Pension scheme de-risking a practical guide

Transcription

1 Pension scheme de-risking a practical guide

2 Pension scheme de-risking a practical guide Introduction The Aon Hewitt Mid-Market Pension Survey 2012 found that over 80% of UK pension schemes with assets up to 500m are closed to new entrants and 40% have also closed to all accrual*. These schemes will increase in maturity over time and both scheme sponsors and trustees will naturally consider their plans for reducing scheme risk. However, de-risking will not happen automatically. Scheme decision makers will need to take positive steps to ensure that the de-risking occurs. The best de-risking plans will include details of not just the ultimate target, but also the steps along the way and, perhaps as importantly, what operational model is required to make sure the plan is delivered. In this guide, you will find everything you need to design your de-risking plan, to ensure it can accommodate positive and negative events in future and to decide how to structure your operational model to deliver on this plan. The aim is to be practical, so there are key questions to ask yourself throughout the guide as well as space for notes on your own situation. The operational model will need to be robust. It will need to cover the business as usual delivery of benefits to members in addition to implementation of the de-risking plan. It will also need to be flexible enough to cope with both positive and negative events along the way. The reality is that most schemes de-risking plans will last many years into the future. There is therefore a crucial oversight and decision-making role for trustees and employers to perform to ensure that de-risking ambitions remain on course or to make adjustments to the plan when necessary. *Source: Aon Hewitt Mid-Market Pension Survey We have quoted this survey throughout the guide. If you would like to discuss any of the issues raised in this guide, please contact one of us using the details below: Matthew Arends , matthew.arends@aonhewitt.com Rebecca McGowan , rebecca.mcgowan@aonhewitt.com

3 Contents Targets 4 Flight plans 5 The best laid plans 6 De-risking opportunities 7 Liability de-risking 8 Reviewing the flight plan 9 Readiness for action 10 Readiness for action: the pension scheme 11 Readiness for action: trustee boards and pensions teams 12 Readiness for action: access to advice and support 13 Summary 14 Glossary 15

4 Pension scheme de-risking a practical guide Targets Setting the funding target is crucial because it defines what de-risking means for the scheme. Different targets feel different when you get there and may be stepping stones to further de-risking. Moreover, the less residual risk in the target, the harder it will be to achieve. Buy-out target (eg gilts minus 0 0.5% pa) Self-sufficiency (low risk) target (eg gilts plus 0 0.5% pa) Reliance on growth (eg gilts plus 1% or more pa) What will it feel like? Reliance on growth Self-sufficiency Buy-out Growth assets risk High Low Nil Importance of matching assets Reliance on sponsor for expenses At risk of sponsor insolvency At risk of increasing longevity Not that important Important Very important High Some None Substantial risk Modest risk Little risk Yes Yes No What is your long term target? 60 70% of mid-market schemes define their long term target as self-sufficiency. Choose the target carefully because it will influence all other aspects of de-risking 4

5 Flight plans The flight plan is a statement of how the target is going to be met. Aside from the target itself, the main variables are the investment strategy, deficit contributions, the timescale and the nature of any de-risking triggers. Most of these variables are constrained by practical factors; the process of setting the flight plan is a question of choosing the best combinations of these variables consistent with the constraints. Investment strategy High target return may look attractive but could backfire and generate substantial losses. Deficit contributions Setting contributions at too high a level may be tempting, but can pose cash risks to the business. Timescale Long timescales can make even the toughest targets look possible, but you are reliant on the employer covenant for a long period. Target Making your target easy will ensure you reach it, but is it really a target you are comfortable with? Setting the flight plan 1. Identify constraints - assessment of affordable contributions - limitations on asset allocation - maximum timescale to achieve target 2. Choose initial values for the variable items 3. Model ability to meet target 4. Check if level of risk is acceptable 5. Change variables to see if a better combination can be found See also the Aon Hewitt publication: Do Funding Triggers Work? for our research on the positive impact of triggers on de-risking. For 32% of mid-market schemes their target is an aspiration only they have no formal plan to reach it. A realistic flight plan makes the difference between an ambition and an achievable target 5

