Finance Directors' Guide to Pensions
Liability management and risk reduction
Many employers have taken the first step to containing the growth of future pension liabilities by closing their scheme to new entrants, changing the benefits being accrued or even closing to future accrual altogether. However this still leaves employers with a legacy past service liability which should be managed.
There are a number of methods that employers can use in order to remove, or reduce the risks associated with their defined benefit schemes. The legacy liabilities can also be reduced and re-shaped using a variety of techniques (so called liability reduction exercises) with the effect of improving the scheme's funding level.
This section sets out the preliminary considerations before undergoing any past service liability management or de-risking exercise.
The employer's objectives for the pension scheme and wider corporate objectives for their business will be central to any liability management and risk reduction review. Typically trustees will be looking to maximise the level of security for the members of the scheme and will probably be looking for benefits to ultimately be bought out with an insurance company. However, the cost of purchasing annuities with insurance companies will not be viable for most employers and may not be considered an efficient or effective use of capital, which could otherwise be reinvested in the business.
Employers should therefore decide on their key objectives, which might include minimising cash contributions or maximising their credit rating for example, and seek to understand their tolerance for volatility and appetite for risk, before considering their options for the scheme. We would also recommend the employer discusses their objectives for the scheme with the trustees sooner rather than later, although this will depend in part on their relationship with the trustees.
Before deciding which liability management and risk reduction exercise should be considered in more detail, it is important that employers identify and understand the key risks that are inherent within their scheme. They should also understand the possible impact of "downside risk" on future cash calls and the employer's balance sheet position.
For example, some employers may be prepared to commit to a higher level of cash contributions if future volatility can be reduced. Some employers may actively choose to retain certain risks if they do not believe the market price required to remove the risk is reasonable.
A high-level feasibility study is an efficient way of determining the costs, and possible savings, of liability management and risk reduction exercises. This will allow an employer to assess the value for money of such exercises and which would help the employer meet its agreed objectives for the scheme and business.
A Pension Increase Exchange offers members the option to exchange their non-statutory future pension increases for an immediate one-off uplift to their current pension. The terms offered to the member are usually such that the value of the one off uplift is lower than the value of the increases being given up. As a result the funding level will improve.
An Early Retirement Exercise accelerates the payment of otherwise uncertain pension payments through the members' cash commutation option. This reduces the risk and duration of the liabilities and can improve the scheme's funding level, as cash is usually cheaper to provide than the equivalent benefits through the scheme.
An Enhanced Transfer Value Exercise provides members with the option to transfer their benefits out of the scheme on better than usual terms. This extinguishes the member's liability in the scheme and removes any risks of adverse future experience.
All these options will also serve to improve the scheme's buy-out position and will usually improve a scheme's ongoing funding and accounting position.
Please see our Liability Reduction Exercises section for more information.
A scheme's investment strategy will be one of the key areas of risk for the employer. However, many employers are reliant on the extra returns that it is hoped will materialise after taking rewarded investment risks. Many schemes are looking to implement more sophisticated but still transparent investment strategies to capture these extra returns in a more controlled way.
A longevity swap allows a scheme to reduce or remove the risk of increased costs if future improvements in life expectancy are greater than anticipated. Unlike an annuity policy a longevity swap allows the scheme to retain control of the scheme's assets.
Pension schemes can have a significant impact on a company's accounting position. Our interactive modelling tool can help Finance Director's understand and quantify the factors influencing the financial position of the scheme so that they can be linked into the company's own internal plans for its core business. It also allows an instant assessment of the sensitivity of the accounts to the year end assumptions so that the Finance Director can make a fully informed decision on the optimal approach.