A way through the maze: The challenges of maintaining UK pension schemes

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A way through the maze: The challenges of managing UK pension schemes is an Economist Intelligence Unit report that examines the risks associated with running UK pension schemes, and explores the approaches to governance, funding, investment, and scheme design that companies use to manage these risks. The report was commissioned by Towers Perrin. Phil Davis was the author of the report and Rob Mitchell was the editor.

The Economist Intelligence Unit bears sole responsibility for the content of this report. The Economist Intelligence Unit’s editorial team executed the online survey, conducted the interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of Towers Perrin.

Our research for this report drew on two main initiatives:

■ We conducted a survey of 206 C-level, or board-level executives of UK companies in late summer 2007 as the credit crisis was emerging. Respondents were primarily chief executive officers, chief financial officers and chief human resources directors, although some other roles were also represented in the sample. The survey included companies, and pension schemes, of a variety of sizes, and from a wide range of industries.

■ To supplement the survey results, the Economist Intelligence Unit also conducted a programme of qualitative research, comprising a series of in-depth interviews with trustees, advisers and other participants in the pensions environment.

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A way through the maze: The challenges of maintaining UK pension schemes

  1. 1. A way through the mazeThe challenges of managing UKpension schemesAn Economist Intelligence Unit report commissioned by
  2. 2. A way through the maze The challenges of managing UK pension schemesAbout this researchA way through the maze: The challenges of managingUK pension schemes is an Economist Intelligence Unitreport that examines the risks associated with runningUK pension schemes, and explores the approaches togovernance, funding, investment, and scheme designthat companies use to manage these risks. The reportwas commissioned by Towers Perrin. Phil Davis was theauthor of the report and Rob Mitchell was the editor. The Economist Intelligence Unit bears soleresponsibility for the content of this report. TheEconomist Intelligence Unit’s editorial team executedthe online survey, conducted the interviews andwrote the report. The findings and views expressedin this report do not necessarily reflect the views ofTowers Perrin. Our research for this report drew on two maininitiatives:● We conducted a survey of 206 C-level, or board-level executives of UK companies in late summer 2007 as the credit crisis was emerging. Respondents were primarily chief executive officers, chief financial officers and chief human resources directors, although some other roles were also represented in the sample. The survey included companies, and pension schemes, of a variety of sizes, and from a wide range of industries.● To supplement the survey results, the Economist Intelligence Unit also conducted a programme of qualitative research, comprising a series of in- depth interviews with trustees, advisers and other participants in the pensions environment.We would like to thank the many people who helpedwith this research. © The Economist Intelligence Unit 2008 1
  3. 3. A way through the maze The challenges of managing UK pension schemes Executive summary ● The risks associated with running UK pension trustee competencies. Many companies, it seems, schemes are becoming more severe. The majority of have difficulties in determining the metrics that apply respondents questioned for our survey believe that to their scheme, and in conducting performance the risks facing their organisation’s pension scheme management based on outcomes. have increased over the past few years. The key risks, according to respondents, are regulatory changes that ● More innovative investment techniques have could affect funding, which are cited by 48%, changes yet to enter common practice. Tools to optimise to mortality assumptions, which are cited by 47% and investment strategy, such as liability-driven volatility of equities, which is cited by 40%. investment or the use of derivatives, are widely discussed and written about in the business press, ● Better knowledge and understanding is a key risk but they remain little used among UK businesses. management tool. When asked about the aspects of Just 14% of respondents say that they already have their scheme management that they are keen to improve liability-driven investment in place, and 17% say in the next few years, items related to “knowledge and that they use derivatives to hedge interest rate and understanding” score highly. For example, improving inflation risk. Appetites to use these tools in future their understanding of funding options is seen as the are relatively strong, however, with 41% intending main priority, cited by 42% of respondents, followed to apply liability-driven investment in the next three by improving their understanding of long-term trends, years and 39% intending to use derivatives. which is cited by 36%. With new risks on the horizon, and new techniques to manage, mitigate or transfer ● The idea of transferring liabilities has its appeal, them becoming available, keeping abreast of new trends but practical considerations are preventing take- and often complex concepts has become more pressing up. Appetites for the concept of bulk annuity buy-outs than ever. seem relatively strong, with 60% of respondents saying that they would transfer at least some of their ● Performance management remains an important liabilities if they could do so at a competitive price weakness. When asked about their strengths and with the full support of stakeholders. In reality, weaknesses with regard to different aspects of scheme however, most respondents say that they would be governance, respondents saw their strengths as unlikely to adopt this approach: just 19% intend to the setting and monitoring of investment strategy transfer liabilities to an insurance company over the and the managing of relations between trustees next three years, and 61% say that they do not intend and the corporate sponsor. They were also fairly to explore this option. The main barriers are cited as confident about their ability to put in place a formal being the reluctance of trustees to support such deals, process to identify risks and monitor those risks on and fears about reputational damage should the an ongoing basis. The main areas of weakness were third party fail to meet its obligations. A significant seen to be performance management—of investment proportion also believes that the economic cost of consultants and trustees in particular—and enhancing buy-outs is simply too high to consider it.2 © The Economist Intelligence Unit 2008