6 Pension scheme de-risking a practical guide The best laid plans The pension scheme will not stand still once the flight plan is set. The scheme will face both positive and negative influences and the flight plan needs to adjust to take these into account. In fact, the influences will tend to group into two different types: those that are under the control of scheme sponsors and trustees (such as benefit changes) and those that are not (such as market movements). Key to reacting to changing circumstances is having a process to identify opportunities and threats, and being able to decide how to react. Monitoring a changing landscape Issue Question Your situation Funding level How often are funding updates received? Is there a mechanism to identify significant falls in funding level between updates? Investment performance How often is investment performance measured? How should the scheme react to negative events eg a change in fund manager? Covenant/affordability What is the process for assessing covenant and affordability? Will it capture significant deteriorations in time to take action? New de-risking ideas How do you access the latest de-risking innovations? Trustees and sponsors will need to decide how to carry out the monitoring process. Typically, third parties will be tasked with providing regular updates, but to what extent will trustees delegate the role of actually acting when pre-arranged thresholds are reached? If the monitoring identifies a change to the environment, the next steps are prioritising the issues and then deciding on the actions. Ranking issues by their impact and also the amount of effort required to deal with them is a helpful way to decide on priorities. The reaction to a given event could be one of the following: continue to monitor the situation adjust the flight plan re-evaluate the flight plan entirely The following pages look at adjusting or re-evaluating the flight plan in more detail. 58% of mid-market schemes now monitor funding position at least quarterly. 6% do so monthly. The environment will not stay still so anticipate having to review plans regularly 6

7 Over 30% of mid-market schemes now have funding level triggers in place. De-risking opportunities Some de-risking opportunities will arise from influences outside the control of the scheme, such as rising gilt yields, or falling expected inflation levels. Regardless of the circumstances, the scheme s progress against the flight plan will be affected. How should the positive progress be recognised in the flight plan? Opportunity How it might arise Monitoring and possible impact on scheme Rising yields Falling inflation expectations Rising asset values Attractive asset classes Buy-out/in opportunities Longevity hedging Contingent assets Higher contributions Liability management End of current financial crisis or reversal of QE Fixed interest and index-linked gilt yield gap widens General market movements Market prices move favourably or new asset classes become available Movements in annuity pricing relative to asset values Market developments improve access and/or pricing Unencumbered assets are used to provide security to the scheme Strong employer performance and/or valuation negotiation The employer initiates an exercise Investment update reports and/or funding level updates will indicate when these opportunities arise. The typical impact will be an improvement in the funding level, which will enable de-risking to occur sooner and/or contributions to be reduced. These opportunities will require specific monitoring of the market price for protection. They offer the possibility of removing some or all of the liability risk from the scheme. This type of opportunity will normally be initiated through discussions between trustees and scheme sponsors. The next page covers the specific situation of liability management exercises. Adjusting the flight plan Reach target earlier Use gain to reduce the length of the flight plan and reach target earlier than expected Reduce contributions Use gain to reduce the rate of deficit contributions that the sponsor pays De-risk asset strategy Use gain to reduce the expected return in the portfolio and increase liability hedge to protect position if appropriate Strengthen target Use gain to target a more cautious long-term target (eg move to a buy-out target) Deciding in advance how gains are spent will be a key discussion between trustees and employer 7

