Opinion

Winter Is Coming

Defined benefit pensions are in decline, nowhere more so than in the UK. Fortunately, there are plenty of ways to secure them.

As I write this on a foggy October morning in England, it feels like we are in the autumn of the UK experiment with defined benefit (DB) pensions.

This year, many pension funds and their sponsors have been challenged by falls in interest rates at the start of the year and following the Brexit vote. Those who hedged against interest rate movements have seen funding levels improve, given generally favorable returns. Still, many choose to ignore the warnings that “winter is coming.”

As winter draws in—with less than 7% of the UK’s 27 million private sector workers now accruing a DB pension—pension funds are increasingly focused on reducing uncertainty and recognizing that risk management is not an optional activity when a fund becomes cash ow negative and its time horizon shortens.

Used wisely, recent innovations and trends can help improve benefit security for what are now largely legacy promises.

Longevity-risk transfer: Insurers and pension funds are using standardized documentation and streamlined quotation mechanisms for bulk annuity transactions. This enables greater transparency of pricing, maintenance of price tension between competing insurers, and a swift risk transfer with lower adviser costs. Large pension funds can transact in tranches when the gap between the funding level and annuity prices falls within an acceptable range.

Large pension funds are also making use of captive insurance approaches, in which a longevity-risk transfer is arranged through the reinsurance market by an insurance vehicle owned by the sponsor or the pension fund. Such approaches can reduce costs and allow increased flexibility in terms of investment strategy or timing of premium payments compared to a conventional bulk annuity transaction.

Liability management: Longevity transactions are often carried out in conjunction with liability management exercises. Non-pensioners often prefer an ‘enhanced transfer value’ option, as this allows benefits to be transferred to a defined contribution plan with greater flexibility of retirement options.

If a member wishes to continue to receive a DB pension, pension increases can be restructured to remove inflation caps and floors, which are expensive to insure. This can reduce bulk annuity costs materially. Such exercises allow members to receive a more valuable benefit at a lower cost than the premium for insuring the original pension.

Illiquid credit: With continuing falls in yields, pension funds are looking at a wider range of assets within their liability-matching portfolios to generate positive real returns. This has coincided with reduced availability of credit from banks to the real economy, reflecting their declining capital bases.

Assets such as infrastructure debt, commercial real estate debt, and direct loans are being held alongside gilts, swaps, and investment-grade bonds by pension funds within matching port- folios. While these assets are illiquid and cannot be held on a leveraged basis (unlike government bonds or swaps), they offer a materially higher yield as compensation for embedded credit and illiquidity risks, while generating cash flows with a predictable profile that can be used to meet liabilities. Many of these assets also offer a highly transparent link to the real economy, and are secured against collateral.

As funds de-risk and have less need for leverage, pension funds that are targeting low-risk self-sufficiency are likely to hold higher amounts of illiquid credit. However, pension funds targeting buyouts would be advised to hold a more liquid portfolio of assets at the point of a transaction, so as to minimize transition costs.

What next? There are significant challenges in providing as many members as possible with full benefits given the level of underfunding within pension systems in the UK and elsewhere. Hopefully, the needs of pension funds and plan sponsors undergoing de-risking—and the opportunities these create for providers and advisers—will spur further innovation.

But innovation alone is unlikely to be sufficient if the current combination of loose monetary policy and tight fiscal policy regimes persists. Signs are emerging from central banks of a willingness to consider a more relaxed fiscal policy regime, which, over time, would lead to higher interest rates and less onerous pension liabilities. If successful, a combination of continuing innovation and enlightened policy responses will help ensure that those lucky enough to have benefited from a DB pension can be paid in full.

Hemal Popat is a principal at Mercer and a member of the Institute and Faculty of Actuaries’ finance and investment board.