  4. 4. A way through the maze The challenges of managing UK pension schemesThe risk environmentPensions once inhabited an obscure corner of who said that they had decreased. Smaller schemescorporate life, ignored by everyone until it was their appear to be feeling the heat most keenly—four outturn to accept the gold carriage clock and head out of ten schemes with assets of less than $1bn said thatthe door for retirement. How times have changed. risks had increased “significantly”, compared withPensions talk is on the lips of employees, employers, three out of ten larger schemes. Arno Kitts, head ofpoliticians and the thousands of advisers that service the investment council of the National Association ofretirement schemes. A perfect storm of volatile market Pension Funds, says that the concerns of executives allconditions, stringent new rules and demographic centre on one issue. “Obviously the key risk is that thechange has created unprecedented uncertainty over pension fund cannot pay pensions.”pension provision. Many employers that blithely The poor financial state of some pension schemes iscreated final salary schemes years ago as a standard clear to see. About 6% of company schemes surveyedemployee benefit now wish they had been more had liabilities amounting to more than half of thecircumspect. And employees increasingly fear that the company’s market capitalisation, while four in tenbenefits they believed were rightfully theirs could be said that liabilities were over 20% of the marketsnatched away. capitalisation. That represents a serious risk to the The fears are quantifiable. The majority of financial health of the scheme sponsor. Given that therespondents questioned for the EIU/Towers majority of the schemes in the survey have assets ofPerrin survey believe that the risks facing their more than £500m, the effect on the overall economyorganisation’s pension scheme have increased over is not insignificant, either.the past few years. A full two-thirds said that the Mr Kitts outlines the shock that many companiesrisks had increased, compared with just one in ten have suffered in recent years. “If you are a manufacturing company, you have realised that there is a large investment animal associated with yourOver the past three years, how do you think the risks associatedwith managing your organisation’s pension scheme havechanged? What is the size of your organisation’s liabilities in relation to(% respondents) its market capitalisation? Please choose the option that you think most accurately reflects your scheme. (% respondents) Increased significantly 32 Increased slightly Between 1% and 10% of market capitalisation 32 32 No change 26 Between 11% and 20% of market capitalisation 29 Decreased slightly 8 Between 21% and 30% of market capitalisation Decreased significantly 2 25 Between 31% and 40% of market capitalisation 6 Between 41% and 50% of market capitalisation 3 50% of market capitalisation or more 6Source: Economist Intelligence Unit survey, 2008. Source: Economist Intelligence Unit survey, 2008. © The Economist Intelligence Unit 2008 3
  5. 5. A way through the maze The challenges of managing UK pension schemes Which of the following do you consider to be the most significant respondents said that special employer contributions risks to your organisation from your pension scheme? Please select up to three. would be necessary over the next three years. (% respondents) The risks posed by improving mortality assumptions Regulatory changes affecting pension funding are cited by 47% of respondents. The main worry is 48 simply that people are living longer, so are a bigger Changes to mortality assumptions 47 drain on the pension fund’s resources. Over the past Volatility of equities 40 22 years, the expected average lifetime has risen by Volatility of future inflation expectations 2.7 years, or 3.5%, from 77.7 years to 80.4 years, 36 Potential future accounting changes according to the Credit Suisse longevity index. 26 Women’s life expectancy is higher than that of men Reductions in expected future investment earnings due to changes in asset strategy 25 and has increased from 80.9 years to 82.7 years over Increasing deficits the same period. 21 Volatility of long-term bond yields Moreover, people living longer is only part of 20 the problem. The more taxing issue is predicting Restrictions on desired corporate activity arising from regulatory changes 17 the rate of increase of longevity. Steven Haasz, Source: Economist Intelligence Unit survey, 2008. managing director, wholesale, at Prudential, sums up the scale of the difficulties. “The risk of 75-year- olds living just a year longer is huge. It adds about business that can have a significant effect on it,” he 3% to a scheme’s liabilities, which may negate any says. This is leading companies to examine, perhaps aggressive investment strategy that has been put in for the first time, the risks posed by their pension place to increase returns.” The Holy Grail is to develop schemes and how to manage those risks. “The biggest products that hedge out mortality risk—and several driver of change,” says Mr Kitts, “is when the financial investment banks are working on it—but as yet such a director asks ‘Why is there this big, volatile number in financial instrument does not exist. my accounts and what can I do about it?’.” The volatility of equities was cited as the third According to respondents, the most significant greatest risk for retirement schemes, cited by 40% of overall risk to their organisation from their pension respondents. Although many schemes have reduced scheme is regulatory changes to funding, which their dependence on equities following the 2000- are cited by 48% of respondents. This is hardly 03 market downturn, an astonishing one in ten surprising—regulation has stopped employers still have an equities allocation of 80% or higher in taking surpluses out of pension schemes to reinvest their portfolios. Even the most financially secure of in the business. This means that any contributions, companies, with a predominantly youthful workforce including extraordinary contributions, are unlikely and few pensioners, would struggle to justify such an ever to be available to the sponsor again. overwhelming dependence on the riskiest and most At the same time, changes in accounting rules volatile asset class. have forced assets held as long-term investments In general, it is apparent that survey respondents to be valued at prevailing market prices. As a are most worried about the risks over which they result, at times of market stress, pension schemes have least control. After all, companies can do little appear hopelessly underfunded and a large one-off about regulatory changes except to lobby against contribution may be required from the sponsor. The harmful decisions. And there is, as yet, no solution for likelihood of this happening is not remote: four in ten managing longevity risk (or, indeed, a way to account4 © The Economist Intelligence Unit 2008
  6. 6. A way through the maze The challenges of managing UK pension schemesWhich of the following corporate performance measures is most Among respondents to our survey, 43% say that theaffected by risks associated with your pension scheme?Please select one. balance sheet is the most widely affected measure,(% respondents) followed by 25% for cash flow, 21% for earnings per share and 11% for credit rating. Balance sheet 43 When asked how effective they thought a number Cash flow 25 of strategies were at reducing the risk associated Earnings (per share) 21 with their schemes, the answers varied depending on Credit rating 11 the corporate measure selected. While governance changes were seen as the most effective technique across the board, respondents who selected balance sheet as the most affected measure tended to favour benefit design changes and liability-drivenSource: Economist Intelligence Unit survey, 2008. investment—two approaches that can favourably impact the balance sheet. Respondents who were most concerned about cash flow had little timefor a pharmaceutical company making a crucial for bulk annuity buy-outs, perhaps a reflection ofbreakthrough to prevent strokes). the high costs associated with these transactions. The other principal risk, stock market volatility, Conversely, respondents who chose credit rating asis more manageable, through the use of derivatives the measure most affected by pension risks tendedfor example. But while technical solutions are to be more adventurous and be most likely to favouravailable, the result can be imperfect. Using fewer derivatives and bulk annuity buy-outs.equities might, for instance, have the unintended So pension schemes are becoming aware of manyconsequence of reducing the likelihood of the fund of the risks they face but do not necessarily have themeeting very long-term liabilities, since shares are tools to mitigate them. They are in the midst of agenerally considered a good hedge against inflation. perfect storm and are urgently seeking perfect advice Risks associated with pension schemes can impact to navigate their way through it.on a variety of corporate performance measures. © The Economist Intelligence Unit 2008 5