8 Pension scheme de-risking a practical guide Liability de-risking As well as switching assets from growth to matching to de-risk, there are various ways of de-risking the liabilities. Liability de-risking is now commonplace, whether by changing benefit accrual, buy-in or a liability management exercise. This section explores the detailed considerations of incorporating liability de-risking into the flight plan. How to incorporate liability de-risking into a flight plan Process for deciding when to carry out the exercise: check: is the exercise feasible now? if not, what needs to be monitored? Buy-in: monitor gilt yields and pricing levels? ETVs (Enhanced Transfer Value): monitor gilt yields and funding levels? PIE (Pension Increase Exchange)/Total PIE: monitor inflation levels? Flexible drawdown: monitor gilt and bond yields? what steps can be taken now to make scheme liability de-risking ready eg data readiness (see page 11 for more details) some monitoring may only take place infrequently, due to long lead times and because the IFA basis changes annually (for ETVs) Impact of liability de-risking on flight plans Decide at principle level how to spend gains within flight plan framework, ie: a) reach target earlier b) reduce contributions c) de-risk asset strategy d) strengthen target e) a combination of the above Adjust funding-level based triggers, so a successful exercise does not automatically trip triggers (see Triggers and liability management box) For buy-in, what should the asset strategy be after the purchase? What should the new de-risking triggers be? For PIEs/Total PIE, consider the impact of the exercise on any fixed and inflation-linked hedges For ETVs, decide whether to pay transfers out of growth or matching assets (see ETVs box) Triggers and liability management If nothing else is done, a successful liability de-risking exercise could lead to an improved funding position. This in turn might cause one or more de-risking triggers to be breached, and assets to be switched. Is this the intention? The alternative is to re-set the de-risking triggers in anticipation of the liability de-risking exercise and to spend the gains in another way. ETVs: which assets to use to make payments? Almost 40% of mid-market schemes have run, or are planning to run, an ETV or PIE exercise. Paying out of matching assets would result in re-risking in relative terms, ie a greater proportion of growth assets (but not in absolute terms). Paying out of growth assets can in some circumstances increase recovery plan contributions. Flight plans can recognise liability de-risking exercises and other scheme changes 8

9 During 2012, 15% of schemes with triggers in place re-set those triggers in response to market conditions. Reviewing the flight plan Inevitably, during the course of the flight plan, events will unfold differently to expectations. The previous pages cover positive opportunities; negative threats require their own planning. The challenge is first to put in place structures to identify threats quickly (preferably in advance) and second to be able to react to them promptly. The reaction to many threats will mirror that for opportunities: either to sit tight and stick to the plan, or to adjust the flight plan in some way to recognise the new circumstances. This might even include increasing the level of asset risk (re-risking) see To re-risk or not to re-risk box for more details. However, some circumstances are so significant that a wholesale re-evaluation of the flight plan is needed. Some examples of these sorts of circumstances are given below. Scheme events (buy-in, merger, de-merger) Market events Crash, bull market, gilt yields change Corporate events (sale, acquisition, restructuring) Legislation (benefit promises change) To re-risk or not to re-risk? Re-risking is the process of increasing the amount of asset risk following a setback. Our research shows that only 12% of schemes plan to automatically re-risk the investment strategy when the funding level falls. Even if re-risking is contemplated, would you allow re-risking beyond the level that existed when the flight plan was established? Re-evaluating the flight plan questions to ask in the event of significant change: what has changed to cause the re-evaluation of the flight plan? have the constraints on any of the flight plan variables changed? contributions, investment risk or feasibility of target? has the view of employer covenant altered? can the flight plan be amended to reflect the new conditions, or must it be reconsidered from first principles? Reaching a target A similar re-evaluation of the flight plan will be needed when the target is reached, or is close to being reached. Is the strategy to maintain the target level of funding, or now to target a higher level of funding? Changing circumstances can call for a re-evaluation of the plan 9

10 Pension scheme de-risking a practical guide Readiness for action Missing an opportunity can be expensive or lead to retaining risk unnecessarily. So what are the barriers to implementing the plan? Our 2012 survey of mid-sized pension schemes asked what were respondents key issues of concern and gave a list of 19 to choose from. The feedback revealed that (beyond running costs) the top concerns were all about access to knowledge and resources, and being ready to act as and when events unfold. 1 External costs of running the pension scheme 2 Knowledge rests with a small number of individuals 3 Availability of resources 4 Ability to react quickly 5 Availability of Member Nominated Trustee candidates 6 Time required RANK 1 RANK 2 RANK 3 RANK 4 RANK 5 RANK 6 The following subsections look at the issue of readiness for action in three areas The pension scheme itself Trustee boards and pensions teams Access to advice and support 39% of mid-market schemes are concerned about availability of resources. Having a plan means nothing unless the plan can be acted upon 10

