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.”
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).
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However, present market levels with 10-year gilts hovering around 3.5 percent to four percent are not very attractive, and the same can be said for inflation. So while some schemes are ploughing on with de-risking, others are much more concerned about setting trigger points, which basically say that if interest rates or long-term bond yields hit x or y level, the scheme’s advisors are mandated by the trustees to put a swap in place, or to switch a percentage of the funds into bonds.
As Mollan points out, this is all about getting beyond the inertia that has plagued pension schemes in the past. With trustee boards only meeting at quarterly intervals, and tabling items for discussion at subsequent meetings, it could easily take scheme trustees nine months or more to reach decisions on key actions, by which time market conditions have changed and the opportunity has passed.
Today, however, schemes have smartened up and agreed on trigger points that have become a powerful way of providing the scheme’s fund managers with a mandate for action. This is as simple as agreeing in principle, well in advance, that if the market does x, you do y. The amazing thing is that it took pension schemes 30 years to grasp this simple lesson.
Mark Humphreys, head of strategic solutions at Schroders, says that trigger points have become the way to go for many schemes. “The feeling is that conditions are not quite right at present to initiate de-risking contracts, but that this could change at short notice. Scheme sponsors want the comfort of being able to take risk off the table as the opportunity arises,” he says.
In the course of the next two to five years, Humphreys expects that virtually all UK final salary schemes will have either explicit or implicit trigger points in place that will include a number of explicit or implicit points for one or another de-risking exercise to go forwards.
“The point is that a full buyout is very expensive right now. If you can run your scheme at low risk, and replicate many of the control measures that an insurance company offering a buyout would put in place anyway to manage a scheme it took over, you can run your scheme down to a much smaller cohort of members,” he says.
Humphreys adds that the speed with which both scheme sponsors and trustee boards have moved has been particularly striking over the past six months. Many have gone from a mild interest in flight paths aimed at getting the scheme from its present position to either buyout or the lowest possible risk level, to a real desire to start implementing the initial phases of such schemes. UK pension schemes are now knuckling down for a long, hard journey, with de-risking of both assets and liabilities as a central theme.
“One of the factors that has driven this movement is the fact that some of the big reward consultancies are now offering their own de-risking solutions. This has resulted in quite a lot of emphasis being put on de-risking and the marketing momentum is now achieving results,” he says. “This is an idea whose time has come.”