Pension deficit reduction means less risk

With UK pension schemes generally in better shape in 2010, finance directors and pension scheme trustee boards have been given an opportunity to take some risk off the table. However, in today’s environment of low interest rates, moving to a full buyout is unrealistically expensive for most schemes. So the favourite way forward is for schemes to identify subsets of risk, such as the risk associated with inflation, or with a movement in bank base rates, or longevity, and to address each of these risks separately.

The change in pensions deficits is evidenced by the improvement in the overall deficits of the Aon Hewitt 200 Index - the total deficit (or surplus) for the UK’s 200 largest UK privately sponsored pension schemes.

According to Aon Hewitt, the pension deficit for these companies had been reduced to £52bn as of 1 January 2011, a 40 percent improvement on the £87bn figure recorded on 1 January 2010.

Although many of the conditions affecting the funding position of pension schemes remain broadly similar to this time last year, the equity market rally has eased the pain for businesses, thus offering a renewed sense of optimism for 2011.

With pension scheme deficits looking more manageable, Aon Hewitt principal and actuary Marcus Hurd thinks now is the time for sensible planning, “ensuring that your business has the right risk-reward balance, and considering whether you should lock in to current deficit levels or continue to play market volatility to seek extra return.”

Interest swaps

There is a variety of ways to lessen the overall risks associated with final salary schemes short of a full buyout. Marcus Mollan, head of strategy and pensions solutions at Legal & General, says that one of the favourite approaches for taking out interest rate risk is to engage in interest rate swaps through a gilt total return (that is, the coupons plus any capital gain or loss) swap. The way this works is that the scheme agrees with a bank to pay the floating rate of Libor, while the bank pays the scheme an agreed fixed basket of gilts.

This gives the scheme exposure to gilts without it actually having to find the cash to buy the bonds. Swaps of this kind are extremely cash efficient. No money actually changes hands to initiate the contract, and there is a netting out, depending on whether Libor or the gilt rate is the higher, at fixed intervals, or at the end of the swap contract.

The swap is usually a short-term contract - between three months and three years - and is based on long-term gilts, which gives the scheme exposure to the longer, higher-yielding end of the yield curve (government debt of 10 years’ duration or longer).