  7. 7. A way through the maze The challenges of managing UK pension schemes Scheme governance Amid the gloom there are, though, beacons of hope. improves the likelihood of trustees being able to A surprising finding in the survey is that governance provide pension benefits. It would be sad if there changes to improve decision-making are seen as the was another Maxwell lurking in the shadows and the most effective measure to reduce the negative impact trustees had not taken sufficient steps to introduce of pension scheme risks. This rates more highly than safeguards.” all other putative measures including benefit design Six out of ten respondents said that they are good changes and the use of derivatives. Why does this at setting and implementing processes to identify represent hope? Because governance is one of the few risk. And a large majority of 67% said they are good solutions that can be applied without great expense at setting and monitoring investment strategy. being incurred. Clive Gilchrist, managing director of Bestrustees, Chris Close, partner at Sackers, a specialist an independent trustee firm, says that investment pensions law firm, says that, in the past, many strategy involves considerably more than appointing trustee boards failed to realise they were pivotal a set of investment managers. “Setting investment parts of the pensions machine. “Governance is really strategy means following the actuarial valuation, important. Let’s not forget that some of the larger conducting an asset-liability exercise and selecting schemes are as big as major corporations,” he says. the investments in light of the covenant and risk.” The Pensions Regulator, created in 2004, insists that He adds that it is good practice to assess each an amateur approach is no longer acceptable and manager’s performance every quarter and interview laid down governance guidelines earlier this year. It them at least once a year, so long as this does not lead recommended that pension scheme trustees should to short-term decision-making. “Organising a beauty focus on seven key points: parade based on a single quarter’s performance is not advisable.” 1. Trustee knowledge and understanding While monitoring investment returns is a tried and 2. Conflicts of interest tested process, just 51% of respondents said they are 3. The employer’s covenant good at measuring their own performance and that 4. Monitoring professional advisers of their consultants. Many ideas are being trialled 5. Keeping accurate records to develop consultant and trustee benchmarks, 6. Offering adequate defined contribution although standardised objective criteria have yet investment choices to be established across the industry. Bestrustees, 7. Ensuring proper procedures are followed for one, is working on pilot schemes with several in wind-ups pension funds to enable trustees to measure their own effectiveness. On the simplest measure, the trustees The guidelines need to be adhered to if Maxwell- are invited to rank their colleagues on two issues: how sized disasters are to be avoided in the future, says often they turn up at meetings and how much they Mr Close. “If you have proper governance, it ensures pay attention. Mr Gilchrist says that these questions that the key risks are constantly on the agenda and are more important than may appear at first sight.6 © The Economist Intelligence Unit 2008
  8. 8. A way through the maze The challenges of managing UK pension schemesHow successfully do you think your organisation manages the following aspects of scheme governance?Please rate on a scale of 1 to 5, where 1=Very successfully and 5=Not at all successfully.(% respondents) 1 Very successfully 2 3 4 5 Not at all successfullyManaging relations between trustees and the corporate sponsor 27 36 27 7 3Setting and monitoring investment strategy 26 41 22 9 1Managing administrative aspects of scheme management 25 36 27 9 3Putting in place a formal process to identify risks 25 38 26 8 3Monitoring risks on a regular basis 25 38 29 71Speed of decision making and execution 23 31 26 15 6Manager selection 20 40 26 11 2Measuring performance of asset managers 20 36 27 12 4Enhancing trustee competencies 19 31 36 11 3Measuring performance of investment consultants 18 33 33 11 5Measuring performance of trustee board 16 32 30 16 6Source: Economist Intelligence Unit survey, 2008.“You do not need to be Einstein to be a trustee and should number five to 12, rising to between nine andyou do not have to generate lots of ideas. But you do 12 for larger schemes.need to listen and react with common sense to advice The managing of relations between the trusteesoffered,” he says. and corporate sponsor is another important Administrators, too, should be monitored. Poor governance area and one in which many schemesadministration has let down a number of pension believed they performed well. The good performanceschemes, says Mr Close. “If record-keeping is poor, may be linked to the formalisation of the relationship,benefits can be over- or under-stated and this can following pressure from the Pensions Regulator. “Inharm the employer’s finances in the first case and the past,” says Mr Gilchrist, “discussions took placereputation in the second.” around a table. Now they are more often conducted in There are other issues that are often mistaken as writing so there is an audit trail that could be shown tomeaningless detail but that are, in fact, critical to the regulator.”governance. Take the size of trustee boards: large Procedures to resolve disputes over funding orboards of 15-plus trustees are considered inefficient scheme strategy have also been formalised. Thebecause there is often too much discussion and regulator is now able to act as a referee, althoughinsufficient analysis and decision-making. Equally, it has not empowered itself to pass judgment. Thisboards of just three or four are fallible. They need is a recognition that both parties must reach ato be large enough to delegate time-intensive compromise that they are happy with if they are toissues, such as investment, to specialist committees. continue to work for the good of scheme members.Bestrustees believes that the average trustee board “It is all about partnership—nobody forces a company © The Economist Intelligence Unit 2008 7
