In 2010, drinks giant Diageo reached a landmark deal with its UK pension scheme to help plug an £862m deficit by giving the scheme rights to the income from its maturing whisky spirit.
The use of this so-called contingent asset was part of a sophisticated programme of measures to reduce the deficit and was hailed as an indication of the increasingly innovative approach that companies are taking to deal with pensions liabilities.
Many high-profile companies, including broadcaster ITV, have since implemented similar de-risking programmes that have included the use of contingent assets and other innovative solutions.
According to research published in February, regulation and stock-market volatility have prompted finance directors (FDs) to become much more involved in pensions decision-making at all levels, especially in larger companies.
The study, conducted by research firm Spence Johnson and supported by the UK’s National Association of Pension Funds (NAPF), spoke to FDs and other relevant professionals at 43 (mostly large) firms in the UK.
It found that FDs are effectively leading the decision on defined benefit scheme contribution levels and on de-risking schemes.
According to the report, human resources (HR), once seen as leading on pensions matters, is now increasingly handing over pensions to finance colleagues. Corporate pension schemes around the world have been battered by improvements in longevity, poor investment returns and time-consuming and costly regulatory environments.
This has been compounded by the dramatic reduction in bond yields – which are used to measure scheme funding levels – resulting from the global economic slowdown, the eurozone crisis and, in some countries, quantitative easing (QE).
QE tends to raise the price of bonds and so reduce their yields. In the UK, for example, falls in government bond yields have pushed final salary funds £90bn deeper into deficit since the UK government started its second wave of QE last October, according to the National Association of Pension Funds (NAPF).
This will force businesses to divert money away from jobs and investment and into filling pension fund deficits, it says. In defined benefit (DB) schemes, the employer promises the scheme member the level of the pension benefit that they will receive according to a defined formula – often based on a percentage of final salary or career average earnings.
This means the employer has an open-ended liability to pay those benefits, and it bears the investment risk. In contrast, defined contribution (DC) schemes set the contribution level and pensioners receive only what is in their investment “pot” when they retire. In the UK, DB plans are set up in trusts, with the trustees being responsible for investment strategy and contribution level of the sponsoring company.
FDs are getting more involved in discussions and deals with trustees to protect their companies’ finances.
One FD interviewed for the Spence Johnson research said: “We did this scary graph projecting over 20 years, even with longevity rates as they are. The pension scheme contributions threatened to engulf the profitability of the business – we wouldn’t even be able to afford basic running costs.”
According to Spence Johnson, FDs are not only deeply involved in big decisions on pensions strategy but also informing policy on how and when to pay off deficits, and even in the scheme’s day-to-day investment strategy.
However, there may be several factors affecting risk appetite in a DB scheme, including the strength of covenant (the ability of an employer to fund its pension scheme and underwrite investment risk), size of deficit, proportion of active members and sector.
High covenant companies can still take a low-risk approach and vice versa. But typically, in low or medium covenant companies, trustees support a low-risk investment strategy, whereas the FDs want more risk and they are tending to get their way, says the report.
Over the long term, higher risk investments should perform better, resulting in a lower company contribution. Finance teams around the world are using a wide range of tools to de-risk their pension schemes and new, innovative methods are appearing constantly.
The need to do this is particularly acute in the UK as it has a comparatively high number of DB schemes, but many other areas, including North America and Europe, are also affected.
Many DB schemes have closed to new members and new accruals from existing members. According to the NAPF, only 19 per cent of UK private sector schemes are now open to new joiners, compared with 88 per cent ten years ago.
Closing a DB scheme reduces the escalation of risk, but it doesn’t eliminate risk and many firms need to go further. Many see annuity buyout deals – where the trustees buy an annuity from an insurer that guarantees the payment of pensions to members – as a potential long-term solution. But this option is currently too expensive for most.
Some high-profile companies, such as car makers BMW and Rolls-Royce, and ITV, have used so-called longevity swaps to hedge against future rises in life expectancy.
However, such deals can increase the level of the deficit. In the case of ITV, the firm used a contingency asset – the revenues of a subsidiary company – to offset this increase.
A contingent asset is one that will produce cash for a pension scheme if, for example, the employer becomes insolvent or the scheme fails to achieve a specified funding level.
Keith Jecks, senior investment consultant at Towers Watson, says that they can be an attractive way for all parties to help offset deficits. Jecks says: “Companies are offering contingent assets in lieu of contributions. Or, in exchange for a higher risk investment policy, they’ll put some contingent assets aside in case things go wrong.”
Increasingly, employers are reducing liabilities by offering scheme members incentives to transfer out to alternative pension arrangements. The incentive could be in the form of a direct cash payment, an enhanced transfer value (ETV), or both. However, these often come with a warning that the overall transfer sum might be less compared to staying in the pension so companies need to make sure employees get appropriate advice.
