Finance Directors' Guide to Pensions
Liability reduction exercises
Liability reduction and risk management exercises are effectively techniques which allow you to reduce and re-shape past service liabilities, with the effect of improving the pension scheme's funding level and reducing the inherent risks.
This is possible through offering members the opportunity to exercise various options; we discuss the circumstances when such options can be favourable to members and the employer below.
These exercises can reduce the liabilities as the offer made to members is not typically priced on neutral terms, so that the value of the benefits being given up is shared between the employer and the member.
We discuss the four main forms of liability reduction exercises below.
Apart from deciding whether or not to take a tax-free lump sum, members retiring from DB schemes have very few options regarding their pensions. Compared to DC schemes (especially following the DC flexibility announced in the 2014 budget), DB schemes are very inflexible. Trustees and companies should be asking themselves if their DB schemes are really giving members the benefits they want at retirement.
A DB member could achieve the flexibility they want by transferring the value of their scheme benefits to an immediate annuity or drawdown arrangement. An annuity provides flexibility on pension increases and the level of dependants' benefits. This route may also offer a significantly higher tax free retirement lump sum in many cases. A drawdown arrangement provides complete flexibility on the amounts drawn from year to year.
On 21 July 2014, the government confirmed that it would continue to allow transfers out of DB schemes in order for members of those schemes to access the DC flexibility.
From a company viewpoint, every member who transfers out will reduce the liabilities and risk in the scheme. Since transfer values are 'best estimates' and funding reserves are prudent, the deficit in the scheme will usually also reduce if a member transfers out (although the reduction can be quite small for older members). If the trustees are reducing transfer values because of underfunding in the scheme, it is usually worth the company topping up the transfer to the full amount because of the reduction in risk and liability if the member transfers. This would make the offer more attractive and increase the likelihood of the member transferring.
A transfer option can be established as a standard part of the individual retirement process. At the same time, or later, the option can be offered to all non-pensioner members over the age of 55 as a bulk exercise.
A pension increase exchange exercise involves offering pensioners the opportunity to exchange their non-statutory future pension increases for a one-off uplift to their current pension. Where inflation linked increases are given up this exercise will reduce the scheme's exposure to future inflation risk (the risk that future inflation is greater than expected). These exercises also reduce the exposure to future longevity risk (the risk that pensioners live longer than expected). This is because the obligation to a member with an increasing pension is much more highly geared to how long they live compared to a member with a non-increasing pension.
An early retirement exercise can be offered to both deferreds and actives over the age of 55. Essentially the key to the success of an early retirement exercise lies with the members' rights to commute part of their pension for a tax free cash lump sum. This payment of this cash is usually very popular with members taking retirement; no additional incentive is usually provided.
Further, the payment of a one-off cash lump sum is typically cheaper to provide than the alternative pension benefit due to the commutation terms that are offered; this can have the effect of improving the scheme's ongoing funding level (depending on the early retirement factors and the valuation commutation assumptions).
All non-pensioner members who leave active service have the right to transfer their "deferred" pension out of the scheme. Under usual circumstances this is calculated on what is known as the Cash Equivalent Transfer Value basis. This is meant to represent the Trustees' best estimate view of the cost of providing the members' benefits.
These exercises will sometimes require an additional capital injection from the employer so it will need to carefully consider the exercise in the context of their overall business objectives.
Relatively high levels of enhancement are sometimes required in order to meet the "critical yield test". This is the test that an Independent Financial Advisor would carry out to determine whether a transfer out could be in a member's best interests. The critical yield test effectively involves calculating the level of investment return that would be sufficient to provide benefits broadly equivalent to those being given up in the DB scheme from investing the transfer amount in a defined contribution arrangement; this will vary for each member depending on their term to retirement and their attitude to risk.
An ETV can be an extremely cost effective way of de-risking a pension scheme however the exercise must be run properly with clear member communication and the provision of independent financial advice for members.
The Pension Regulator's (TPR) primary objective is to protect members' accrued benefits and it is concerned that some members may be disadvantaged by what it has labelled as 'incentive exercises'. It has therefore issued guidance with the purpose of providing employers who are considering undergoing such an exercise with a list of relevant issues to consider (from a regulatory perspective) and the best practice standards of conduct. Where the guidance is not followed, there is a risk that this could lead to the employer being accused of mis-selling, which in turn could lead to reputational damage and even legal action being taken against the employer.
TPR has issued full guidance on incentive exercises.
The main five principles discussed in the guidance are the following:
A Code of Good Practice was published in 2012 following concerns about poor practices being adopted when undertaking a liability reduction exercise. The Code was revised in February 2016 to take into account developments in the pensions landscape.
The Code is intended to improve the standard of Incentive Exercises whilst acknowledging that they remain a legitimate tool for sponsors looking to manage the defined benefit scheme liabilities. Whilst the Code is voluntary, the Monitoring Board anticipates all Incentive Exercises will follow the spirit and principles of the Code. The Pensions Ombudsman and Financial Ombudsman Service will also use the Code when arbitrating on disputes involving Incentive Exercises. Examples are available alongside the Code to help illustrate when a particular situation might fall within the scope of the Code, and other issues such as proportionality.
The Code of Good Practice on Incentive Exercises for Pensions can be found here.
The Regulator's guidance "recognises that there will be members whose personal circumstances mean it is more likely that they would benefit from accepting such an offer". Indeed there are a number of scenarios where members may feel they will be better off accepting such offers. These could include cases where members' personal circumstances are different to those assumed in the scheme funding assumptions, such as members who do not have a spouse or who expect their future life expectancy to be materially lower than average.
Members are typically attracted to offers that increase their income earlier as they look to pay off mortgages or credit cards with high interest rates so the opportunities presented by liability reduction exercises will appeal to them. In many cases a higher initial income fits in better with a pensioner's expenditure over the period of their retirement.
Where members have concerns about the security of their benefits in the scheme and the solvency of the scheme employer, they may prefer to accept an enhanced transfer out of the scheme and reinvest the proceeds in a personal pension. The Regulator also notes that very occasionally members are "sophisticated investor(s)" and may have the expertise to use their pension pot to out-perform scheme assumptions and boost their ultimate benefits.
Lastly, it is worth reiterating that such exercises are choices for members; no undue pressure should be placed on members to accept these types of offers and the offer should not be detrimental to those not accepting. The Regulator has stated that "coercing or placing undue pressure on members to transfer or give up benefits held within their pension scheme is a serious risk to members' benefits and will result in action taken by the Regulator where appropriate".