Corporate risks - pension de-risking: An old age problem

Pensions de-risking has been labelled as one of the most important corporate issues today. Companies are increasingly burdened by their defined benefit schemes, with even the most mature ones capable of carrying liabilities in payments for up to 40 years.

Research from Hymans Robertson shows that a record £11bn of pension scheme risk transfer deals were completed in the last year, and it expects the market to grow significantly, anticipating deals covering £15bn of liabilities during 2010.

So, with the majority of final salary pension schemes now closed to new entrants and a sizeable number closed to future accrual, trustees and employers are now considering the options of how to secure members' benefits with insurance solutions looking increasingly attractive. This year's Association of Insurance and Risk Managers' conference will see this issue and the options for large corporates with significant pension issues under discussion.

Nicholas Bailey, group risk manager at BBA Aviation, who intends to visit the conference, admits that his company is running at a deficit in its pension scheme and although he is a seasoned professional in his field, he is attending to access information about how to try and fix that.

Historical liabilities
He says: "The defined benefit scheme has been closed off and we are in the process of revaluing it, but it will obviously be at even more of a deficit by the time we finish that process. As a corporation we have bought an annuity with Legal & General, but if you have got historical pension liabilities it can generate some big numbers that can affect your results and your trading going forward."

One such figure that Martin Jenkins, head of pensions at law firm DWF, highlights, is the latest figures from the Pension Protection Fund, which states that 85% to 90% of pension funds are in deficit.

He suggests: "Almost universally now, medium and large corporates are moving to de-risk their salary related pension arrangements. At DWF we do not know of any employer with a substantial staff pension scheme that has not at least begun this process. In the past, many employers concentrated on improving the asset side of the fund, for example, seeking better market returns and improving the quality of the investment expertise available to the trustees. It is clear that in most cases this will not be sufficient and, therefore, employers have turned to the liability side."

Myles Pink, head of marketing and product development at Paternoster, an historic player in this market but one that is inactive presently with regards its own balance sheet, says that trustees are very focused on the insurance solution at the moment.

He continues: "The big difference between an insurance solution and, frankly, any other solution, is that an insurance company is required by the Financial Services Authority to establish a very prudent reserve on day one. On top of that, they can then offer other things like collateral in a longevity hedge. In May 2009, we took a decision with the FSA that we would not write additional risk on our balance sheet until we raised more capital. We are currently working with potential capital providers to get more into the business.

"In the meantime, my new business team is working with Abbey Life, the 100%-owned subsidiary of Deutsche Bank and a highly solvent insurance company. This is the vehicle through which we made the BMW longevity hedge."

And longevity hedging, which hedges the risk that pensioners live longer than expected, is an increasingly attractive option for risk managers according to Costas Yiasoumi, head of pension longevity solutions at Swiss Re: "For many corporations, the risk materialising from the pension plan may far exceed the commercial risks the business is running. The most obvious risk for companies is asset and financial risk, and that can be managed by adjusting a strategy and implementing mitigation for financial risk. Pension plans are now turning their attention to longevity, the major insurance risk many still carry. That is why we are seeing some larger pension plans starting to look at longevity hedging while retaining the asset opportunity instead of bulk annuities."

Lane Clark and Peacock warned last month that another option, a buy-out, which involves the purchase of individual annuities with an insurance company in the members' names, will see prices rise as demand for pension scheme de-risking grows. It predicts that £15bn of new business will be written during 2010, nearly double the £7.5bn in 2009. This would take the total liabilities insured since 2007 to nearly £40bn.

Matthew de Ferrars, partner at Pinsent Masons, suggests that buy-ins and buy-outs are less attractive at the moment, because although it takes all the risk off the table, it also involves handing all the assets over to an insurance company. A buy-in is the purchase of a bulk annuity policy as an asset of the pension scheme. The trustees remain responsible to the member to provide the benefit, but have a 'matching asset' that produces an income stream that should be the same as the benefit they pay out.

Mr Pink disagrees, highlighting that the buy-in and buy-out market was pretty buoyant last year, with about £3.5bn compared with £8bn the year before but, given the average is £1.5bn to £2bn, he claims this is "pretty impressive".

Clearing prices
"We have seen volumes of £1bn in the first quarter this year. What that is telling you is that pension schemes and insurance companies are actually finding clearing prices to take on the whole of the risk. So, trustees are prepared to pay the current rates, but those rates are much higher than they were in 2007 or 2008 because the FSA rang a bell to say that insurance companies have to be a lot more concerned about credit default risk. We think they are being over prudent, but we have got to do what the regulator suggests."