11 Only 32% of mid-market schemes are comfortable that they are in touch with most members. Readiness for action: the pension scheme How many times has lack of clarity over scheme data, or the benefits being provided, slowed down or prevented a de-risking project? Resolving these issues in advance may seem like an unnecessary exercise at the time, but will pay dividends when opportunities to de-risk arise. How does your scheme rate against our list of elements of a clean scheme? Your scheme Clean member data (eg spouses pensions for pensioners, compliance with the Regulator s data cleanliness requirements) Confirmed benefits (eg all unusual categories of membership fully documented, administration processes reconciled with scheme rules, Guaranteed Minimum Pension (GMP) reconciliation) Member resolution (eg tracing of missing members, existence exercises completed, unclaimed benefits policy) Deed review (All documentation up to date and complete) Employer history (Employment records for members recorded for statutory debt purposes) Processes and procedures (Clear documentation of policies, processes and procedures, discretionary powers documented) Equalisation (Clarity over the sex equalisation of benefits) Asset readiness (eg ensuring assets are liquid or moving assets into asset classes that match annuity prices over time) Investing some time acting on the scheme s data and processes can pay dividends later 11

12 Pension scheme de-risking a practical guide 34% of mid-market schemes are concerned about ability to react quickly. Readiness for action: trustee boards and pensions teams Once the objective for the pension scheme is to de-risk, the work of the pension scheme divides more distinctly into two areas: design and oversight of the flight plan implementation of the flight plan itself Over time, the scheme s organisational structures are likely to change to reflect these two different areas. Where does your scheme fit on our time line below? Path to operational de-risking Assets and liabilities Risks retained Risks systematically reduced Low risk target Operations Insourced management Focused working Outsourced operations Complete control retained by trustees and sponsors Multiple hand-offs More reliance on sub-committees Streamlined governance processes Light-touch management Third parties tasked with implementation Pre-determined actions when conditions met Use the checklist below to identify potential improvements to the organisation of the pension scheme: Issue Question Your situation Focus Is the work of the scheme clearly differentiated between strategy and implementation? What does this mean for organisational structures? Speed of response Are the trustee board and pension support team structured in the best way to act quickly when opportunities arise? Resourcing What can be done to ensure there are no resourcing constraints? Access to advice Does the team have access to the external support it needs? Can any improvements be made? The scheme s operating models will need to adapt to changing circumstances 12

13 94% of mid-market schemes feel that integrating services with one provider gives easier access to solutions that require multiple professional skills. Readiness for action: access to advice and support The support for the scheme will fall into two main categories: day-to-day and specialisms. Day-to-day The scheme will need efficient processes to monitor and implement the flight plan. The key areas will be funding, assets and members, and these need to work together as seamlessly as possible. Examples of data flows are: member data between actuary and administrator cash requirements between investment consultant and administrator Specialisms Previously in this guide we have highlighted the need to be able to react to opportunities and threats. This will mean calling upon expert assistance as and when required. Putting these together, leads to the following `hub and spoke' operating diagram below which shows each specialism feeding into the day-to-day activity: funding position between actuary and investment consultant Annuity purchase Self-service administration Covenant assessment Day-to-day Communications Funding Members Project management Assets Clean scheme Delegated investment Contingent assets Legal advice Are the working practices of your scheme established to support this kind of operating model? Having the right connections to advisers will mean access to both innovation and resources 13

