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Pension funds urged to consider 'mortality buffer'

UK - Pension trustees in the UK should consider introducing a mortality buffer to prepare for margins of error in longevity assumptions, according to a report by UBS Global Asset Management.

In the manager’s 40th annual Pension Fund Indicator report, it also called for the debate surrounding the suitability of equity investments by pension funds to focus more on the appropriate pricing levels for equities.

Calling for a focus on liability risk management rather than asset risk, the report said trustees should introduce a mortality buffer able to offset “unknown adverse future events”.

“This margin, or buffer, would then be used to cover adverse changes in longevity,” the report suggested, saying that “prudent assumptions” should be employed by trustees when setting out their deficit funding objectives to secure higher deficit payments from sponsors.

It added that trustees could also aim for an additional investment return target, above the existing benchmark, with the funds earmarked specifically for any increase in longevity risk.

The report continued that the “middle ground” approach - between mortality buffer and full risk transfer to an insurance company through buyout - would be to ask an insurer to guarantee their pricing for a number of years, with the scheme’s investment strategy adapted to return the premium needed.

“The advantage of this approach is that it eliminates the risk of future changes in the pricing basis by the insurer and gives the scheme assets time to generate additional return (‘the buffer’) that can be used to pay for the higher buyout price.”

UBS argued that such an approach would also reduce the changes of further contributions from the scheme sponsors.

Additionally, it suggested that the debate into the fair valuation of equities should become important once more, saying that “strangely little” of the recent discussion surrounding the use of equities had focussed on the subject.

“Looking forward, the determination of the appropriate amount of equities for a scheme should now be influenced by a number of factors including relative valuations scheme design, asset-liability comparisons, the employer’s own balance sheet and willingness to fund shortfalls, academic research on equity characteristics and diversification, and appetites for risk and reporting issues,” it said.

The report added that, in practice, many funds would simply rely on rules of thumb, aligning pensions in payment with bonds.

It concluded: “Given the complexity of the issues and the lack of consensus on the correct way to fund a scheme, pragmatism might well be as good an approach as any.”

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