There is a lot of movement in the market attracting players from the insurance world but Mr Yiasoumi warns that solutions aren't without risk for the insurers involved. For example, he says the impacts of longevity can be large, citing that underestimation of life expectancy by one year on a £1bn pension plan adds £40m to the liabilities, which would then need funding.

"We have calculated that a one-year mistake can easily happen in the context of life expectancies for pensioners running at some 20 to 25 years after normal pension age," he says, adding: "Insurers have an appetite for writing longevity because it diversifies their portfolios.

"That capacity has a natural finite limit, but it will not be coming under stress for many years. However, the sheer size of pension longevity exposures means that capacity might become a sought after commodity in the future.

"It is for this reason that Swiss Re was a founding member of the Life and Longevity Markets Association, a not-for-profit venture to promote a liquid traded market in longevity and mortality-related risk. In the longer term we see the development of a capital market investor base in longevity as a way that would enable insurers to maintain capacity for pension plans looking to hedge."

Mr Pink agrees: "At Paternoster we are not blinkered to the fact that it is only ever going to be an insurance solution because frankly if large amounts of pension schemes are going to be shedding off billions and billions of pounds worth of liability we are going to need a capital market."

John Fitzpatrick, spokesperson and board member of the LLMA, says that it sees the large demand coming from defined benefit plans wishing to be insured or protected going forward and believes the market needs to have some standards in place: "The LLMA is seeking to create standard contract embassies and collateral mechanisms to transfer risk and the longevity risk to investors and, thereby, create a substantial capacity that will be required when a significant number of pension funds choose to insure their pensions. Several of the largest investment banks, insurance companies and members of the association are contributing their expertise and talents to develop these standards."

However, he believes for the next 18 months to two years there is an adequate capacity for any pension fund to sell its longevity risk to the pension insurers: "If the surveys are correct, when you get beyond that period of time, the demand could be quite high for pension insurers and that will require a solution that moves the risk out to investors in a traceable form. We know from experience with interest rate and inflation swaps that they only develop as a large market once standardised contracts and embassies are created, so we are attempting to do that with longevity risk.

"The objective is to keep the cost of pension scheme transfers stable despite demand rising for the product, we do that by increasing the supply or the capacity of others in the world to take on the risk of longevity. Investors have been reluctant to take on the risk of longevity until the assumptions have reflected the latest science and evidence of how long people live and until there is a standardised contract, embassies and collateral mechanisms to trade the risk. When those conditions are present I anticipate that investors will buy the risk of longevity, just as today they buy the risk of people dying too soon, lethal epidemics, hurricanes, earthquakes and typhoons and many other things that are ugly and pernicious risks."

But Alistair Jones, relationship manager for insurance clients at Lloyds TSB Corporate Markets, says there is evidence that insurers are selective, which could also add to the problem of whether there is sufficient capacity.

He considers: "Met Life will only look at schemes greater than £2m and Alico and Aegon will only look at schemes over £5m. There is some form of selectivity there in the market and you also have to consider that it may be the case that some of these insurers will look at specific pension schemes with a certain demographic."

Significant risk
He also thinks there are five risks that risk managers need to be aware of in all of this, starting with investment, longevity, inflation and interest rate issues. "But the main one that pension schemes tend to forget is the covenant risk. If you look at the make up of a pension scheme, 30% to 40% of the fund is based upon the company's ability to service that going forward. Clearly if the company has problems and it is looking likely to go insolvent, then there is a significant risk to the pension fund. Making that back into a buy-out for example, makes the covenant risk disappear to a certain extent. Clearly there is risk on the insurer, but this is where the strengths of a buy-out come in, because it has to hold capital against the risks of the pension scheme, the same as any insurer," he explains.

Discussions about the options for pensions re-risking look set to continue for some time and Mr Pink concludes by suggesting that the Pensions Act 2004 has played some part in where we are today: "Since that time trustees have been seen to have personal liability for their action or inaction. They can't ignore the problem and they don't want to be seen to be taking ill advice. What we have seen is a consultant free-for-all whereby everybody is showing the various de-risking options to everybody else. That is why insurance companies have become a lot more active and start up companies enter the market, because trustees had to see what options were available."

Options available for pension de-risking
Buy-outs
Involve the purchase of individual annuities with an insurance company in the members' names. Once bought out, the pension scheme obtains a full discharge in respect of the bought-out benefits.

Buy-ins
The purchase of a bulk annuity policy as an asset of the pension scheme. The trustees remain responsible to the member to provide the benefit, but have a 'matching asset' that produces an income stream, which should be the same as the benefit they pay out.

Longevity swap
Hedge the risk that pensioners live longer than expected.

Pension trustees
Responsible for investing the money, administering the plan, and paying benefits. At least one-third of trustees must be nominated by members.

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