Engaged Investor

Defined benefit (DB) pension schemes in the UK have now largely moved from seeking to maximise the return on assets to ensuring that their risk exposure is reduced and controlled. As a result, the star fund managers of the 80s and 90s have been replaced by experts who can show schemes how to manage risk through an array of innovative solutions.

BlackRock head of LDI Tarik Ben-Saud says schemes need to assess the impact of possible bad outcomes on their funding position. “If things go wrong, what is the downside? If there is an equity bear market and bond yields also fall, what is the ‘cost’ to the scheme?” he asks. He adds that as schemes become more mature, their ability to recover from bad outcomes diminishes.

But some schemes need to take more risk than others as SEI director, European institutional advice, Charles Marandu, explains: “The key thing is to understand the level of risk embedded in the scheme. If a scheme is only 50% funded, it might be appropriate to take quite a lot of risks in asset allocation to improve the funding position”. Conversely, schemes that are well-funded now want to preserve that by minimizing risks where they can.

Getting your bearings for de-risking

More schemes are following the examples of the first high-profile cases of pension funds implementing de-risking approaches, such as bulk buyouts or longevity swaps. Hammonds international head of pension and partner Francois Barker says it is now common for pension schemes to use some or all of the de-risking choices on the menu depending on their preferences, liability profile and the availability of cash and other resources. These options include liability-driven investing (LDI), buyouts and buy-ins, mortality or longevity swaps and some newer innovations, such as pensioner increase swaps and the use of special purpose vehicles (SPVs).

Club Vita longevity consultant Andrew Gaches said there is a now a big pipeline of schemes queueing up to reduce their risks when the time is right. “Schemes are getting ready to make a move when financial conditions are such that it makes sense.”

STARTING OUT

We look at some of the different routes to de-risking available to trustees.

Enhanced transfer value (ETV) exercises

Francois Barker of Hammonds says: “Enhanced transfer values (ETVs) are very much the vogue and are likely to continue to be so, even if the Pensions Regulator (TPR) says it doesn’t favour them. The main practical hindrance is finding cash to inject into schemes to top up transfer values, but I have seen it done imaginatively where companies have persuaded trustees to use contributions that have already been committed to the scheme.”

Barker adds that despite warnings over ETVs from TPR, there is no legal principle that prevented an employer from approaching its former employees with an offer in relation to benefits derived from their period of employment. The key issue was that the offer was communicated in an open and transparent way to allow members to make an informed choice. Provided that trustees are satisfied that members are not being misled, there is no reason to be obstructive.

Pensioner increase swaps

Pensioner increase swaps are where pensioners give up their entitlement to future, non-statutory increases in return for a higher base pension now. Barker says: “It gives pensioners more money when they are younger and they may see real value in that. It is a genuine win-win, as companies will typically give away only a proportion of the future cost saving to pensioners.”

He adds that few pensioner increase swaps have come to market to date, but there is a lot of interest in them.

Using derivatives to de-risk

Building out a liability matching portfolio, through the use of swaps and gilts can help schemes hedge out (or protect themselves against) risks caused by interest rate movements and inflation. Ben-Saud said: “Promising pensioners index-linked pensions exposes schemes to the vagaries of future inflation.” Interest rate risk is a major threat to mature DB schemes, as it directly affects liability valuations.

Both inflation risk and interest rate risk can be hedged by the use of derivative swap contracts, but Ben-Saud said recent market dislocation has led to yields on gilts moving higher than yields on swaps. This is not normally the case as swaps carry counterparty risk (ie the risk that the other party involved in the swap will default), so usually have a higher yield to compensate.

“Typically a 30 year gilt yield is 40 basis points more than a comparable interest rate swap.” He adds that schemes need to source liquidity in order buy gilts. “Clients have gone back to their index equity portfolio and are replicating a portfolio by using index futures, converting a physical equity portfolio into futures. This way of thinking is becoming more comfortable for schemes.”

Using trigger points to lock in funding improvements

State Street Global Advisors managing director and global head of LDI Joe Moody says a dynamic de-risking approach can be used to reduce the amount of risk in a portfolio as the funding ratio rises. “The trustees need to agree a road-map upfront so they know what’s coming.

As the funding ratio rises, they go from amber to green and switch a percentage of assets from growth assets into gilts and bonds,” Moody explained. This approach reduces the potential for future returns, but also reduces chances of funding worsening.

Buyouts and buy-ins

A bulk buyout of all scheme liabilities is the ultimate sledgehammer to crack the de-risking nut, but is expensive, even if a scheme if fully funded, as insurance companies need to hold a higher proportion of bonds and gilts than schemes usually do and add a premium for their costs and profit margin.

However, markets conditions are changing. Pension Insurance Corporate (PIC) partner and head of origination Jay Shah says: “As equity markets have picked up, we have seen situations where a full buyout is less expensive than expected and companies are now able to grasp the opportunity”.

Partial buy-ins, where a scheme holds an insurance policy to cover the pensions of a specific group of members such as pensioners, have also become widely used. “We are finding that there is a greater convergence between a scheme’s assessment of the funding position and our assessment of their liabilities, so it is more affordable for schemes,” Shah says.

Shah says that PIC will drill down into scheme data to find where the scheme assessment of the liability was close to PIC’s, such as for older pensioners or those with smaller pensions.

He adds that a lot was made of preparing data before a buyout but it could be overstated. “In our view, data needs to be good enough but doesn’t need to be perfect. The impact of market movements on pricing is far, far greater than the impact of slightly better data.”

Special purpose vehicles

Another growing area for de-risking is the use of special purpose vehicles (SPVs) to give schemes an income stream from a corporate asset. Marks & Spencer and Sainsbury are understood to have done this with property leases for some of their stores, which were placed in a SPV paying an income stream to the pension fund. One advantage of this is that the net present value of the income stream can then be capitalised and used to reduce a scheme deficit.

From the company perspective, the asset in the SPV can be returned to the control of the company, if it is no longer needed in the future, but if the company becomes insolvent the scheme has first call on the asset in the SPV, giving it capital protection on the downside as well as an income. Barker says: “The main issue for the trustees is the covenant for the SPV; an SPV is only as good as the income flow attached to it and that is only as good as whatever is generating that income. The SPV will need to be independently valued by the trustees”.