UK: Risk…or de-risk

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While the market for bulk annuities and partial buy-outs continues to grow, many funds have not even started to hedge interest rate or inflation risk, finds Gill Wadsworth

The pensions derisking market - buy-ins, buy-outs and longevity hedging - is big business in the UK with a predicted £15bn (€18bn) in transactions expected to be completed in 2010.

Consultant Lane Clark & Peacock (LCP) anticipates that £40bn of pension liabilities will be insured by the end of the year as more sponsors and trustees seek to secure their schemes with third parties.

However, while £40bn is an undoubtedly significant sum, it's a mere drop in the UK's £923bn defined benefit liability ocean and there is ample scope for the sector to continue its stellar growth.

Thanks to ongoing concern about sponsor stability and the risk of default coupled with growing numbers of solutions and opportunities to pass liabilities to a third party, the derisking market continues to offer huge appeal to the nation's beleaguered DB schemes.

Jerome Melcer, partner at LCP, says: "We expect to see a significant increase in UK companies looking to either share pension risks with members using liability management techniques, or hedge pension risks using the fast-developing range of financial tools such as insured buy-in contracts and longevity swaps."

However, there is growing concern that de-risking solutions are targeted principally at the larger end of the DB market, something that trustees and sponsors may not be fully aware of as they, and fund sponsors, are wooed by promises of an end to funding woes.
Hamish Wilson, partner at consultancy firm HamishWilson, says: "There are plenty of solutions though they are primarily aimed at the larger funds. The real barrier is trustee knowledge [and] they would be well advised to resist what they do not understand."

The concern is that trustees and sponsors are made aware of the ‘trendier' options in the market and are keen to engage with buy-in solutions before they have dealt with more immediate de-risking issues, for example adopting a straightforward liability-driven investment (LDI) strategy.

Richard Butcher, managing director at independent trustee company Pitmans Trustees, says: "The solutions aren't a problem; it is the way that they are sold and used. Most schemes seem to adopt a flavour of the month approach rather than developing a long-term total de-risking strategy and then slotting solutions into it. There is a lack of joined up thinking, a lack of a consistent a long-term de-risking dialogue."

Indeed according to Butcher, most of the schemes with which he works have not yet adopted an inflation or interest rate matching strategy. Such comments are borne out by LCP's Accounting for Pensions 2010 report, which found 32 of the FTSE 100 companies had taken no steps to reduce pension risk. Additionally, research conducted by Pension Review Associates and published by the CBI in July found that 60% of companies running DB plans did not feel fully confident that they had done all that they could to mitigate the risk of their pension arrangements, while more than 40% were yet to decide on a definite course of action to manage the risk of their DB arrangements to the wellbeing of their organisations.

Deborah Cooper, head of Mercer's retirement research group, says schemes must do more to protect themselves against market volatility and the risks inherent in their funds.
"Many [schemes] have already taken a variety of steps to de-risk ensuring more stability in their funding levels but they are still glaringly exposed to economic factors such as global investment markets and future inflation. Without an effective risk management strategy and the capability to monitor and implement changes quickly, companies and trustees will be unable to take advantage of market opportunities as they arise," Cooper says.

As more schemes look to crowd into the buyout market, insurers can seize the chance to cherry-pick the best clients and increase their prices. Only those schemes that have already de-risked as far as possible and managed their record keeping are set to seal the most favourable deal.

Clive Wellsteed, partner and head of LCP's buyout practice, says: "Recovering funding levels have improved affordability since 2009 and, as recent experience shows, funding positions can change materially over days. A sustained upward swing will mean insurers struggle to satisfy demand."

He continues: "The message to companies and pension schemes is that you do not want to be last in the queue - particularly if insurers become more selective over which schemes to focus on. Careful preparation now will allow you to move quickly and get strong engagement from insurers once the time is right."

Among the suite of possible de-risking solutions, partial buyout remains the most frequently transacted since these are accessible and more affordable for some of the smaller schemes. Elsewhere in the market, the options for all but the largest tier are relatively restricted. In particular, longevity hedging, which is the newest solution in the de-risking market, remains very much the preserve of the largest schemes. For example, just two schemes account for the £4.3bn in longevity swaps undertaken in 2010.

Pitmans Trustees' Butcher says: "[Longevity swaps] are the preserve of the larger funds and there are an awful lot of small schemes that need help."

And in spite of widespread predictions for a continued growth in longevity deals, Hamish Wilson is sceptical about the wider appeal of this strategy.

"It's like insurance, if you are rich you do not need it and if you are poor you may not be able to afford it. [Longevity hedging] comes at a cost and so much depends on your objectives and the need for and ability to pay for risk management," he says.

For most UK schemes the focus for the time being is managing immediate risks with an eye on entering the buyout and buy-in market at some point in the future. According to the CBI survey, just one in 10 schemes plan to manage DB risk using a insurance solution, with 36% preferring to close the scheme to new entrants and a further quarter looking to sever the link to final pensionable salary.

For buyout providers, competition remains intense with some companies faring better than others. According to Pension Capital Strategies, the pipeline of business in 2010 is healthy for some insurers and for others prospects look gloomy which suggests that schemes have choosing preferred partners at the outset and are not opting for a full market review.

Among the big winners is Pension Corporation, which between December 2009 and March 2010 secured 50% of the biggest bulk annuity deals. David Collinson, partner at the firm, predicts a continued uptrend in all kinds of buyout transaction, but anticipates the largest growth among partial buy-in deals.

While the derisking market offers strong and viable solutions to the numerous challenges facing DB schemes, there is clear evidence that, even among the largest schemes, inertia and ignorance about risk management are rife. Trustees and their sponsors need assistance in getting to grips with their problems before they move on to the solutions if wholesale DB risk is to be managed effectively.

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