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Investment Issues for Closed Final Salary Schemes
This document summarises the investment strategy issues facing the trustees of a pension scheme which is about to discontinue or wind-up in relation to the investment strategy of the scheme.
Trustee Responsibilities
When the decision is taken to discontinue or wind-up a scheme, the trustees should obtain investment advice. The investment issues for a scheme that is in such a position are different to those faced by an ongoing scheme.
Employer's Covenant
The strength of the employer's covenant will be key in determining the scheme's investment strategy. This refers to the employer's ability to fund any deficit in the pension scheme that exists or may arise, and it will depend very much on the individual circumstances of the case. At one
extreme, the employer may be insolvent and the trustees have no prospect of receiving any further contributions or recovering any debt on the employer. At the other extreme, the employer may be large relative to the scheme and financially strong, so the ability to meet any debt on the employer is secure.
In some cases, a change in the employer covenant, such as the employer going into receivership or administration, may be the reason why that the pension scheme is being discontinued.
Annuity Purchase
The trustees should establish the scope and likely timescales for purchasing immediate annuities in respect of pensions in payment.
Where the scheme is being wound-up with an insolvent employer, and assuming the scheme will not be taken over by the Pensions Protection Fund (PPF), it may be that the aim will be to wind the scheme up and purchase annuities in the near future. This will reduce the risk of any future worsening of the funding position which may adversely affect the level of benefits that members will receive. An exception to this may be a large scheme for which it is not possible, or cost effective, to buy annuities.
Schemes which are being discontinued but where the employer is still able to contribute as necessary may be run as a closed fund with no prospect of being wound-up in the near future. For such schemes, however, the trustees may still plan to purchase annuities as and when members retire.
Before immediate annuities are purchased, the trustees should check that this will not hamper their ability to buy deferred annuities (for members not yet retired) at a later date. Some insurance companies may only sell bulk deferred annuities if the trustees buy bulk immediate annuities at the same time.
Transfer Values
Members retain the right to request a cash equivalent transfer value of their benefits to be paid to another pension scheme, unless the trustees have received the agreement of the Pensions Regulator that transfer values need not be paid.
This can cause a problem because once a transfer value is quoted it has to be guaranteed in cash terms for three months (again, unless the Regulator has agreed that this will not apply). Even if the scheme's assets are invested in bonds, rather than equities, in order to match the liabilities, (rather than equities) there is a risk that asset values could fall during the 3 month guarantee period so that the reserves held do not cover the transfer value. Conversely, moving the relevant assets into cash does not solve the problem because the member could choose not to take the transfer value, in which case the cash reserves would be mismatched against the liability.
The trustees might consider the extent to which an option strategy may be appropriate to protect against the risk of transfer values during the guarantee period. In the final stages of wind-up, when annuities are being purchased, the insurance company may be prepared to assume this risk.
This risk is linked to the method used to calculate transfer values; in particular whether equity-based or gilt-based assumptions are used. If transfer values are calculated using weak assumptions, or if they are heavily scaled-back by the trustees, this might reduce the volumes paid. Alternatively, employers or administrators/receivers might offer incentives in some circumstances for members to take transfers in order to reduce the eventual debt on the employer. The actuary should always consider whether the transfer value basis and method of scaling-back remain appropriate.
If the trustees can make reasonable estimates as to the likely volume of transfers then this should be allowed for in the investment strategy adopted.
It is important for the trustees to be aware of the risks associated with different transfer value strategies as described above. The trustees should seek actuarial advice where necessary.
The Balance between Risky Assets and Secure Assets
Probably the most important decision for the trustees to make is how to split the fund between risky assets (held with the objective of achieving a higher long-term investment return) and secure assets (held in order to match the liabilities as closely as possible).
Until the trustees are able to extinguish their liabilities by buying annuities, secure assets would consist of cash and Government bonds designed to match the term, currency and nature (i.e., fixed or inflation-linked) of the scheme's liabilities. However, it may not be possible to match the liabilities exactly. Apart from longevity risks, bonds may not be available to match the longest liabilities or certain types of pension increase such as Limited Price Indexation. It may be possible to achieve a closer match for such liabilities using swaps.