14 Pension scheme de-risking a practical guide Summary De-risking a pension scheme is a long-term project that will have many parts to it. The keys are to set the right targets and to introduce the correct structures to react to change. Use the checklist below to identify how prepared your scheme is for de-risking. Checklist for de-risking the scheme Your scheme Set the target funding level for the scheme Choose the target carefully as it will influence all other aspects of de-risking. Determine the key variables under the flight plan to meet the target (Timescale, contributions, investment strategy, triggers.) Put in place a process to monitor and amend the plan This will involve monitoring market movements and accessing the latest thinking. Different circumstances may require no change to the flight plan, an adjustment, or a wholesale review. Decide how to spend positive experience Reduce contributions, the timescale or de-risk? Decide the reaction to negative experience Re-risk the scheme? Continue to monitor? Review the flight plan? Ensure the pension scheme is ready for de-risking Have all steps been taken to take advantage of opportunities as they arise? Check whether the internal structures are in place Are the pension team and the trustees organised in the best way to support the de-risking plans? Access to support Do you have access to the expertise, innovation and resources you will need as the flight plan progresses? De-risking is a long-term exercise but the right approach leads to success 14

15 Glossary Long-term target This means the long-term aim of the funding and risk levels of the scheme. Typically a target will have a measurable funding level, a defined degree of investment risk and a date by which it should be achieved, eg it may be for the scheme to be self-sufficient within 20 years. Self-sufficiency This term is used in different ways by different people and in different contexts. For true self-sufficiency, the pension scheme would not need to call on the sponsor for additional funding under any circumstances. It would therefore need to hold reserves against adverse experience and these reserves are likely to exceed those required for an insurance company buy-out. In practice, this term is often used to mean low residual risk, so that most significant investment and demographic risks have been removed or hedged, where low risk will depend on the situation. Flight plan A flight plan is a statement of the target timescale and financing strategy to meet the long-term target. The financing strategy will cover both contributions and the investment strategy and will take into account the desired chances of meeting the funding objective. The idea of the flight plan is to make the path to the objective more certain. It will often include funding level triggers. Enhanced Transfer Value (ETV) A liability management exercise. The employer offers to enhance the actual transfer value if the member agrees to take a transfer value under the terms of the offer (usually the offer is only available for a limited time). The member has a choice of whether or not to take up the offer. Pension Increase Exchange (PIE) A PIE exercise is a liability management exercise where the members of a scheme are offered a higher non-increasing pension as an alternative to their standard increasing pension. There is no compulsion to accept the offer. Often the amount of the flat pension is set so that the funding level will improve somewhat as a result of the exchange. For example, some of the saving which is generated by no longer having to pay increases on the pension will reduce the scheme deficit with the remainder being used to enhance the member's pension. PIE is only possible on tranches of pension where pension increases are in excess of statutory increases. Members may be provided with PIE on retirement or an exercise may be carried out for existing pensioners. Total PIE Total PIE is a liability management exercise. Deferred members over the age of 55 are offered a transfer value to a personal pension, which is then converted into an immediate pension with no pension increases. As a result of the transfer, the liabilities of the scheme are reduced. Funding level trigger The trustees may decide that when setting the flight plan, they will alter the investment structure of the pension scheme when the scheme reaches a certain funding level. For example, if the pension scheme ever becomes 80% funded, the trustees agree in advance to convert some growth assets to matching assets in order to de-risk. Such triggers require an agreed monitoring regime. Clean scheme A clean scheme is a scheme that has validated its data and processes so that future exercises can be conducted rapidly and the risk of hidden future problems has been minimised. A clean scheme will typically have carried out exercises: to check and resolve uncertainties in its member data (eg sex equalisation or members employment histories); to document all member benefits; and to ensure that its procedures are stable, so that they are robust to future changes in personnel and would enable a quick response to future threats or opportunities. 15

16 For more information contact: Matthew Arends on Rebecca McGowan on Or: Please speak to your usual Aon Hewitt consultant, go to aonhewitt.co.uk/derisking or call About Aon Hewitt Aon Hewitt is the global leader in human resource consulting and outsourcing solutions. The company partners with organisations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates and administers a wide range of human capital, retirement, investment management, healthcare, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. Copyright 2012 Aon Hewitt Limited Aon Hewitt Limited is authorised and regulated by the Financial Services Authority. Registered in England& Wales. Registered No: Registered Office: 8 Devonshire Square, London EC2M 4PL. aonhewitt.co.uk Follow us on October