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	2007 Review/2008 Preview

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2007 review/2008 preview

2007 saw pension scheme risk management move up the corporate agenda. Five significant drivers seem to be responsible for this increased board-level interest.

Life expectancy increased still further, and hints of new ‘solutions’ began to emerge. The use of derivatives to better match pension liabilities continued its journey from leading edge to mainstream – and hardly a month went by without another new entrant to the market for taking on defined benefit (DB) pension liabilities (insurers and others).

And just as companies started to take steps to address their increasing liabilities, many UK DB schemes moved into surplus on an accounting basis, bringing new concerns about trapped surplus. Add to that high profile pensions issues in some of the UK’s biggest corporate transactions. What will 2008 bring us?

Risk of trapped surplus

A year ago it looked as though companies would have to learn to live with pension deficits on the balance sheet – only for improvements in equity markets, and rises in bond yields, to move the aggregate funding position of FTSE 100 companies’ pension schemes into an accounting basis surplus for the first time since 2002. This only serves to reinforce what we already know – assets still heavily invested in return-seeking investments and liabilities linked to corporate bonds mean a bumpy ride!

Figure 1 shows the funding position on both accounting and (estimated) buyout bases (allowing for movement in gilt yields, but not increasingly competitive buyout costs). Of course, the aggregate figure hides some schemes with surplus (even excessive surplus in Shell’s case) and others with big deficits still – but despite recent equity market volatility, many companies may see an FRS 17 surplus on the balance sheet at year end.

Figure 1 | FTSE 100 pension scheme funding levels have improved over past two years

As the spread between gilts and corporate bond yields has widened, more schemes are finding that their Scheme Specific Funding Objectives (usually set with at least some reference to gilt yields) are a tougher test than accounting bases. Equally, some trustee boards have used recent investment gains as an opportunity to set higher funding targets in the future. One widely publicised example is that of the EMI pension scheme’s trustees who have proposed a funding target beyond FRS 17 under new private equity owner Terra Firma. This case is now being adjudicated by the Pensions Regulator, following disagreement between the two parties.

In future, we expect many companies to have a pension scheme surplus on their accounting disclosure basis despite being asked to meet higher funding demands. However, under IAS 19, the publication of interpretation IFRIC 14 means employers can only show a pension accounting surplus if they have an inalienable right to that surplus at some point in the future – and for some schemes it is at best unclear whether or not this right exists.

Some companies may react to this imbalance by adopting more prudent mortality assumptions for accounting purposes. In the longer term, as trustee funding requests increase, we expect contingent assets such as escrow accounts to be used increasingly to manage the risk of surplus. Contingent assets are attractive where cash can be better used to develop the business and where there is a real risk of employer funds being trapped in the scheme. We are seeing some innovative solutions, including M&S’s decision in 2007 to set up a property partnership with their own pension scheme.

Internal management of financial and longevity risks

An informal survey, carried out at our autumn seminar on corporate risk, indicated an increased recognition that pension risk is just another facet of the broader corporate risk management agenda. Decisions about whether to accept, manage or off-load risk require similar analysis. Two risks that many employers will retain – at least for now – are investment and longevity.

While the trustees have the final say on investment, forward-thinking companies are working with their trustees to establish investment committees (perhaps including their advisers). We suggest companies can take the initiative in commissioning analysis to determine appropriate investment strategies. Asset liability modelling techniques have become increasingly sophisticated, and are now essential tools in the analysis of both equity-bond splits, and of alternative asset classes – including derivatives and hedge funds. They provide the basis for maximising the efficiency of the portfolio, and give scope to de-risk the investment strategy further without reducing expected returns.

Furthermore, giving the investment committee the remit and authority to react quickly to investment markets can prove invaluable. Many pension schemes were advised in early July 2007 – before the credit squeeze – to consider locking-in investment gains by switching a proportion of their equities into bonds. In many cases, the next trustee board meeting was some way off and the opportunity was lost. Those schemes that had set up quick-moving investment teams were, however, able to take advantage of the short-term improvement. Figure 2 shows how setting appropriate funding thresholds for such switches could help to guard against subsequent falls in equity markets or falls in bond yields.

Figure 2 | Timely response to improving funding levels allows schemes to lock in gains

2007 also saw greater interest in managing the risk of life expectancy improvements. At a seminar held by Watson Wyatt in October 2007, almost all companies represented expressed concern about longevity risks and 60 per cent were considering (or had already taken) steps in which these risks could be managed. Whilst some companies have done so via benefit design (for example, introducing a defined contribution (DC) scheme, or reducing DB benefits if life expectancy increases) others are awaiting developments in the market for longevity hedging products.

