Pension Funds and their Advisers

Pensions Risk – the new Black?

The good news is that the subject of pensions is now firmly on corporate agendas. the bad news is that pensions now seem to be only ever associated with negatives and phrases like ‘black hole’, ‘millstone’, and ‘industrial relations issue’. the view from the top is that pensions have become an unmitigated disaster with sudden unplanned increases in costs, greater public disclosure of these
costs, uncontrollable investment markets, members up in arms, or at the gates, because they are been denied the luxury of a final salary plan. can it get any worse?

Well, let’s see how things develop in the wake of the credit crunch, and collapsing, wildly gyrating markets. is it any wonder that companies and trustees are all too keen to listen when a whole bunch of new providers appear and offer to take away the pain of pension plans: “we can help
you to de-risk your dB pension plan, or if you want, to take away all of the risks that your dB pension brings you.” why would any sane finance director not listen to the sellers of this message? But what is the reality of risk transfer, or risk removal, and how does it marry up to expectations?
Most importantly, will the whole idea of risk turn out to be just another flash in the pan? i think not and will try to show why i think risk, and specifically pensions risk, will be on corporate agendas for many years to come.

Let’s start with perceptions of pensions. the last few years have, for many companies, changed their views forever about pension plans, and how they need to deal with them. in the ‘good old days’, pensions was a small neglected part of corporate life, something the hR director muttered
about periodically, and sometimes even became a ‘problem’ for the Fd of how to account for a surplus (this is a negative deficit, for younger readers). then we hit the perfect storm of the 2000s with drops in interest rates pushing up liabilities, asset values plummeting, and actuaries pilling
on the misery by increasing longevity projections. hence the subject is now on the ‘top table’ agenda, as a bad problem to be ‘dealt with’. however hard companies tried, by piling on more contributions, making changes to investments and reductions in benefits, getting members to pay
more, and closing to future accruals, the problems just didn’t seem to go away. so the corporate attitude to pensions has changed forever, i fear. the table below summarises old thinking and new thinking, not for everyone, but for the vast majority of companies that want to get on with their
business, rather than being distracted with running a pension fund, with a corporate side business.

Against the new background of having to manage short-term risk, the cycle of pension scheme financing and funding can be mapped out as below.

Identify. work out just what the objectives are. what is our desired end state? For many sponsors the eventual goal now will be to have no dB liabilities and risks, ultimately to accumulate sufficient assets to be able to buy out the benefits from an insurance company, perhaps one of the new monoline insurers lik Paternoster, synesis or Pic. others may decide that self sufficiency is their target. Even those who continue to offer open final salary plans will want to identify their risk related objectives, to have only so much exposure in their profit & loss account, or on their
balance sheet. at this stage we should also identify constraints on our actions and whether there are any hard limits that we cannot breach, or prior covenants that will place barriers on our freedom of action?

Quantify. the next stage is to get down to some hard number crunching. what is our risk budget, typically expressed in terms of the downside bad events that we wish to avoid? Techniques like Value at Risk will be appropriate here, but beware of the multiple versions of this apparently well defined statistic. ideally we will work though our objectives and come up with mathematical solutions. what is the optimum balance of cash contributions and investment gains that we will need to achieve our goals? what has been lacking from many pension plans to date is a truly integrated approach to pension scheme financing? how do contributions and investment policy interact, and vary in response to changes in investment markets, employer covenant and so forth? the quantification process will give rise to a Risk Roadmap, a quantified route map that shows how we can get to our desired objectives, together with the associated downside risks.

Act. now we need to get down to action in dealing with the risks we face. at the risk of talking through one’s R’s, we can identify four broad action headings: retain, reduce, remove or even raise the risks that we face. some of these may be relatively simple.Removing risk is what we call insurance. You pay somebody a premium to insure you against the risks you face. in extreme circumstances the premium might be the total
cost of a buy out to take away all risks. on a more measured basis we might remove interest rate or inflation risks by entering into swap contracts, under an ldi or hedging strategy. Check that the price is right though and beware of those who tell you this is a no cost insurance option. we can reduce our risks in a number of ways, by changing benefits, for example, to reduce our vulnerability to inflation. But the idea of retaining or
raising risk looks counter intuitive, surely we want to get our risks down? this may be a long-term goal, but in the medium term, many sponsors will need to keep taking risk because they expect to get rewarded for it. investing in equities and other return seeking assets is very much a risky process, market movements have convinced us all of that, but they are expected to be rewarded in the form of longer-term superior returns. Many
sponsors need those extra returns to reduce the cash cost of getting them to a risk free position, a true conundrum!

Reassess. whatever actions we take, we then to need to monitor the outcomes against our Risk Roadmap. close monitoring will enable us to adjust the Roadmap to changing conditions. If we are well prepared with our governance processes sorted in advance, we can use the wild fluctuations in markets to our advantage, locking in excess investment profits that seem to be generated on a daily basis. But we do need to have the lines of communications, and execution, well mapped out between trustees and employer, and between trustees and whoever is charged with the execution of their pre-agreed instructions. where we take major actions, such as an Enhanced transfer Value (EtV) exercise, this may well accelerate our progress towards the end position. So we should keep the plan under constant review, adjusting it as events unfold and may
even be able to review our overall objectives. For example, if we really do remove risks associated with deferred pensioners and pensioners, think EtV exercises and partial annuity buyout, then perhaps we can afford to keep a smaller dB plan in operation for
our current employees?

Working through this process requires trustees and sponsors to have access to advisers with deep knowledge of both their liabilities and the range of potential assets. the adviser also has to be on top of the new developments and opportunities, such as new annuity providers, new hedging
strategies, new longevity solutions, new credit insurance solutions, a list that gets added to on a daily basis. which of these are right for your plan and which can you safely ignore? what role do these new ideas and new products play in helping you to meet your objectives and can we slot
them into our Risk Roadmap? as well as having a trusted adviser who can help them navigate these new swamps, sponsors and trustees may increasingly look to a different type of relationship with their adviser, asking for a much more hands-on role, and expecting the adviser to deliver solutions rather than just advice. Yes companies want advice about the shape, cost and likely success of an EtV exercise but many would simply prefer the adviser to get on and organise the whole process, ideally aligning their rewards with the success of the exercise from the sponsor’s
perspective. in the investment space, the ‘solution set’, the range of assets to invest in and the techniques for hedging and risk mitigation, has exploded in the past few years. can we afford the luxury of teaching trustees about all of these new solutions and concepts, when, markets and market opportunities are changing so fast? a better model may be for the trustees to set the overall policy objectives and constraints, and then to delegate the execution of that policy to their investment consultants, who will, ideally, be rewarded in relation to how well they have helped their
clients towards the agreed objectives.

With markets changing at a bewildering pace, new ideas and techniques arriving each day, and the risks associated with getting things wrong magnified all the time, is it any wonder that sponsors and trustees want to outsource the execution of their Risk action Plan? Getting the objectives
right, mapping out constraints and barriers is the real task for these decision makers. the best way to navigate the minefield out there is a job for the professionals, the new breed of Pension Risk Professionals.

Biography of Kevin Wesbroom

Kevin is an experienced pension consultant who has been advising high profile clients for over 30 years. he is a qualified actuary who has been involved with many different aspects of pension, investment and broader employee benefits, as well as management role, and was responsible for establishing hewitt’s UK defined contribution team. He has a limited client portfolio to ensure that he is available to take on urgent and demanding roles. His clients include a major software supplier and global investment bank. his recent projects include a review for the dwP of hybrid plans and he is currently leading a benefit review for the UK higher Education sector.