt that the global financial crisis and the recession it spawned has put risk reduction firmly in the minds of those running pension schemes.  And as economic conditions have started to improve - albeit slowly - risk reduction for pension schemes has become more affordable.         

All this adds up to this new decade looking set to be the biggest and fastest growing yet for the risk reduction marketplace.  A vibrant, healthy and competitive risk reduction market means that where DB schemes have been closed, existing scheme members, their Trustees and sponsoring employers are all able to move to a more secure, controlled and lower risk context.       

So if 2010 is the year for trustees to take a serious look at whether to de-risk their pension scheme, what are the risks they 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 recession takes its toll, sadly this is risk that increasing numbers of trustees must steel themselves to face.

The more common risks, faced by all trustees to one degree or another, and those 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.   

Whilst 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.

More so than ever in these rapidly changing times, it is crucial that trustees allocate the right amount of time and energy to a full and proper risk assessment. Once they understand the risks that they are running, then they can start to develop a risk management plan to address them.  

Developing such a plan may feel daunting.  This is not at all surprising given the technically challenging nature of these issues and the state of flux in which most of them exist.  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.

As mentioned earlier, there is a wide and growing range of de-risking 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.  

Purchasing longevity swaps alongside interest rate and inflation hedging achieves a “DIY buy-in” strategy.  However, trustees need to be aware of the significant operational risk and management costs that will be added by such an approach and the possible gaps that can be left in coverage such as the longevity of dependants.  

Many schemes may find the simpler approach of a partial buy-in more attractive.  A partial buy-in can address all the elements of risk for a given slice of the scheme membership and benefits, potentially giving trustees and the sponsoring employer greater reduction in total risk without incurring the additional complexity of a DIY solution.  

As we move into the so-called ‘twenty tens’,there is no question that risk reduction is firmly on the pension trustee agenda. For many trustees, the need to take action to reduce risk is urgent and imperative. And almost all trustees should consider conducting a proper review of the risks faced by their scheme if they have not done so recently. Although these challenges can seem daunting, the good news is there are plenty of places to turn for help and there is a growing and vibrant market ready and willing to provide a wide variety of solutions.

John Smitherman-Cairns is Corporate Development Director at Lucida and can be contacted on 020 7647 1607 or at john.scairns@lucidaplc.com