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