  9. 9. A way through the maze The challenges of managing UK pension schemes Which of the following aspects of your pension scheme When asked about the aspects of their scheme management are you most keen to improve in the next year? Please select up to three. management they were keen to improve, aspects (% respondents) of “understanding” scored highly. Improving Understanding of funding options (eg, use of contingent assets) understanding of funding options, in particular, 42 is seen as a priority, cited by 42% of respondents, Understanding impact of long-term trends (eg, changes to longevity) 36 followed by improving understanding of long-term Asset allocation 35 trends, cited by 36%. As might be expected, there is Response to regulatory change a gulf between the knowledge base in small schemes 32 Performance management of fund managers compared with larger ones. For instance, just 14% 28 of large schemes (those with £1bn-plus assets) said Understanding of investment trends 24 that they needed to improve their mastery of asset Management of interest rate and inflation risk allocation in the next year, while 32% of smaller 20 Relationships with members schemes said that this was a critical learning point. 19 Trustees are well advised to take training seriously. Relationships with external advisers (eg, investment consultants and asset managers) 19 The regulator’s Trustee Knowledge and Understanding Speed of reaction to changes in capital markets 17 regime is free and voluntary, and there are compelling Other reasons to undergo minimum levels of training. Where 3 problems arise in funds, the regulator has intimated Source: Economist Intelligence Unit survey, 2008. that it would take a dim view of cases where basic knowledge levels were low and little attempt had been to set up a pension scheme,” says Mr Gilchrist. “It is made to raise them. there because the company believes that attracting Low levels of knowledge are the main reason why and retaining people is important.” many in the industry wonder whether the whole At the same time, without distance between model of lay trustees running pension schemes the trustee board and scheme sponsor, conflicts should be overhauled. Should, for example, of interest can arise. For example, companies may pensions be run by professionals? After all, Myners use the same advisers as their trustees, and may be recommended that employers paid trustees for unaware that this is the case. Mr Gilchrist says that their work. Surprisingly, Mr Gilchrist, a professional conflicts of interest are becoming less common. “It trustee, believes any changes could be harmful. was usual for the financial director to be a trustee, but “Being paid would not change anything for most much less so now. The FD may attend meetings but it trustees. They do the job because they want to do should be on the explicit understanding that it is in a it,” he says. Lay trustees have much to offer, he company capacity.” believes. “They are not investment experts, lawyers or The issue of knowledge and understanding has actuaries, but they know the company and its ethos, risen to the fore in the wake of the Myners Report and they know the scheme and its members. It would in 2001 and this is underscored by the survey. be a great loss if things changed.”8 © The Economist Intelligence Unit 2008
  10. 10. A way through the maze The challenges of managing UK pension schemesInvestment strategyInvestment is an imprecise art and few, even among Sachs Asset Management. This resulted in a mismatchthe world’s best investors, end up with a masterpiece. of predominantly equities on the asset side, yet bond-Failure inevitably occurs and each occurrence instils like liabilities. “The strategy worked well in the 1990s,fear and disillusionment in the minds of investors. but then they came unstuck,” he adds.For this reason, investment styles come and go with Scarred by this experience, many pension fundspredictable regularity. As recently as the early 2000s, realised that asking their investment managers tothe majority of pension schemes employed a balanced beat an index or a rival manager had no bearing onapproach, uniformly allocating 60% of assets to the fund’s ability to pay pensions. This long-overdueequities and the remainder to bonds. The sharp stock realisation has dramatically changed the nature ofmarket downturn of 2000-03 inevitably threw many institutional investment. In terms of asset allocation,of those portfolios into disarray and, today, the old the biggest shifts over the next three years are likelybalanced approach is rarely seen. to be increased use of private equity and a reduced But whether a high allocation to equities is allocation to equities. Over one-fifth of respondentsdesirable is less important than whether there is a said that they expected to have a greater allocationcoherent approach to investment. It is clear that, in to private equity in three years’ time, while more thanthe past, many pension funds thought little about one-quarter expected to have a smaller allocationwhat their investments were supposed to achieve. to equities. Only 17% said they would have greater“The mindset of pension funds was focused on assets exposure to equities.alone rather than assets relative to liabilities,” says Barings Asset Management says that exposure toIain Lindsay, a senior portfolio manager at Goldman equities depends often on the financial health of theIn the next three years, what changes do you expect to your asset allocation? If you do not use a particular asset class and have nointention of doing so in the next three years, please select “Not applicable”.(% respondents) Greater allocation No change Smaller allocation Not applicableEquities 17 52 26 4Bonds/Gilts 18 55 21 6Property 17 44 15 24Private equity 22 30 8 40Hedge fund (specialist trading approaches) 17 22 10 51Hedge fund (long/short equity style) 15 25 9 51Commodities 11 29 11 49Other 3 25 7 65Source: Economist Intelligence Unit survey, 2008. © The Economist Intelligence Unit 2008 9
  11. 11. A way through the maze The challenges of managing UK pension schemes pension fund. “I see a mixed picture,” says Jonathan can allocate to hedge funds, property, structured Cunningham, head of international sales at BAM. notes and even products that provide returns from “Some schemes are looking to add risk, investing falling markets.” BAM’s Dynamic Allocation Fund, in less efficient emerging markets where there are for instance, has a 23% allocation to international longer-term opportunities for alpha. Others use multi- equities, 40% to UK equities, 20% to funds of hedge asset funds to try to take risk or volatility out of the funds, 12% to property and 5% in cash. These portfolio.” allocations are adjusted depending on economic Indeed, multi-asset funds are sweeping all conditions. before them at the moment, sucking in assets at a Another popular investment approach that has breathtaking rate. Their rise stems from many pension gained prominence in the post-2003 era is popularly schemes’ realisation that they threw the baby out known as “core-satellite”. This is based on the belief with the bath water when they ditched the balanced that most investment performance comes from approach. They are now increasingly adopting a market “beta” and that active managers should be “new balanced” approach and employing multi-asset used opportunistically only. So, a large weighting is funds to implement it. The main differences between made to passive index-tracking strategies and a small old balanced and new balanced is that the modern “satellite” portion is reserved for active management, version uses a bespoke benchmark that relates to such as hedge funds. the