Ways to reduce final salary pension liabilities

Pensions deficits can hit organisations for six, so Matthew Craig looks at techniques for controlling final salary liabilities, including new-style insurance bulk buyouts

Executive summary
• Under the current accounting and regulatory framework, pension deficits can hit financial statements and be a heavy burden for corporate sponsors.
• There are several initial stages to controlling defined benefit (DB) liabilities: reduce current liability costs; offer enhanced transfer values; cut discretionary benefits; raise member contributions.
• The next step is de-risking or the adoption of investment strategies that reduce risk in the scheme. Liability-driven investing (LDI) is the generic term for implementing control of DB liabilities.
• The last stage is to transfer the DB liabilities elsewhere. Paying an insurance firm to take on liabilities in a bulk buyout is one way of finally removing the DB liability.

It is hardly surprising that reducing defined benefit (DB) pension liabilities is one of the most pressing pension issues for many finance directors. Benign market conditions may have put many schemes back into surplus, but FDs know all to well that under the current accounting and regulatory framework, pension deficits can hit financial statements and be a heavy burden for corporate sponsors.

According to a 2007 survey by the National Association of Pension Funds, only 31% of private sector DB pension plans are now open to new members. Once a scheme is closed to new members, it is on the road to its eventual wind-up, but at the same time, the closure will have little short-term impact on pension costs. Given this, it is unsurprising that the management of, and reduction in, DB liabilities is a huge, developing area in pensions.

David Bird, Towers Perrin principal, retirement, comments: “Employers had expected to pay 10%-15% of pay towards DB pensions. Some 20% is now the norm, with some paying more than that. Employers are seeking to make pensions more affordable.”

He adds that a tougher accounting and regulatory framework for pensions has changed boardroom attitudes: “It is leading lots of firms to say ‘we will settle what we can, when we can’.”

Clive Fortes, Hymans Robertson’s head of corporate consulting, says that at a typical FTSE 350 employer, pension liabilities are often 25% of the firm’s market capitalisation. He says: “FDs should be taking a very real interest in the size of the pension scheme. It is not so much whether the scheme is in surplus or deficit, but the overall pension risk that is the issue. If a corporate Treasury department took the sort of risks that many pension schemes are taking, then heads would roll.”

For FDs and others seeking to control their DB liabilities, there are several stages in doing so. The first stage is to reduce the cost of current liabilities. Offering enhanced transfer values, cutting discretionary benefits or raising member contributions are all ways to do this.

After downsizing, the logical next step is de-risking or the adoption of investment strategies that reduce risk in the scheme. Liability-driven investing (LDI) is now the generic term for implementing a framework for controlling DB liabilities, which should address previously unrewarded risks, such as interest rate and inflation risk.

Perhaps the last stage is to transfer the DB liabilities elsewhere, as few employers, if any, want to run a DB pension scheme through to its conclusion when the last member dies. Paying an insurance company to take on liabilities in a bulk buyout is one way of finally removing the DB liability. However, bulk buyouts can be expensive, as insurance companies have strict capital reserving rules, which can be significantly above full funding on an FRS 17 or IAS 19 basis. As a result, many companies start by trying down-size liabilities over the medium term in preparation for an eventual buy out.

Bird says Towers Perrin’s research has found DB staff contribution rates rising to around 8% or 9% now, double the norm of a few years ago. Other options are to limit how much of pay is pensionable, or to base benefits on average, not final, salary.

One galling aspect of DB liabilities for employers is that they can relate to former employees who are now deferred members of a scheme. This group are also very expensive to reserve for, as there may be a high degree of uncertainty over when they will retire, making them an obvious target for enhanced transfer exercises, where individuals are offered an incentive to transfer out.

Hewitt Associates UK leader for global risk services, Kevin Wesbroom, comments: “Everybody seems to start from the point that enhanced transfers are a bad thing and that is quite an issue for FDs; they have to balance the need for them with possible reputational risk from adverse publicity. There will be some interesting judgement calls to be made.”

But he adds: “The Pensions Regulator has helped enormously here, as his guidance has set out best practice here and I also think the generosity of what is on offer has improved as well.” As a result, Wesbroom says that transfers can offer a win-win for both employer and member. In terms of making a transfer exercise successful, Wesbroom says making the process as simple as possible for members and offering them a cash incentive to transfer are key factors, but notes: “People get very twitchy if you substitute some of the enhanced transfer for cash.”

According to Bird, at least one very large company has undertaken a deferred member transfer exercise which was not publicised. “FDs are naturally nervous, but nevertheless some will go ahead. The key to getting it right is to make the offer mutually advantageous for members and the scheme.”

Stephen Scholefield, a partner at law firm Pinsent Masons, says transfer exercises should not worry trustees, provided transfer payments do not harm the benefits of remaining members. “As long as the option to transfer is presented fairly and with a proper explanation of the risks involved, that’s fine. In most cases where an enhancement is needed, the company pays cash into the pension scheme to fund it, so it is neutral for scheme funding,” Scholefield says.

After reducing liabilities where possible, de-risking them is another step in reducing their overall impact. As stated, the use of LDI can reduce the volatility of deficits. Another development which the UK may see, is the closer involvement of asset managers in pension fund investment. This approach has been pioneered in the Netherlands, where is it known as fiduciary management. Robert Hayes, managing director and head of strategic advice at fund manager Blackrock, says a fiduciary approach can be considered an evolution of LDI.

