Special Report - Pensions Risk Management: Bull, horns, grab – getting a grip on pensions risk

There are two ways for a finance director to deal with their company’s final salary scheme: ignore it until the trustees request additional funding and accept that these funding demands will come out the blue, will always be painful and might be terminal under certain circumstances ­ or work more closely with the trustee body to agree a total strategy for both de-risking the scheme and getting it into a fully funded position.

The first option we can ignore, since it can only be pursued by schemes that have no problems worth speaking about and such schemes are extremely hard to find. The first thing to be said about the second option, as Kevin MacLaughlin, a principal at reward specialist Mercer observes, is that the FD starts from a difficult position: he is not in control of the scheme’s investment strategy. That is taken care of in its entirety by the trustee body. The main point here is to reiterate that for FDs to execute any strategy, they need to cultivate a positive relationship with trustees.

Assuming this exists, there are six major risk categories FDs can look to work on ­ investment risk, interest rate risk, inflation risk, mortality risk, risks associated with the strength of the employer covenant and salary risk ­ the risk that wages will spiral over time, or that particular employees will get huge increases in their final years.

Investment risk
In an ideal world, a pension fund would match its liabilities, which generally run over 20 to 30 years or more, with assets that have a long maturity date and little or no risk.

Long-dated government bonds are ideal if we stick to the presumption that there is no particular risk the UK is going to go bankrupt and default on its loans (since modern economies in desperate times inflate their way out of their debts by printing money, rather than by defaulting ­ which impacts the value of the returns and goes to inflation rate risk, but you still get your money back even if it doesn’t buy very much any more).

Matching liabilities to assets is called Liability Driven Investing (LDI) and is a goal schemes aspire to. However, the problem for FDs is that because government bonds are considered such low-risk instruments, the government does not need to offer much by way of interest to reward investors. If the scheme had nothing but government bonds, then the company would have to put a great deal more into the scheme.