Some insurers and investment banks are now offering facilities (such as ‘longevity swaps’) which can help to hedge longevity risk in a similar way to the scheme’s financial risks. In 2007, JP Morgan started work on a mortality metric, which it hopes will lead onto the development and trading of option contracts in mortality. It may however be some time before this market is sufficiently developed for a significant number of schemes to hedge away their longevity exposure.

Settlement of benefits (the transfer of pensions risk to other parties)

Only two years ago, with the pensions buyout market a duopoly offering limited capacity, the prospect of buying out benefits with an insurer seemed unattainable for companies looking to settle substantial pensions obligations. The market has developed dramatically over the last 18 months, with at least 15 insurers now actively competing in this area and prices falling as a result. Following a formal bidding exercise, schemes can often be bought out with an insurer or other ‘secondary market’ provider (more about this below) for around 120 per cent to 130 per cent of the accounting (FRS 17/IAS 19) liabilities (and in some cases, even lower). The results of a poll carried out at a Watson Wyatt seminar in March 2007 (Figure 3), suggested that at these levels perhaps 20 per cent of respondents would be willing to buy out.

Figure 3 | How much would you pay relative to accounting (IAS 19) liabilities to buy out?

As rapidly as the traditional buyout market has grown, it has been outpaced by the number of new entrants to the market for pensions risk management. Financial institutions, and other companies, now offer a range of products whereby pension schemes can transfer all or part of this risk.

At one extreme we have seen the acquisition of entire pension schemes via corporate restructuring, with the acquirer running the scheme on in the expectation of making a profit. Dealing prices are lower than buyout cost, because of the greater flexibility and lower capital requirements in running a scheme under the pensions regulatory environment than in the insurance regulatory environment. However, care needs to be taken over the financial support available to the pension scheme in these situations – the financial strength of the new company standing behind the pension scheme may be weaker than that of an insurer, and indeed that of the original sponsor.

In August 2007, Citigroup notably acquired Thomson Regional Newspaper’s (TRN’s) pension scheme. TRN benefited from a lower price than an insurer could offer, the scheme’s trustees benefited from Citigroup’s strong covenant, and Citigroup paid a price to run the pension scheme in the expectation of making a profit in the long run.

2007 also saw a change in heart over the offer of enhanced transfer values (typically payable to a personal pension arrangement) to deferred pensioners. At a Watson Wyatt corporate seminar in June 2007, 27 per cent of attendees had already considered enhanced transfer exercises or were doing so at present, with a further 55 per cent open to considering the idea in future. Whilst there remains a fear that such offers come tainted with risks of mis-selling, a greater willingness by employers to offer sizeable enhancements (for example, at a level up to 110 per cent of FRS 17), and open communication, are helping to mitigate these concerns.

We expect momentum to build further in the area of pensions risk transfer as companies recognise the widening spectrum of options available to them and as the new alternatives to traditional buyout become commonplace.

Corporate transactions

Pension scheme trustees are finding themselves in the headlines following high-profile take-over talks.

The press had a field day on the purchase of Alliance Boots by KKR and Stefano Pessina. Cash was provided to ensure the scheme was funded well above the FRS 17 level and additional, non-cash security was given to a ‘self-sufficiency’ measure. The concept of self-sufficiency, whereby a scheme expects to have enough resources to meet benefits allowing for a fairly prudent investment policy, is one that appears to be gaining currency with trustees in leveraged bids.

Pensions Corporation’s recent bid for Telent (the service company that remained with the Marconi pension scheme after Ericsson bought the bulk of the Marconi business in 2005) with its attaching £2.5bn scheme, with a £500m escrow account available if the scheme has no call for it, also demonstrates how difficult M&A can be when pensions are at the heart of the deal. Following the recommendation by Telent that shareholders accept a 600p a share bid, the trustees wrote to the Regulator, who appointed three new independent trustees. Pensions Corporation had the unusual option of being able to withdraw its bid if such changes were made to the scheme, but at time of writing, the offer has gone unconditional. It will clearly be interesting to see how this deal unfolds and the precedent it may set for future cases.

Despite questions over the Regulator’s powers in take-overs such as this, the cases above demonstrate the benefit of giving thought to how the trustees will react prior to acquisitions and sales. If anything, there seems to be a general expectation in the industry (however unfounded) that, in the new world where they are expected to act as a creditor, trustees are likely to negotiate for additional funding and explicit security during corporate transactions, and will be making an independent assessment of what a deal means for covenant. Corporate advisers used to working day-in, day-out, with trustee boards can help acquiring companies consider how best to engage with trustees to avoid fuelling concerns that they will naturally have in such situations.

So, to summarise, for 2008 we see increased focus on internal and external pensions risk management – particularly mechanisms to avoid trapped surplus, and wariness of trustees in corporate transactions. Ignore pensions at your peril!