“Some of the investment strategies that would make sense [for DB liabilities] can be quite complicated or unfamiliar to the average trustee. That is the impetus for the fiduciary approach; the client says to an asset manager: ‘Here are the liabilities, here is the level of risk we are willing to take, now manage it on the year-to-year basis and keep us updated on the liabilities’. I think it is quite an effective model,” says Hayes.

Schemes may also consider a partial buyout, with pensioners being seen as relatively affordable, as their liability can be calculated more precisely. Partial buyouts by solvent employers are an important trend in the buyout market, which until recently was dominated by Prudential and Legal & General. However, the arrival of new firms such as Paternoster, Synesis Life and the Pensions Corporation, as well as interest from the likes of Aegon, Citigroup, Goldman Sachs and UBS among others, could benefit FDs able to move smartly. Wesbroom says he had seen prices quoted for a £400m buyout fall by 7% in two weeks simply due to competitive pressures. “Some of the new entrants haven’t written any business yet and they would like to,” he comments.

It is widely expected 2008 will see more large-scale buyouts – Wesbroom is aware of a couple of £1bn plus deals being processed at present. Aon Consulting principal Paul Belok comments: “There are certainly rumours of a couple of very big buy outs. I expect 2008 to be at least as strong as 2007.”

Belok adds that buyouts are still too expensive for many companies and that continuing benefit accrual to existing members is a barrier to full buyouts at many schemes. For these reasons he does not expect the buyout market to reach its peak until five to 10 years from now. Nevertheless, momentum is building up, or as Barnett Waddingham partner Paul Jayson puts it: “There will be a snowball effect – there is a lot of interest out there. Companies want to get these liabilities off their book and there are now a lot more solutions.”

Non-insured pension aggregators

Among the alternatives to an insured buyout, there have been a few cases of large and well-funded DB schemes being acquired by a non-insured pension aggregator, which takes on the assets and liabilities and hopes to manage the scheme at a profit. One such example was the purchase of the £200m Thomson Regional Newspapers fund by investment bank Citigroup. Francis Fernandes, head of pensions actuarial at Citigroup, says: “We are actually seeing new solutions which have been executed in practice and are not simply academic exercises.”

This type of deal could benefit scheme members by improving the quality of the employer covenant, but the Pensions Regulator may well step in if it perceives a weakening in a scheme’s position.

Recent months have seen the arrival of new options for dealing with DB liabilities from companies such as Brighton Rock, the Occupational Pensions Trust (OPT), Tactica Insurance and Pensions First. For trustees, FDs and even consultants keeping up to speed with developments in the DB liability market is now a struggle.

Of these new faces, OPT appears to be a pensions aggregator at the smaller end of the market, taking on schemes with assets up to £500m, while Tactica seeks to insure an employer against investment volatility for a 10 year period. Brighton Rock offers covenant insurance, which means it will pay scheme benefits if the sponsoring employer goes under. And Pensions First offers a range of bond products to manage DB risks. Pensions First partner Timothy Lyons says the bonds can be tailored to scheme needs and aim to fill the gap between LDI and full buyout. “Whatever the CFO and trustees feel is the best solution, we can create a bond that will deliver it for them,” says Lyons.

In looking at different solutions, Hyams’ Fortes says he thinks FDs would prefer a permanent answer to their DB concerns to a five or 10 year solution. “At the moment it doesn’t exist, but I think we will see a longevity market develop where FDs can trade different longevity risks in the same way that property derivatives can be used to trade in different parts of the property market.”

Andrew Reid, Watson Wyatt’s head of corporate consulting, says an issue to consider when looking at partial solutions, such as buying out a group of members, is what the future will bring: “Trustees and employers need to be mindful about what might happen if there is a major change, such as the employer going bust and the trustees having to wind up the scheme. Trustees need to be careful about the equity between different classes of members in such situations [ – they might be wary of one class being significantly better off than another].”

From a legal perspective, Pinsent Masons’ Scholefield says that treating different classes of members differently is acceptable if trustees can justify it. He adds that trustees also need to do their homework on understanding any vehicles or structures being used, their financial strength and other due diligence matters.

A final thought is that organisations in financial trouble may be able to avail themselves of the Pensions Protection Fund (PPF) which now takes on insolvent employers’ schemes. Scholefield says he has seen cases where otherwise solvent employers have persuaded the trustees and the PPF that it is in the members’ best interests for the PPF to take on a scheme. “The big accounting firms are more alive to the possibility of this happening now, but the PPF is a fairly tough negotiator and it will want sufficient upside in any deal so it can justify the risks involved,” he adds.

With an estimated £1.5bn in DB liabilities and the ways to deal with them increasing rapidly, DB liability settlement looks like being one of the hottest tickets in pensions for some time to come. At the same time, many FDs and trustee boards will undoubtedly face a steep learning curve as they grapple with the issues in reducing their DB liabilities.

Why liability management is a developing area
31% of private sector defined benefit (DB) plans are now open to new members, slightly down from the 33% recorded a year ago
Source: 2007 survey by the National Association of Pension Funds

58%of large private sector firms expected to see increased staff contributions to DB plans
Source: Towers Perrin

60% of UK companies are considering, or have taken steps towards, hedging the longevity risk in their pension scheme. Almost all are concerned about this risk.
Source: Watson Wyatt report, October 2007

64% of firms want to reduce the volatility of DB scheme costs and just over two-fifths want to reduce the absolute level of DB costs.
Source: 2007 pensions survey by the Confederation of British Industry, (among 246 companies with 1.1m employees)




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