Cover story – De-risking
With the majority of defined benefit (DB) pension schemes closed to further accrual, one chapter of the UK’s pensions history is gradually closing. Indeed, the number of people enjoying a guar- anteed retirement income backed by a corporate sponsor is shrinking. Pension scheme liabilities have been weighing heavily upon cor- porate balance sheets and most sponsors would like to see the back of them sooner rather than later. But the process will take time. In the meantime, trustees are being charged with ensuring that scheme members still receive what they are entitled to. A dif- ficult balancing act. More than 70% of schemes are looking to de-risk – that is to pass the responsibility of paying their former employees’ pensions to an insurer – within the next 10 years. Some are more ambitious, with 39% aiming to achieve this within the next five years, says Mercer. Yet with the events of the past few years showing how quickly conditions can change, a key question for many DB scheme trustees is: how do they manage their final years? But with central banks on the verge of introducing monetary tightening and bond markets being historically volatile, the de-risking process has become less predictable. For instance, rising gilt yields have been good news for fixed income heavy investment portfolios. For the first time in more than a decade, final salary pension schemes have been consistently in surplus during the past year, according to the Pension Protec- tion Fund (PPF). By the end of February, DB schemes in the PPF universe booked a solid aggregate surplus of £133bn, giving them a funding ratio of 109%. In contrast, just two years ago, the aggre- gate deficit stood at £124.6bn, meaning that final salary schemes were only 93% funded.
This stark improvement is, of course, driven by the marginal rise in gilt yields combined with relatively favourable asset price valu- ations. But experienced trustees know that the pendulum could easily swing to the other side.
Another threat is a potential rise in inflation, which could wreak havoc on fixed income heavy portfolios. Granted, the majority of mature DB schemes have hedged most of their inflation and interest rate risk, but 70% of plans are not fully covered, accord- ing to Mercer’s latest de-risking survey.
A good year With DB balance sheets at generally favourable levels, now might be a good time to grasp some opportunities to de-risk more of their liabilities. It is no wonder then, that insurance companies are predicting a strong year for buyouts. But are trustees following suit? Buyout providers are optimistic that they will. Rohit Mathur, head of international reinsurance business at Prudential Retirement Strategies, believes that the market will continue to grow. “All indications are pointing to a strong 2022,” he says. “It’s early in the year but consultants are
18 | portfolio institutional | April 2022 | issue 112
The opaqueness of the pricing of buyout deals is really uncomfortable. Dinesh Visavadia, Independent Trustee Services
predicting a similar market to last year, perhaps even a little bit higher at between £30bn to £40bn worth of PRT buy-in and buy- out deals. Looking at the pipeline, that is a realistic assumption.” But the flow of transactions in the bulk annuity market has slowed somewhat. Following the record years of 2018 and 2019, where transactions worth in excess of £40bn were booked, growth slowed to £30bn in 2020 and £28bn last year, according to Barnett Waddingham. Mathur believes that 2022 could be the year where a number of larger retirement funds pursue buyout transactions, chiefly because UK schemes are much further along their journey and bond market volatility offers a chance to lock in favourable rates. “Volatility could also mean that there may be more opportune times in the market where pricing becomes more attractive. We saw that in 2020,” he says. “Again, the key is, are you ready to transact, have you done your homework?” Dinesh Visavadia, director at Independent Trustee Services, agrees. “Credit spreads have widened. That gives a real good opportunity for many schemes and pushes them towards the buyout or buy-in region.
“They are now within touching distance of that,” he adds. “That is an unusual situation to have within the corporate setting.”
Shortfall But the flipside of volatility is a dent in investment returns and stark swings in asset valuations for schemes that may be further away from a buyout scenario and are not fully hedged. The onus is now on the trustee to form a plan to manage those liabilities, says Alan Pickering, president of BESTrustees. “There is tremen- dous pressure on sponsors with a legacy DB scheme to try and take advantage of either risk transfer or the various forms of con- solidation that are coming onto the market.” For those schemes, bond market volatility can be stressful, says Kevin Wesbroom, a professional trustee at Capital Cranfield. “One month we are talking about £57m in liabilities and the next month it is £67m. That is pretty scary.
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