Technical
16 Nov 2012 12:21pm

Living with defined benefit pension risk

New research into occupational pension schemes shows CFOs having to handle a range of complex challenges

Sponsored feature: supported by Mercer

The jury may be out on the efficiency of quantitative easing (QE) in stimulating depressed economies, but one thing is certain: CFOs of large companies are convinced it is causing huge financial headaches for them as they seek to manage defined benefit (DB) pension scheme risk.

According to a major new piece of research from ICAEW and Mercer, a global consulting leader in talent, health, retirement and investments, CFOs believe that the impact which QE is having on gilt yields is making it prohibitively expensive to cap DB risks and adding to the deficits that many DB pension schemes are already carrying.

“A material millstone around corporate UK’s neck” is how one finance director described the current situation. “If corporate UK is having to scrabble around, trying to find £320bn of deficit funding, it is seriously diverting cash away from any investment in productive activity.”
“We intend to de-risk but the position is quite simple at the moment,” another finance director added. “We don’t want to de-risk at current gilt yields. A lot of people are in the same place.”

The research involved 100 senior financial executives – mostly CFOs and finance directors – in large companies (FTSE 100 and 250, plus other substantial employers in the UK), all of which sponsor DB pension schemes. Ten qualitative telephone interviews with survey respondents supplemented the quantitative research, exploring the issues raised in greater depth. The report provides insights into the way companies are managing their DB pension scheme risk and coping with the unprecedented challenges that the current economic conditions are throwing at them.

Not surprisingly, DB pension scheme risk is way up the business agenda, thanks to the combination of historically low gilt yields, the uncertain economic climate, market volatility and increasing demands on pension funds as life expectancy improves. The research found that virtually all finance executives (98%) rank DB pension scheme risk as a priority, while 39% regard it as a top priority. More than half (57%) said they expected their scheme to have a negative impact on their organisation’s financial performance over the next three years. 

A material challenge

Financial executives tend to view DB pension scheme risk as unique and particularly difficult to manage, since it is often much larger, more complex, and longer-term than some other broader financial and operational risks. There is no “one size fits all” approach to managing the risk, the research found, as executives tell us they base their strategy on the materiality of the risk on financial performance and the company’s cash requirements. Almost all have a plan to manage the risk though and 89% align this with the broader corporate risk framework. This is seen as useful for understanding the relative scale of risks.

Top concerns in managing DB risk include: the impact of low bond or gilt yields increasing liabilities; the level of funding required or reducing the deficit in the pension scheme; and the investment strategy – such as deciding the correct level of risk, the type of asset or credit to invest in, or how to match assets to liabilities. Financial executives are also worried about the volatility in the size of the scheme deficit and the required funding ratio, and how to ensure that the return on investments matches the DB scheme liabilities.
Given the current economic environment, there is a strong desire among financial executives to mitigate the risk, but paradoxically that same environment ensures that they feel they are limited in what they can do. This is proving to be intensely frustrating. As one finance director pointed out: “Regulation, governmental action, market forces will all have a material effect on the risk issue, all of which are out of the control of the pension trustee or the company”.

Another said: “It would be lovely to be able to eliminate the risk, but we can’t see a way of doing that at this point because it would require significant cash contributions from the company, more than the company could afford.”

As a result, some organisations are playing a waiting game until gilt and bond yields recover and concentrating on those risks they have control over. Almost all (93%), for example, have closed their schemes to new members and half (51%) have closed them to future accrual. But despite current market conditions, many are still making preparations to move ahead with risk management in any case, more than a third are planning to implement a glide path or journey plan of de-risking triggers (38%) or invest in assets that better match liabilities (34%) over the next three years. Other tools include inflation hedging (47%) and interest hedging (38%), and around one in ten (9%) are using a mix of inflation, interest and longevity hedging to reduce DB pension risk. But half (48%) of the organisations surveyed aren’t currently using any of these tools because of the cost, perceived complexity and concern over risk in the current market.

The role of trustees

Nearly all finance executives (94%) say their working relationship with the trustee board is excellent or good. Managing the DB pension scheme is sometimes seen as a partnership and, generally, they think trustees have the necessary governance structures, experience, time and expertise to manage investment arrangements and implement the most appropriate investment strategy.

There is room for improvement though: 77% of the finance executives report missed market opportunities because investment decisions took too long, while some think that pension scheme trustees avoid using hedging because they find it difficult to understand and are therefore reluctant to agree a strategy that includes hedging as an element. Then there is the difficulty in reconciling what the executives see as the sponsor’s longer-term view for DB pension schemes with the trustees’ desire for more short-term solutions.

Mercer believes there are things that sponsors and trustees can do together to manage the risk more effectively, while balancing both short- and long-term goals. The key is to be able to act quickly when appropriate, to ensure that the trustees have the ability to act, and to address the governance challenges.

Effectively, a plan needs to be mapped out that takes advantage of the opportunities available so that pension scheme financing
and risk are addressed, permanently. “In the absence of taking action,” Mercer warns, “the deficit will grow and remain volatile.”
As one finance director said: “Ultimately, the only way the pension trustees and the pension members will get the liabilities paid in full is by the performance of the company and the strength of the company. Therefore it is inherent on the company to make sure they are managing the risk accordingly.

“It’s a two-way street. The pension fund trustees could rant and rave that they want more money, but ultimately if it’s going to damage the company, then they’re putting their repayment plan at risk. So there has to be a good working relationship between the sponsor and the trustees and, in our case, we work hard to make sure that stays in place.”

 

Mercer’s essential elements of a journey plan

  • The target (or end state) for the level of risk should be a shared objective with the trustees.
  • There should be clarity on the fundamental investment beliefs about the trade-off between risk and reward, so that the market and scheme funding conditions required for de-risking to take place are agreed between the sponsor and trustees.
  • There should be a gradual implementation process, which takes market-related opportunities where possible and can be delivered within the “governance budget” available.
  • There should be contingency protections to address trustees’ most critical downside concerns.
  • There should be sufficient flexibility in the central plan to ensure it is kept as simple as possible and everyone accepts that further adjustments can be made down the line.

 

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