Big schemes dispense with longevity risk in deficit challenge

We have recently released our third annual survey of private sector defined benefit (DB) schemes in the UK with assets of over £1bn.  The survey of 170 schemes focuses on scheme type, asset allocation, investment performance, deficit contributions, and adviser fees.

Our analysis shows that these schemes continue to have a significant financial impact on the business of the sponsoring employer; but as the pensions industry continues to develop, companies and schemes are using an increasing range of options to mitigate the risks.

Pension schemes are making little headway into accounting deficits

Deficit contributions made by the employers sponsoring schemes covered by our survey ranged from around £7m to £400m a year.  The average annual deficit contribution was £94m.  Despite this being a substantial chunk of cash, the aggregate funding level of the schemes in our survey remains very similar to the previous year at 94%.

75% of the schemes with available data have a deficit on their company accounting basis.  This is a very similar proportion to the previous year, when 78% of schemes had a deficit on the accounting basis.  Accounting liabilities are based on corporate bond yields and may bear little resemblance to the liabilities calculated on a funding basis.

As corporate bond yields have plummeted over 2014, companies are likely to be facing greater pension scheme deficits in their next set of accounts unless the scheme has significant matching assets such as bonds or gilts.  The effect of low bond yields will be compounded by the introduction of the new accounting standard FRS102 for accounting periods ending on or after 1 January 2015.  Under FRS102, the ‘expected return on assets’ will cease to be used, and the finance cost will be replaced by a ‘net interest’ entry, calculated using the discount rate applying at the start of the period.  This could have a significant effect on companies’ profit and loss accounts.

Risk reduction continues apace

For some employers, a large defined benefit pension scheme can represent a volatile accounting expense and substantial business risk.  With 4 in 5 big schemes now closed to new entrants, employers are increasingly looking to manage the pension legacy.

Bulk annuity contracts remain a popular option as a means of removing all investment, inflation and longevity risks associated with a group of members or the whole scheme, with a number of notable transactions during 2015.

Longevity risk, the risk that people live longer than expected, is one of the key risks that large pension schemes are exposed to.  While longevity may not pose as great a risk to pension schemes in the short term as, say, large falls in equity values, it has proved to be an expensive risk to have taken over the last 20 years. Longevity risk is unrewarded (i.e. the scheme is not expected to benefit from holding the risk) which means it is important for sponsors to consider whether this risk can be hedged for an acceptable cost.

Several big schemes entered into a longevity swap instead of a full buy-in or buy-out in 2014.  As the market develops and simple, index-based alternatives become more widely available, a longevity swap may become a real alternative for a smaller scheme seeking protection against improvements in the actuarial longevity assumptions over the swap's term.

There are other options available for schemes where a significant deficit makes a buy-in/buy-out or enhanced transfer value exercise unattractive.  Leveraged interest rate or inflation hedges might be appropriate, as could be a PPF-compliant group guarantee (to help reduce the PPF levy) or an asset-backed contribution (to improve the disclosed funding position without requiring substantial cash contributions).