Independent trustee roundtable: How schemes are reducing risk

Samiea Ashraf, associate director, 2020 Trustees

Ashraf is an associate director in the Manchester office of 2020 Trustees. She is a qualified pensions actuary with significant pensions, actuarial and trusteeship experience.

Donny Hay, client director, PTL

Hay is a client director of PTL and has more than 25 years' experience in the pensions and investments industry, both as an asset manager and as an independent trustee.

Adrian Kennett, director, Dalriada Trustees

Kennett is a director of Dalriada Trustees and head of its ongoing trusteeship practice. He acts as both trustee chair and member of the board of trustee on a range of appointments.

Wayne Phelan, managing director, PS Independent Trustees

Phelan began working as a professional trustee in 1990 and currently works with a range of clients and has worked on many high profile trustee appointments.

How close are the pension schemes you work with to a buy-in or buyout at the current time? What do you see as the bars to such insurance-based solutions?

Samiea Ashraf: We have several schemes that are closely monitoring buyout terms and we expect a significant proportion will transact by the end of the year assuming markets do not move materially against us. Most of these schemes have been planning for buyout for a few years.

Given current insurance pricing, buyout does remain a much longer term objective for bulk of our schemes. The cost of buyout can be significant for sponsors and given the current economic uncertainty most are conserving cash to use to fund future growth initiatives.

The main barrier to insurance is the pricing terms, especially for smaller schemes (i.e. those with assets, say, under £25m) where the ability to create a competitive insurance tender is greatly reduced.

An additional barrier is the premium charged for insuring deferred members who have some time until retirement. Deferred premiums appear to have been hit particularly hard by Solvency II and this has moved some of our monitored schemes much further away from transacting.

Insurers also tell us that recent tightening of credit spreads have led to price increases which, compounded with Solvency II, has presented material difficulty with transactions that were previously very close to enacting.

Donny Hay: Some schemes are close to buy-in, few to buyout. Research suggests that, on average, schemes are about 85% funded on a technical provisions basis but on a buyout basis, it will be far lower than that, 60-70%, so there is quite a big gap.

Barriers to buyout include adviser costs, which can be £50,000 or more; the cost to the sponsor; legal uncertainty about benefits, especially in areas such as GMP equalisation and data quality; and the number of deferred members, which are often very expensive to insure given greater uncertainty around benefits. Also, the exercise can be very time consuming for a trustee board.

Getting realistic quotes is hard unless you are very serious - it is lot of work for an insurance company to run all your data through their systems, to look at the data to see how clean it is, and to do all the necessary tests in order to give as good a price as they can. If they can't get clean data, or they are not able to do enough analysis as to where the risks lie within the liabilities, then they won't price it as competitively.

Adrian Kennett: Each scheme has its own specific characteristics. However, the majority of schemes are funded considerably below full buyout. Some schemes have bought-in slices of their liabilities - most frequently those of older or higher liability pensioners.

There are a number of difficulties to overcome however. These aren't insurmountable, but include a number of things.

First, insurers are charging a significant premium relative to the funding basis our clients are typically using to determine their technical provisions and therefore the additional funding required is considerable.

In addition some advisers are charging high costs for these exercises; there are often benefit and data uncertainties, including GMP equalisation for example; and there are difficulties in minimising variations between how the insurer pricing moves and how the scheme assets move.

A change in mindset of all parties involved is also required as the quarterly meeting schedule simply isn't effective.

Finally, there are some concerns over insurer appetite - there has always been a lack of competition for insurance transactions for smaller schemes, which has reduced further with some smaller schemes struggling to find anyone willing to quote.

Wayne Phelan: There are probably two camps. Firstly, those schemes that have got their investment strategy lined up with liabilities and have had some decent returns. These schemes are probably close to transacting either on a buy-in or, for some of them, a full buyout.

The other camp are schemes who, with where yields are, are probably 10 years away from being able to fully buyout but, along that journey, are very much looking to transact on a buy-in if possible.

What are the bars to this? I think the obvious one is funding, and that really is the main driver of whether people are looking at insurance-based solutions or not.

How are your schemes preparing for any future transaction? What are the key areas, if any, you are working on?

Samiea Ashraf: As a minimum we are getting our schemes buyout ready by undertaking data exercises aimed at ensuring the quality of the data and thereby potentially improve pricing terms.

Liability management exercises remain a standing agenda item across all our schemes and are in various stages of completion. We accept there is a potential selection risk created in running liability management exercises as a pre-cursor to buyout however at present this is a risk we are prepared to accept as part of the overall de-risking framework.

