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• When reducing risks linked to final salary plans, employers are extending timeframes to up to 20 years.
• Organisations can pledge company assets, such as land and property, to under-funded pension schemes for an
eventuality such as insolvency.
• Deficit recovery plans longer than 10 years will come under greater scrutiny from the Pensions Regulator.
Case study: Diageo offers liquid assets
In its efforts to reduced its DB scheme’s deficit, Diageo, which owns a number of Scotch whisky distilleries, contributed £430 million in maturing whisky to a joint venture. This will cut the scheme deficit of almost £900
million and reduce the levy charged by the Pension Protection Fund (PPF). This investment is also an asset available to the scheme.
The maturing whisky will also create a series of annual payments of £25 million to the scheme for up to 15 years. If, at the end of this period, the scheme is still in deficit, trustees can sell their stake in the joint venture back to Diageo for a maximum of £430 million. If there is no deficit, Diageo will recover the whisky without a payment.Finally, scheme members can see robust funding in place.
A spokesman for Diageo says: “Although Diageo is a strong company with an excellent cash flow and market-leading position, it is preferable for the trustees to have assets by way of security in the, albeit unlikely, event of our being unable to meet obligations to the pension fund.”
Case study: Berkshire sets up longevity insurance
The Royal County of Berkshire was one of the first local authorities in the UK to hedge its longevity risk. Nick Greenwood, pension fund manager for the Royal County of Berkshire Pension Fund, wanted to reduce volatility around the scheme’s assets and liabilities, making the employer contributions more stable and predictable. On the liability side, one way to do this was to reduce the impact of the scheme’s pensioners living longer than expected, so the pension fund set up a longevity insurance deal with reinsurance giant Swiss Re.
The Financial Services Compensation Scheme told the pension fund that in the unlikely event of anything happening to Swiss Re, it would pass on the contract to another insurer on the same terms.
Employers are using strategies stretching over decades to de-risk their defined benefit pension plans, says Matthew Craig
The name of the game for UK defined benefit (DB) pension schemes and their sponsoring employers is de-risking.
A combination of factors has brought this about. For example, most corporate DB plans were set up decades ago and in their early days, contributions were paid in and invested. But with the maturing of the baby boom generation, DB plans have a higher proportion of pensioners or deferred members approaching retirement, so the ratio of liabilities to assets is greater.
Also, employers are now very sensitive to the cost of DB plans, particularly because the accounting standards for pension funds use market values, which can highlight worrying movements in scheme funding. Employers have decided the time has come to eliminate any unnecessary DB risks which could destabilise and even bring down what are otherwise fundamentally sound employers.
When it comes to de-risking a DB scheme, there are various options on both the asset and liability sides. David Tildesley, director of corporate consulting at Bluefin Corporate Consulting, says: “Whether it is on the asset side, through swaps and insurance buy-ins, or on the liability side, through closure to accrual and transfer value exercises, there is no doubt employers have woken up to the true cost of DB pensions and reducing risk.” One of the first measures to reduce risk is to close the DB plan to new members.
Tildesley says: “The difficult economic conditions have forced a number of employers reluctantly to close their DB schemes to existing employees. Some have seen this as the price for better job security.”
After closure to new members, schemes are now looking at closure to any further accrual. If this happens, any new benefit accrual will normally be made in a defined contribution (DC) plan.
One issue for employers is the timescale for reducing DB deficits. The Pensions Regulator says deficit recovery plans longer than 10 years will come under greater scrutiny. But the regulator says long-term undertakings and the tough economic climate should be seen within this longer-term context. Tildesley adds: “Although 10 years has been a typical timeframe reflecting initial guidance from the regulator, timeframes are extending to 20 years, reflecting the size of deficits and a difficult economic outlook.”
Plug the funding gap
As well as paying off deficits with cash contributions, employers are looking at more imaginative ways to plug the funding gap.
One is using assets owned by a business in conditional or contingent asset deals. Contingent assets are company assets that are pledged to an under-funded pension scheme if a specified trigger event, such as insolvency, occurs. Land and property owned by an employer can also be used, or a letter of credit or a parent company guarantee.
One potential drawback is that this type of deal might make an organisation less attractive to other creditors, and so increase the cost of borrowing. On the other hand, the use of a contingent asset could reassure trustees of an under-funded scheme.
Contingent assets are company assets that are pledged to an under-funded pension scheme if a specified trigger event, such as insolvency, occurs. Land and property owned by an employer can also be used, or a letter of credit or a parent company guarantee. Less attractive One potential drawback is that this type of deal might make an organisation less attractive to other creditors, and so increase the cost of borrowing. On the other hand, the use of a contingent asset could reassure trustees of an under-funded scheme.
There are also some more immediate steps employers can take under a long-term plan to reduce scheme deficits. Tildesley says: “Initial steps we see are closure to future accrual, consideration of pensioner buy-ins, enhanced transfer values and pension increase exchange exercises.”
Francois Barker, partner and international head of pensions at Hammonds, says: “What they do depends on their preferences, whether they have cash available and the profile of their liabilities.”
A pensioner buy-in is when a pension scheme purchases a bulk annuity with an insurance company, which effectively insures benefits for a selection of pensioners, allowing trustees and employers to manage the scheme and effectively retain its assets. The liabilities for this group can be calculated fairly precisely, so insurers can offer more attractive quotes than for buying out all scheme liabilities. For the scheme, a pensioner buy-in improves the security of benefits, while the employer can reduce the size of its pension liability. Importantly, the scheme retains control of the insurance policy, which provides an income for the pensioners, because it may be needed as a scheme asset in the event of employer insolvency.
Enhanced transfer value (ETV) and pensioner increase exchange exercises are increasingly popular ways to reduce risk. An ETV is particularly suitable for employers that think the cost of the transfer value in addition to any enhancement is less than the liability or the cost of managing it. For example, it may cost an employer £200,000 to fund the cost of an individual’s pension, compared with a transfer value of £150,000. If it can persuade the member to take an ETV of £180,000, it will have cut the cost of the liability by £20,000. But the regulator has said ETVs might not be in the best interest of members and it is seen as best practice to offer independent financial advice.
Pension increase exchange exercises are similar, but offer retirees a higher starting pension in exchange for future increases. It is harder to offer financial advice in this scenario because individuals have to weigh up factors such as their likely life expectancy.
Working with trustees
Employers must work with scheme trustees to develop a de-risking strategy. Francis Fernandes, advisory director at covenant adviser Lincoln International, says: “With UK DB pensions, [organisations] cannot separate employer covenant, investment strategy and funding. Any proposed changes by the employer must be considered in the context of these factors. Because of the UK set-up, employers have to consult with trustees, something overseas parent organisations often find hard to get to grips with.”
From the trustees’ point of view, securing the best deal for members is critical. Fernandes says: “Trustees have to act in members’ best interests and once the future accrual is switched off, it is harder to see why they would not be looking to secure all the liabilities as quickly as possible. This can lead to tricky negotiations, as employers may want to spread a deficit recovery period over a longer period. Both parties have to work together to find ways to bridge the gap.”
When it comes to reducing pension scheme risk, employers and scheme trustees face many choices and decisions, but with goodwill, hard work and smart thinking, it may be possible to ensure member benefits are delivered safely in a way that enables trustees to fulfill their duties and employers to run their businesses effectively.
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