liabilities, employs dynamic (rather than static) But some schemes have come to believe that all asset allocation and uses best-of-breed funds run by existing investing styles are flawed. An increasing many firms rather than a single, monolithic balanced number is trying to remove investment benchmarks manager. from the equation altogether. A large minority of Financial innovation is also playing a part in the respondents (43%) thought that liability-driven changed landscape. “Multi-asset funds now have more investment (LDI) is the best way of reducing the tools at their disposal,” says Mr Cunningham. “They negative impact of pension scheme risk on the How successful do you think the following strategies are at reducing the negative impact of pension scheme risks on your chosen measure? Please rate 1 to 5 where 1 is very successful and 5 is not at all successful. (% respondents) 1 Very successful 2 3 4 5 Not at all successful Don’t know Benefit design changes 24 30 23 13 3 8 Liability-driven investment 23 20 30 9 4 13 Governance changes to improve decision making and control of pension issues 21 39 20 11 3 6 Use of derivatives or structured products to manage interest rate and/or inflation risks 20 26 29 11 4 10 Use of derivatives or structured products to manage equity risks 17 27 28 15 4 9 Bulk annuity buy-outs 17 21 26 14 8 14 Use of contingent assets, guarantees and other credit support tools 16 28 27 12 3 14 Alternative assets, such as private equity and hedge funds 14 24 31 16 7 8 Source: Economist Intelligence Unit survey, 2008.10 © The Economist Intelligence Unit 2008
  12. 12. A way through the maze The challenges of managing UK pension schemescompany’s finances. This is perhaps a surprisingly term market blip negatively impacts a company’shigh figure given that the term “LDI” has been in finances. Paul Bourdon, head of European pensioncommon currency for less than five years. solutions at Credit Suisse, puts it this way: “If you LDI aims to match liabilities with bond-like returns have 70% equities, over 20 years there is likely to be athat hedge out the effect of inflation and interest premium. But, over five years, there could be swing ofrates. This is often done using a swap, since cash plus or minus 40%.”bonds and futures are too exposed to the vagaries of Thus swaps, once little understood by mostthe market and do not have sufficiently long duration pension funds, are now firmly on the radar. Surveyto match the very long-term liabilities of pension respondents revealed that derivatives to hedgefunds. inflation and interest rate risk are becoming popular— To some extent, LDI has been driven by mark-to- 17% of respondents use them now and 39% intend tomarket accounting rules, which mean that a drop in use them in future.value of a pension scheme’s assets imparts a nasty hit Whereas early LDI adopters tended to buy swaps toto the balance sheet of the sponsor. Equities, among try to match all their liabilities, this has become lessthe most volatile assets, are therefore less desirable. common. While more mature schemes may seek toWhile they reduce a deficit in the good times, a short- match their remaining liabilities, newer schemes often CASE STUDY major cash portion, that 94% of our assets,” Liability-driven investment at WH Smith: says Mr Stewart. Six percent (about £50m) was invested in equity options. The total Easing up on equities drives down pension risk portfolio is expected to return just above the expected liabilities. In 2003, a reversal of fortunes on the high The board took a series of measures, Pension liabilities are far more street coupled with a very public private including two one-off contributions predictable now, too. In April 2007, the equity approach prompted UK retailer WH totalling £170m, and a transfer of pension company capped its service accrual for Smith to take a serious look at its pension assets from equities and bonds to a far less 2,500 current employees who are still part strategy. With earnings down and despite volatile liability-driven investment (LDI) of the defined benefit scheme, which was the failure of a debt-laden buyout approach scheme. closed to new members 11 years ago (most in early 2004, the board suddenly became The company made its first contribution employees are part of the company’s defined extremely uncomfortable about the deficit of £120m into the scheme in 2004 and, contribution plan). In effect this means the in its defined benefit scheme, then running around the same time, began to look at ways risk to the company has gone down, because at about £152m. to escape the ups and downs of markets. it is easier to predict the expected cash flow In addition, 60% of the pension funds’ It eventually settled on an LDI approach. needed to cover payments for the 18,000 assets were invested in equities and 40% “It was pretty clear from a relatively early past and present employees currently were in bonds. If the market took a turn stage that an LDI solution was one that fit covered by the closed plan. for the worse, the deficit might balloon our needs, but it took a lot of modelling to The result has been dramatic—today the even further, putting cash flow at risk and determine the optimum position,” says Mr deficit is down to £42m and falling, and the threatening to scupper the shareholder Stewart. board feels confident that the LDI approach dividend. At the end of September 2005, the has the company’s £635m in assets “It was pretty clear that we had to de-risk company moved 94% of its pension assets sufficiently hedged against a bear market. the pension scheme pretty significantly,” into a large, liquid cash fund, hedging “In truth I don’t think I could have asked for recalls Alan Stewart, WH Smith’s group against inflation and interest rate rises with a better outcome in terms of what we sought finance director. derivatives. “There really is no risk in the from our strategy,” says Mr Stewart. © The Economist Intelligence Unit 2008 11
  13. 13. A way through the maze The challenges of managing UK pension schemes wish to test the water and match just a part of them. given shifting mortality assumptions. “Some schemes “Schemes typically implement partial LDI solutions to forego the precision of matching for the promise of begin,” says Mr Lindsay. “They look to get comfortable strong long-term equity returns,” says Mr Lindsay. “It’s with the LDI strategy before deciding whether to a balance and there is no obvious right or wrong.” extend the match to a greater proportion of the For others, the issue is more black and white. Raj liabilities.” Hedging interest rate and inflation risk Mody, a partner and actuary at the pensions practice with swaps typically consumes 60% of the scheme’s of PricewaterhouseCoopers, believes that LDI can assets, leaving 40% free to invest in “alpha-seeking” be a crude, unreliable and expensive approach. strategies that can offset longevity risk and, in the He advocates a proprietary strategy that he calls best-case scenario, produce a surplus for the fund. “covenant-driven investment”, whereby companies Nevertheless, LDI remains a relatively unloved regard their pension schemes as fully-fledged strategy—just 14% of respondents said that they subsidiaries. Decisions about the pension fund are already use it, although 41% intend to apply it in no longer taken in isolation but in relation to other the next three years. “LDI is talked about a lot more business activities. Mr Mody believes that for some than it is actually implemented,” says Mr Lindsay. sponsors this approach negates the need to hedge out The resistance is often behavioural—trustees find it inflation and interest rate exposure. “If inflation goes hard to conceive of foregoing any windfall that comes up, you may have the opportunity to pass the costs from rising interest rates or falling inflation. “In many onto your customers. This provides a natural hedge conversations with trustees they are concerned about for the pension fund rather than buying expensive being locked in to the LDI strategy at the wrong point inflation instruments. The same applies when interest in time,” he adds. rates fall—yes, your pension deficit tends to rise, In addition, matching assets to liabilities is a but lower rates are good for the company as a whole precise technique that may not deliver precise results because it can borrow money more cheaply.”12 © The Economist Intelligence Unit 2008