Donny Hay: Where relevant, schemes are monitoring pricing, cleaning up data and having a plan which ties a future buyout into the investment strategy.
One area that can be a stumbling block however is the pension accounting hit in the year you carry out a buy-in or buyout, which can be a barrier for the employer. Accounting rules allow you to value liabilities at corporate bond levels, but a buyout or buy-in is very much a gilts-based measure so, in the year that you complete any insurance transaction, you are going to have an increase in the value of the liabilities you are putting into buy-in or buyout and that needs to be recognised.

Adrian Kennett: Key areas schemes are working on include the consideration of investment strategy targeting buyout over the medium to long-term; data cleansing; benefit audit and rectification; and liability management.

Contractual negotiations are another area of focus - with some people looking at the cessation of accrual or severing of ongoing salary linkage for example.

Wayne Phelan: There are two elements to this. The first is on the practical, operational side and making sure your data is in good order; and making sure you know exactly what benefits you are going to secure, which tends to lead to having a good benefits specification available to then take to the insurers, something which shows that you are not only serious about a transaction but also makes sure you are valuing the right liabilities.

The second element, and probably the more practical one for most people, is looking at the investment strategies and the contribution patterns to get there.

Most of our schemes have refined what they are doing to make the journey more predictable and, hopefully, more certain. These refinements include the increased use of liability-driven investment (LDI), a bit more diversification in growth assets and a lot more monitoring of how well the funding position does to lock in any gains.

To what extent do you believe there is a significant pent-up demand among schemes waiting for costs of insurance-based risk reduction exercises to fall?

Samiea Ashraf: There is strong demand as defined benefit (DB) schemes become more of a legacy issue. Ultimately it comes down to price and the gap between a scheme's current funding position and buyout. More fundamentally, it is difficult to see insurance-based solutions falling in price in the current climate of increased solvency reserving demands, retained high-level demand for bonds and upward creeping inflation. Outside of innovation which we currently have no insight into, we struggle to see how the costs will shift by the quantum needed to satisfy the waiting demand.

Donny Hay: There is a bit of pent up demand but most schemes are waiting for their funding gap to close, using this waiting period to get their house in order and clean up their data.
Indeed, most pension funds are now doing work with their administrators to clean up their data and that is necessary to do exercises like buy-ins and buyouts.

Adrian Kennett: A look at the regulator's Purple Book indicates a massive shift away from ongoing DB accrual over the last decade which hasn't been mirrored by an increase in the number of schemes winding-up. Some 66% of members in 2006 were in open schemes. By 2016 that figure was 19%. Less than 1% of members are in schemes which are winding-up. Given the increasingly legacy nature of these schemes and the volatility in the funding which must be disclosed, there is a desire to remove the scheme from the company balance sheet.

Solvency is expensive in a low yield market place but on the other hand the cost of borrowing is relatively low and therefore some sponsors are willing to borrow the shortfall to remove the risk while others would rather let their investments do the hard work.

As everyone wakens up to the fact that yields are going to be lower for longer there is an equal realisation that insurer pricing is unlikely to dramatically improve in the short- to medium- term.

Some are looking to other risk reduction strategies whilst others are making hard decisions about how long they have to or can wait. Those that can't afford to borrow to reach buy out/in levels in an acceptable timescale are looking for alternatives such as population slicing or PPF+ compromises. Therefore, there remains a steady flow of insurance-based risk transactions with some funded by credit, some for slices of the population and some for reduced benefits.

Wayne Phelan: There is probably a massive amount of demand sitting in there. I think that any finance director, owner or manager of a business has probably taken the view they never want their door darkened again by these liabilities - if they can transact at a nil cost or low cost to get them off their books forever, I think we will see a lot of demand for that.

But this demand is not necessarily matched by either supply of insurance or advisory capability - there are some specialists in this area but getting this right occupies quite a lot of bandwidth.

To what extent are your schemes currently looking at or conducting liability reduction exercises. What are the challenges you face when looking at these?

Samiea Ashraf: As mentioned, liability management remains a standing discussion item at our trustee meetings. We believe such exercises should be run by companies and trustees in a collaborative manner to provide members with additional options in an easy to understand manner. Independent financial advice is a must for such decisions.

The challenges mainly centre on how independent financial advisers are being hindered by rigid Financial Conduct Authority (FCA) guidance in assessing transfers. Using a formulaic transfer value analysis (TVAS) approach is not the appropriate way to analyse most retirement decisions.