Another de-risking option is the use of triggers that aim to lock in investment gains when a scheme reaches defined funding-level targets. This is part of a wider approach called liability driven investment (LDI), which aims to match a scheme’s assets with its liabilities and hedge against inflation and interest rate rises.
According to the Spence Johnson research: “FDs had not often formed views on longevity swaps. ETVs are attractive to some, as are the use of triggers. Several FDs talked favourably of their LDI programmes.”
Paul McGlone, principal and actuary at consultant Aon Hewitt, says that contingent assets are a popular way to offset deficits as corporate cash flows become squeezed.
“Corporate bond yields and gilt yields are at record lows,” he says. “Trustees want security, but companies don’t want to pile cash into the scheme. What else can they offer? Some businesses, such as John Lewis and Sainsbury’s, have put assets into vehicles that the pension scheme has certain rights over.”
“There is also lots of interest in LDI. Then you have ETVs – the UK regulator is concerned about these, but some are well thought out and reasonable in that they are well communicated and transparent.”
Jecks says: “Falling asset values and bond and gilt yields create a horrendous situation. FDs will look at all the risks and think, ‘Which ones can I make money out of and which are just risk?’
“They want to hedge out the latter, but given market conditions many say that the instruments you need to do that are too expensive. Some, who have good employer covenants, know it will increase volatility in the scheme [to stay in higher risk investments] and it could be years before the bet comes off, but they are willing to run with that. If you can improve investment returns, you will massively save costs and it’s hard to see bond yields being as low as they are now ten years from now. That’s why finance is getting more involved, as they want that risk on.”
Case study one
James Chisholm, CFO of trade association The British Glass Manufacturers’ Confederation (British Glass) and chairman of trustees for the British Glass Pension Scheme, agrees that finance will play an increasingly important role in pensions management.
He says: “Pensions are such a big liability on companies’ balance sheets that more and more finance departments will get involved to try to de-risk. The main risks to our scheme are that the deficit continues to grow and the company is unable to afford repayments. The scheme and the company are integrally linked. If one fails, then the other will follow, and none of the stakeholders want that.”
The British Glass pension scheme faces many typical challenges. The scheme has been closed to accruals since 2009. It has 81 members and a deficit of around £1.3m, which amounts to about 40 per cent of assets.
Chisholm says: “The scheme fell into deficit after a statutory change to the way funding was measured in 2005. Then the global economic downturn hit and longevity increased to the extent that the last members are expected to live to 100 and not leave the scheme until 2080. At the same time, British Glass made a loss of £500,000 in 2008/2009, though with extraordinary measures and the support of staff it subsequently returned to profit.
“As a company and a trustee body, we are changing from a passive to a much more active approach to investment and to de-risking the scheme. That means pro-actively reviewing our investment portfolio, looking to reduce volatility risk with hedges against inflation and interest rates; and reviewing the potential to offer members the opportunity to transfer out of the scheme through enhanced transfers.
“We are also looking to put in trigger points to make sure we can respond quickly and effectively to changes in the economy that will impact the scheme. It could be easy to agree a recovery plan with the regulator, pay the monies agreed [to meet the regulator’s required funding level], sit back for three years and hope things get better. In my view, they generally won’t and now more than ever is the time to be getting more involved with managing the liability on a daily basis.”
Case study two
As well as getting more involved in DB schemes, FDs are also likely to have a greater role in managing defined contribution (DC) pensions in future, according to the Spence Johnson report.
While DC schemes don’t have the same funding problems as defined benefits, they still face challenges around governance and regulation. Integrated Processing Solutions (IPS) is a cheque processing utility formed in 2004 as a joint venture between the two largest banks in South Africa, Absa Bank and Standard Bank South Africa.
The IPS pension scheme has 747 members with R300 million (£22.6m) invested. The scheme is DC, so the company has no open-ended liability.
But, Jaco Joubert, IPS group finance manager, and trustee of the IPS Pension Scheme, says it still needs careful management to meet the challenges posed by regulation and increases in longevity.
Joubert says: “Typically, IPS fund members choose the default lifestyling portfolio which shifts them into appropriate investments as they near retirement. During 2011, the trustees decided to shift the age tiers in the lifestyling portfolio, in line with the rise of the fund’s average member-age. This optimises the replacement values at retirement, but still on a conservative basis. The change increased the age level up to which funds are invested in ‘wealth creation’ (equity portfolios), before a more conservative ‘wealth preservation’ (balanced and absolute return portfolios) and finally ‘capital preservation’ (guaranteed portfolios).”
The scheme also faces a number of regulatory challenges, says Joubert. “The Pension Funds Act and the new Code for Responsible Investments in South Africa require that the trustees consider environmental, social and governance factors when investing assets,” he says.
“Since 1 January 2012, trustees have also had to consider BEE (Black Economic Empowerment) factors when appointing service providers, including asset managers.”
Tim Cooper is a regular contributor to Financial Management
Illustration: Jon Gray
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