  14. 14. A way through the maze The challenges of managing UK pension schemesFundingPension scheme finances have improved in heightened fear of making mistakes for whichimmeasurably in the past five years. Final salary they could be later held accountable, often openschemes of FTSE 100 companies had a combined negotiations with an aggressive view of the fundingsurplus of around £12bn in mid-July, according levels required.to actuary Lane Clark Peacock, compared with a Some trustees will adopt an overly cautiousdeficit of £59bn in October 2002. But trustee boards approach to funding issues. On occasion, trusteehave long memories and funding remains a major boards have even asked for schemes to be funded topreoccupation. Indeed, understanding funding insurance buyout levels, significantly higher than aoptions was the aspect of the scheme that most fully-funded ongoing scheme. Although they havesurvey respondents said they would like to improve little chance of succeeding, at least the trusteeover the next year, with 42% citing it. This was way board’s minutes will record an attempt to extract theahead of improving asset allocation and investment maximum contributions from the scheme sponsor.trends. But such excesses are not only likely to fail—they The eagerness to keep on top of this issue is also risk damaging trust between the sponsor and thehardly surprising. Passed in November 2004, the scheme. One approach that can prevent the wholePensions Act demands that each scheme sets a target relationship unravelling is for scheme sponsors tofunding figure. But this number depends on several take the lead in funding negotiations, rather thanvariables and is open to negotiation. Trustees, living simply reacting to a call for cash.Which of the following strategies have you used in the past three years, and which do you intend to use in the next three years?If you have no intention of using a particular strategy, please select “Do not intend to use”.(% respondents) Already in place Intend to use in next three years Do not intend to useClosure of defined benefit scheme to new members 46 22 31Increased employee contributions 37 37 26Special employer contributions 35 40 24Transfer of liabilities to life insurance company 20 19 61Closure of defined benefit scheme to future accrual 19 31 50Transfer of liabilities outside of traditional insurance sector 17 23 60Use of derivatives/ structured fixed interest products to hedge inflation/ interest rate risk 17 39 44Liability-driven investment approaches 14 41 46Use of contingent assets to support scheme funding 8 38 54Source: Economist Intelligence Unit survey, 2008. © The Economist Intelligence Unit 2008 13
  15. 15. A way through the maze The challenges of managing UK pension schemes Once funding has been agreed, both sponsor and Of course, for those employers that have switched scheme need confidence that it can be delivered, even all or part of their pension schemes onto a defined if the company’s operations falter. So when asked about contribution basis, funding is less of an issue. The the areas of their scheme that survey respondents number of members in defined contribution schemes were keen to explore in the next three years, the use of exceeded those in defined benefit schemes for the contingent assets was seen as a priority. first time at the end of 2006. Nevertheless, while Contingent assets give the pension scheme a the switch to DC rids companies of one set of risks, claim on physical or financial assets owned by the another set come into play. For example, employees sponsor in the event that the company collapses or may fail to make adequate payments into their is weakened to the extent that it cannot continue to pensions, choose inappropriate investments and end fund the scheme. up with insufficient retirement income. A survey by Just 8% of respondents said that they already the National Association of Pension Funds published have contingent assets in place, but 38% intend to in 2007 found that 81% of DC scheme members failed use them over the next three years. There is a wide to make proactive investment choices and were placed choice of assets that can be called on in a contingency, in the default option. Mr Mody is concerned about the including money in escrow, a letter of credit from a long-term repercussions: “I’m not sure if companies third party, property, receivables and loan issue notes. should be dumping all the risk on to the employee who There are also a number of trust-based solutions, such often does not understand the choices available. In a as the approach that Marks and Spencer announced decade or so, people in DC schemes will start retiring in January 2007 whereby property assets were placed in numbers and we may see a backlash as the problems into a partnership formed with its pension scheme. become clearer.”14 © The Economist Intelligence Unit 2008
  16. 16. A way through the maze The challenges of managing UK pension schemesTransfer of liabilitiesOver the past decade, it has become customary for If your organisation’s senior management could transfer all or some of the organisation’s liabilities to a third party at alarge companies to sell off non-core areas of their competitive price with the full support of stakeholders, do youbusiness in order to concentrate on activities that feel they would choose to do so? (% respondents)they understand and can manage profitably. Thesame rationale is also being increasingly applied to Yes, they would 18pension funds. Transferring schemes in their entirety transfer all of our liabilitiesto insurers is not as straightforward as divesting a Yes, they would 42business unit but the market, spearheaded by Legal transfer some of our liabilities& General and Prudential, has nevertheless been No 40buoyant. Prudential has completed more than 425deals on its own, worth over £4bn in total. Some aresmall transactions of just £1-2m but there have beenseveral £400m-plus deals including Ferranti and Source: Economist Intelligence Unit survey, 2008.Dalgety in 1999, and C&A in 2002. Certainly, appetite for the concept of bulk annuitiesseems strong: in our survey, 60% of respondents with powers to impose penalties on companiessaid that they would transfer at least some of their that did not reduce their deficits. Second, changesliabilities if they could do so at a competitive price to accounting standard FRS17 forced companieswith the full support of stakeholders. This supports to be more transparent in reporting their pensionPrudential’s belief that there could be deals in the liabilities, leaving their balance sheets exposed tonear future that dwarf the C&A buyout. “In the next 