If the trustees are intending to purchase annuities within, say, 12 months, then the relevant liability values would be the annuity costs rather than the benefit payments. Insurance companies may indicate from time to time what bonds they use to determine their annuity prices. These bonds should be used where possible to attain a closer match to liabilities.
Where the scheme is underfunded and does not have sufficient assets to meet all of the liabilities, then the matching bond portfolio should be constructed by considering the wind-up priority order and looking at the liabilities that would be covered.
The trustees will then be faced with a choice between holding the matching bond portfolio in order to protect the benefits that are currently covered by the scheme's assets, and investing some of the portfolio in riskier assets in the hope of achieving a better investment return. In general, the stronger the employer covenant, the greater the investment risk many trustees would be prepared to take: if the investments do not achieve the required returns then the employer might be able to increase its contributions to the scheme. Also the likely term to buying-out the remaining benefits, where appropriate, will determine the extent to which it remains appropriate to take investment risk.
The strength of the employer covenant will determine who is affected by any investment risk taken: the company (in terms of the future contribution rate required), the members (in terms of the level of benefits that can be provided), or both.
If in any doubt as to the ability to judge the strength of the employer's covenant, the fall back position would normally be to invest for security of members' benefits rather than for a potentially higher return.
Investment risk could be taken by the trustees investing a specified proportion of the scheme's assets in asset classes such as equities, corporate bonds or alternative assets. The level of investment risk will depend on the proportion of the scheme's assets invested in such asset classes, and the asset classes chosen (e.g. equities are likely to be riskier than corporate bonds). The principle of diversification to reduce investment risk continues to apply. Taking investment risk could also mean using an active investment manager, or adopting a "liability driven" approach, where the fund manager is benchmarked against the matching bond portfolio, but with the ability to move away from the matching assets as and when it sees fit in order to add value.
The actual strategy adopted will depend on the individual circumstances of the scheme. For example, a discontinued scheme with a strong sponsoring employer that is not in wind-up might not choose to invest all of the scheme's assets in investment-grade bonds, whereas others would. The trustees must always be aware of the risks associated with their investment strategy.
Liquidity and Transaction Costs
Unlike an ongoing pension scheme, a discontinued scheme may not be able to hold assets for a long period of time. It may need to sell assets to meet benefit payments or fund annuity purchases.
Therefore, it is not appropriate for the trustees to make new investments in asset classes with low liquidity or high buying/selling costs (such as private equity or direct holdings in property). If the trustees hold such assets, they should generally seek to sell them where possible.
Getting a good price may mean that selling low liquidity assets should not be rushed. However, this should be balanced against the risk relative to the liabilities of holding those assets.
Even if the trustees are invested in more liquid asset classes such as quoted equities, there may be a material cost in selling these. The trustees may wish to investigate ways to minimise this.
Pension Protection Fund (PPF) Levy
Initial interpretation of draft regulations regarding the PPF suggested that the risk based levy payable by all pension schemes would be based to some extent on the investment strategy adopted by the scheme. Broadly, it was expected that the more "risk" inherent in the investment strategy of a scheme the greater the risk of future underperformance which could cause a scheme to become eligible for the PPF, and therefore the greater the levy should be for such schemes.
Initial proposals for the risk-based levy do not incorporate an allowance for investment strategy, but this may well be included at some point in the future.
Fees
The trustees must keep a close eye on investment management and advisory fees. There is no point putting in place a sophisticated investment strategy if the cost of doing so outweighs the benefits. For smaller schemes, in particular, it may be appropriate to keep things simple.
Consultation with the Employer
The trustees should consult with the employer before implementing any changes to the investment strategy. In particular, any proposed material change in strategy will need a revised Statement of Funding Principles to be put in place, and the employer should be consulted on the new draft.
If a scheme effectively no longer has an employer then the trustees should establish whether there is another party with whom they should consult (for example the company's administrators/receivers/liquidators). In this circumstance a new independent trustee may have been appointed, and their views on investment strategy should be sought at an early stage.
Legal Advice
The trustees should consider taking legal advice on their duties and actions.
Barnett Waddingham LLP, November 2005.