Almost all our schemes have undertaken trivial commutation exercises.

Donny Hay: Lot of schemes looking at most of these - FROs are popular; PIEs are being considered but have a limited impact; but there is no demand for ETVs as, with the introduction of the pension freedoms, straightforward transfer values have become a popular option at or near retirement.

The challenges can be the cost of undertaking a liability reduction exercises; providing individual financial advice; and the time involved for both trustees and sponsors.

Adrian Kennett: Defined contribution (DC) pensions flexibility raised sponsor hopes of a rush to transfer out of DB schemes and, while interest has been high, the increase in actual transfers has not been as material as some predicted. On some of our schemes there has been interest in transfer values particularly among members with sizeable liabilities who might have lifetime allowance issues or are planning for inheritance.

Interest from sponsors in liability reduction remains high however, but when they realise the cash influx needed to make an exercise successful their eagerness often dissipates.

And, as with all liability management exercises, the challenge we face as trustees is ensuring that members are presented with complete and accurate facts, that the appropriate advice is available and that the relevant guidance has been followed. DB pension schemes can be complex beasts - the issues which members are being presented with are correspondingly complex. Those issues need to be explained in a fair and transparent manner.

Wayne Phelan: Enhanced transfer values where, at one point, quite attractive but I think the market has moved forward as transfer values are at an all-time high for members and most schemes aren't having to enhance because they look very attractive anyway. As a result, a lot of schemes are now looking at whether they remind people that a transfer value is an option but not enhance it, and we are seeing quite a lot of interest in that.

Pension increase exchanges are the area that we are really support. In my mind, pensions always got it slightly wrong in that people tend to have the biggest pension when they are the least likely to be able to spend it, ie in their 80s or 90s when most people want to enjoy their last flush of youth in their 60s or 70s. As such, exchanging increases for a higher initial pension is something that is really attractive, easy to implement and easily understood for members, so we are seeing quite a lot of traction around that.

Some of the smaller elements in terms of trivial benefits and those sort of things are more of a tidying up exercise rather than necessarily having a big impact on helping schemes secure the benefits in full, but getting rid of smaller records is a nice thing to do as it leaves you with a smaller number of records to focus on.

What do you believe will be the key risk reduction trends among the schemes you work with over the coming 18-24 months?

Samiea Ashraf: We expect mainly at retirement options to increase in demand over the next two years.

We also expect more sophisticated investment products to become more widely available to all scheme sizes to allow for better risk protection (i.e. derivate overlays or absolute returns with LDI).

Donny Hay: One of the key trends will be for schemes to increasingly automatically quote transfer values at retirement or when people ask about pensionable salary. FROs, PIEs and trivial commutation will also continue to be popular.

Providing transfer value quotes is something a lot of schemes have been considering. Take-up of these quotes can be in the high single digits in some cases - and it is often popular among higher paid employees with other arrangements elsewhere. I think this trend will continue.

I also expect schemes will increase the amount of assets they hold in matching assets and LDI strategies.

Finally, I think the growth in fiduciary management, which tends to accelerate liability management, will continue.

An increasing number of trustees and sponsors are going to want to outsource investment complexity and that is what fiduciary management is about. And that is going to be attractive to many schemes as consolidating the arrangements in this way can have many benefits in terms of costs, greater access to sophistication, operational capability.

It is not a panacea, but I think DB schemes, particularly those that are closed to new members and future accrual are seen as legacy debt problems for sponsors and they want them dealt with efficiently and cost effectively. Options like fiduciary management are becoming more popular because of that.

Adrian Kennett: There are a number of key areas - including a focus on the British Steel Pension Plan, with a number of companies watching the outcome of this closely.

In addition to this, there is likely to be an increased implementation of asset de-risking, using strategies such as LDI, as well as a continued diversification of growth assets, with some schemes moving into illiquid asset classes.

Many schemes may also implement trigger structures; implement PIEs, FROs or trivial commutations; or consider a move towards fiduciary management.

Finally, I think there will be continuing work on data and benefit rectification, particularly with regards to GMP reconciliations.

Wayne Phelan: I think there are going to be two key things. One is liability measurement and whether people look more at LDI; even though you could argue that it is a challenging time to do that, it still has a function and is capital efficient.

The real challenge is going to come from the growth assets and making sure that they deliver - we are in a period of complete uncertainty, whether that is Brexit, whether that is the global economy, all of those sorts of things.

I think we are going to see a lot more challenge around how growth assets achieve their returns and, more importantly, whether things like diversified growth funds really are delivering what is expected of them.