12 fluctuations in the market. Finally, life expectancymonths, there are likely to be fewer but larger deals is improving, making it more difficult to account forgetting done,” says Ted Clack, bulk annuities director future liabilities.at Prudential. As a result, healthy schemes and healthy At least ten new entrants (see boxout) to the companies are now looking at buyouts as a deriskingmarket in the past 18 months are hoping to take deals option, rather than as a last resort. Trustees, forthat could break the £1bn level for the first time. This example, may seek a buyout because they arewould inject pace into a sector that previously focused concerned about the sponsor’s stability, particularlyon schemes of insolvent companies. “This used to if it is a highly leveraged company, possibly followingbe a winding-up business after an employer got into a private equity takeover. Alternatively, a companydifficulty,” says Mr Clack. “That has changed in the may conduct a wide-ranging review of its activitiespast couple of years.” and decide that it no longer wants the operational and A number of factors have combined to make the regulatory risk of running a pension fund.environment for bulk annuity buy-outs more fertile. Financial innovation is helping to facilitateFirst, the 2004 UK Pensions Act imposed new taxes buyouts. In the past, many schemes could noton defined benefit plans and established a regulator consider buyouts because the hefty deficits made © The Economist Intelligence Unit 2008 15
  17. 17. A way through the maze The challenges of managing UK pension schemes While it is novel, not everyone is Overview of the bulk annuity market convinced by the strategy. Mr Clack at Prudential, says: “The acquirer still has to honour the Until a couple of years ago, only two names Goldman Sachs all have offerings, too. liabilities so it is not clear where returns were associated with pension buyouts: Pru- While many of them go head-to-head will come from. Perhaps they are planning dential and Legal & General. That has now in pitches for new business, most claim to take a share of any surplus, if that is expanded to about a dozen buyout firms, to offer a niche service that will win them allowable.” many of them launched by former Prudential significant market share. Citigroup, for Aegon also claims a unique selling point executives. For example, Paternoster was instance, eschews the normal practice of in its joint venture with investment bank set up in 2006 by Mark Wood, the former using scheme assets to buy annuities. It has UBS. Its idea is to transfer scheme risk chief executive of Prudential’s UK life busi- decided to manage the schemes it buys as gradually, automatically buying annuities ness, with backing from Deutsche Bank. ongoing concerns. It does this by buying if and when funding levels improve. UBS Lucida was founded at the end of last year the sponsoring company in its entirety and is responsible for managing the assets by Jonathan Bloomer, former chief execu- then selling on the operating company and to try to produce the returns needed to tive of the Prudential. Synesis Life, another retaining the pension scheme. This was the execute the next annuity purchase. Aegon 2006 launch, is headed by a group of former model for Citigroup’s August 2007 buyout admits the market is crowded but believes senior Prudential managers. of Thomson Regional Newspapers’ pension there will be a shake-out. Colin Beattie, In addition, there is The Pension fund. Scheme members have effectively head of Aegon Trustee Solutions, says: Insurance Corporation, founded by Duke swapped the Thomson covenant for a “Some players have been around for a year Street Capital, the private equity firm Citigroup covenant and now have recourse and won no business because they have headed by Edmund Truell. AIG, Citigroup, to Citigroup’s considerable balance sheet as overestimated the money available in the Aegon, Aviva, Scottish Equitable and a safety net. market in the short term.” them too expensive to effect. Today, some buyout Paulson, analyst with Bernstein Research, estimates vehicles allow payments to be spread over, say, five that the cost to a company to make the transfer is years. If the total cost of the buyout is £100m, the equivalent to about 30% higher than the number it company may pay £50m up front and £10m a year for must legally report on its balance sheet. Some, such five years. Companies are starting to consider partial as Mark Wood, chief executive officer of Paternoster, buyouts too. “You can just take a block of lives out of one of the new breed of bulk annuity buy-out players, the scheme,” says Mr Clack. “It doesn’t have to be an dispute this figure, but even Mr Wood acknowledges all or nothing approach.” that the perception of a high premium has dampened Despite the mushrooming of providers and corporate enthusiasm for bulk annuity transfers. strategies, most respondents said that they were One company that has looked at buy-outs but is unlikely to attempt a buyout. Just 19% intended to currently adopting a wait-and-see approach is Stolt- transfer liabilities to an insurance company over the Nielsen, the UK shipping firm. “We keep watching next three years. Slow take-up is rooted in long-term that market, but it’s just not deep enough right structural issues—one of the main barriers cited was now,” says Homiyar Wykes, group financial controller concern about reputational damage should the third at the company. “Unless you are keen to do it for party fail to meet its obligations. very pressing reasons like a management buyout or In addition, a significant proportion believes that a takeover, it’s not a cheap way to hand over your the economic cost of buy-outs is too high. Bruno liabilities.”16 © The Economist Intelligence Unit 2008
  18. 18. A way through the maze The challenges of managing UK pension schemes CASE STUDY drive them down by playing one off against the other.” In the end, they went with one Seddon Atkinson of the start-ups, Paternoster, for a price very Competition comes to pension buyouts close to Mr Blackmore’s original budget. With more offers to choose from, it In 2006, when Fiat subsidiary Iveco decided “It gave me severe indigestion,” says Mr was not necessary to delve into the detail to close part of its UK heavy truck division, Blackmore, who has since become finance of actuarial tables and life expectancy. Seddon Atkinson, the company had to find director for Ceridian, a UK payroll and HR Mr Blackmore could focus on the bottom a home for the pension plan, which covered outsourcing company. “The fact that there line—price. Having the right data to hand, some 2,000 current and past employees. were only two people in the market caused however, helped Paternoster to make It should have been a relatively us some grief. We booked the bad news calculations that ultimately drove down the straightforward transfer to one of two big when we announced the closure based on quote. “The fewer assumptions they have to UK insurers, Prudential or Legal & General, the actuary’s estimate, and then found out make the better,” says Mr Blackmore. “They which had cornered the market on pension we had a lot more bad news. It didn’t make all adjusted their price according to the buyouts. The fund itself was healthy— me very popular at headquarters in Turin.” additional data when it came in.” sometimes running a small surplus—but Fortunately for Iveco, the market for Are bulk annuities for everyone? because the company was shutting down, UK pension buyouts, or bulk annuities, was Blackmore understands why CFOs who aren’t law forced Iveco to make a suitable transfer. in the midst of a big shake-up because of forced to transfer their funds might wait The quoted price from one of the two changes to UK pension regulations, with until the price drops even further. “It’s a insurers, however, gave Mike Blackmore, several start-ups challenging the two big decision to make because it’ll cost you a who was finance director at the time, reason established players. Although the start-ups lot of money today when the probable bad to pause. It came in at 80% higher than were primarily after business from solvent news will happen a long time in the future, estimated prices and far higher than the companies, Blackmore started to get quotes based on probable improvements in life amount for which he had budgeted, and for buying Seddon Atkinson’s scheme. expectancy,” Blackmore says. “I personally this was a cost that Iveco would have had to “Suddenly we started getting some believe it’s the right thing to do in the long swallow in its profit and loss. competitive quotes, and we were able to term. It’s better to bite the bullet now.” Mr Wykes is confident that the company can predict scheme is well run. Any action that can secure benefitscash requirements pretty accurately for the next five is looked on favourably,” says Mr Clack.years, and reckons that the cost will be far less than While widespread approval of buyouts may bethe current price for a transfer. “If we do want to pay a some way off, the expanding market is convinced30% premium, why don’t we just put that money into that enticing opportunities do exist. As Mr Mody says:the pension fund?” he asks. “These guys don’t need much activity in the market to Another reason preventing buy-outs, cited by do well. They are playing in an industry with £1 trillionthe survey respondents, was that trustees might be of assets and billions of pounds could be available in areluctant to support buyouts, although Prudential single prize. That’s worth waiting for.”disputes this. “Trustees are there to make sure a © The Economist Intelligence Unit 2008 17
  19. 19. A way through the maze The challenges of managing UK pension schemes Conclusion While no one knows the exact shape of pension involved in implementing these solutions. Many provision in years to come, the one certainty is already have the sneaking feeling that in trying to that it will have evolved significantly. The stakes bolt every door, they will fail to notice when the are too high for the status quo—in which pension roof blows off. Given these concerns, many finance schemes represent a largely unrewarded risk for departments will insist on taking as much uncertainty companies—to remain. The search for new financial out of the equation as possible. This may lead to wizardry to combat demographic and macroeconomic greater take-up of LDI solutions, but companies risks is likely to bear further fruit. The drive for could well head down the more radical path of closing better governance is unstoppable and the controls or selling off their pension schemes. This ultimate put around investment strategy and funding will transfer of risk may not delight employees and inevitably tighten. unions, and it may be expensive in the short-term, But, in the final analysis, it is likely that many but at least executives and trustees will sleep better companies will baulk at the expense and complexity in their beds.18 © The Economist Intelligence Unit 2008
  20. 20. Appendix: Survey results A way through the maze The challenges of managing UK pension schemesAppendixIn August 2007, The Economist Intelligence Unit surveyed 200 board level, or C-level, executives of UK companiesfrom a wide range of industries. Our sincere thanks go to all those who took part in the survey. Please note that notall answers add up to 100%, because of rounding or because respondents were able to provide multiple answers tosome questions.Over the past three years, how do you think the risks associated Which of the following do you consider to be the most significantwith managing your organisation’s pension scheme have risks to your organisation from your pension scheme?changed? Please select up to three.(% respondents) (% respondents) Regulatory changes affecting pension funding Increased significantly 32 48 Changes to mortality assumptions Increased slightly 32 47 No change 26 Volatility of equities 40 Decreased slightly 8 Volatility of future inflation expectations Decreased significantly 2 36 Potential future accounting changes 26 Reductions in expected future investment earnings due to changes in asset strategy 25 Increasing deficits 21 Volatility of long-term bond yields 20 Restrictions on desired corporate activity arising from regulatory changesDo you think that optimising your pension scheme’s risk 17automatically leads to lower levels of risk?(% respondents) Which of the following aspects of your pension scheme No 51 management are you most keen to improve in the next year? Please select up to three. Yes 39 (% respondents) Don’t know 10 Understanding of funding options (eg, use of contingent assets) 42 Understanding impact of long-term trends (eg, changes to longevity) 36 Asset allocation 35 Response to regulatory change 32 Performance management of fund managers 28 Understanding of investment trends 24 Management of interest rate and inflation risk 20 Relationships with members 19 Relationships with external advisers (eg, investment consultants and asset managers) 19 Speed of reaction to changes in capital markets 17 Other 3 © The Economist Intelligence Unit 2008 19
  21. 21. Appendix: Survey resultsA way through the mazeThe challenges of managing UK pension schemes How successful do you think the following strategies are at reducing the negative impact of pension scheme risks on your chosen measure? Please rate 1 to 5 where 1 is very successful and 5 is not at all successful. (% respondents) 1 Very successful 2 3 4 5 Not at all successful Don’t know Benefit design changes 24 30 23 13 3 8 Liability-driven investment 23 20 30 9 4 13 Governance changes to improve decision making and control of pension issues 21 39 20 11 3 6 Use of derivatives or structured products to manage interest rate and/or inflation risks 20 26 29 11 4 10 Use of derivatives or structured products to manage equity risks 17 27 28 15 4 9 Bulk annuity buy-outs 17 21 26 14 8 14 Use of contingent assets, guarantees and other credit support tools 16 28 27 12 3 14 Alternative assets, such as private equity and hedge funds 14 24 31 16 7 8 How successfully do you think your organisation manages the following aspects of scheme governance? Please rate on a scale of 1 to 5, where 1=Very successfully and 5=Not at all successfully. (% respondents) 1 Very successfully 2 3 4 5 Not at all successfully Managing relations between trustees and the corporate sponsor 27 36 27 7 3 Setting and monitoring investment strategy 26 41 22 9 1 Managing administrative aspects of scheme management 25 36 27 9 3 Putting in place a formal process to identify risks 25 38 26 8 3 Monitoring risks on a regular basis 25 38 29 71 Speed of decision making and execution 23 31 26 15 6 Manager selection 20 40 26 11 2 Measuring performance of asset managers 20 36 27 12 4 Enhancing trustee competencies 19 31 36 11 3 Measuring performance of investment consultants 18 33 33 11 5 Measuring performance of trustee board 16 32 30 16 620 © The Economist Intelligence Unit 2008

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