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This year pension schemes, and their sponsoring companies, are in a very different place compared to a year ago. So is it time for action? In many cases, there is likely to be little choice.
Financial turbulence may be the spur to significant changes in the pensions environment such as:
Figure 1 | Action on plan design: closure to future accrual
1 Benefits continue to accrue for existing members 2 Past benefits linked to final salary 3 Past benefits received deferred benefits
The trend of closing defined benefit (DB) pension schemes to new hires has been running for many years now and, soon, only a committed core of companies will continue to offer such arrangements. Watson Wyatt's biennial pension plan design survey in 2008 showed over 70 per cent of final salary schemes were closed to new hires. Despite initial interest in a couple of high-profile examples (Rentokil and WH Smith), it appeared that only a handful of these had taken the 'next step' of ceasing future accrual for existing members.
Over the last couple of years, however, we have seen an increasing number of employers look seriously at closing their schemes to future accrual for existing members. We expect this to become a significant trend during 2009. Though no one would claim it is a straightforward decision to make or indeed implement, financial turbulence can provide both the driver and the justification for this step. Not only do falls in asset values increase the pressure for employers to turn off the tap of DB risk, economic difficulties also provide a compelling justification for more robust activity. The fact is that employees and their unions are more concerned about maintaining employment at present, so that a change in structure of pension provision which reduces employer financial risk is likely to be seen as an acceptable price to pay.
But if the business climate justifies this step, it is still essential to get the communication and consultation process right. In addition to a clear exposition of the business drivers, our experience is that pension scheme design changes are most effective when:
Finally, do not think you have solved the 'pensions problem' for all time: all aspects of a business evolve over time and need periodic review, pension arrangements included. We are now seeing significant numbers of employers review their defined contribution (DC) arrangements, to ensure that they are delivering the expected benefits and are 'fit for purpose'. As DC plans grow in prevalence and the funds within these plans increase, there is a real need to support the members in managing their own retirement interests. Many employers have established governance committees to ensure that their growing DC plans remain on track and meet the ongoing and evolving business objectives.
There is almost certainly further debate to be had in due course about the suitability of DC plans as retirement vehicles, and whether there is a better way to share risk. The current economic environment does not support anything other than a switch to DCs, but in the longer term, DC arguably suffers from as many shortcomings as DB. In the absence of much more favourable investment and annuitisation terms or a significant increase in contribution levels, we expect societal pressure for a better solution to emerge as the number of members retiring from DC arrangements on inadequate pensions grows.
Even for those employers who remain committed to their DB or DC pension structures, the introduction of salary sacrifice can offer real savings to members and sponsors alike. This is a critically important tool to manage costs, and those who have implemented it have arguably secured a competitive margin over those who have not yet done so.
The first round of valuations under the 'new regime' of Scheme Specific Funding saw many trustees and sponsors getting to grips with new responsibilities, not least covenant assessment and 'reasonable affordability' arguments. Given the financial climate, we believe that virtually all trustees will be considering asking for additional support from sponsors at a time when companies have other significant demands on their cash. Sponsors need to take control of these loss making 'subsidiaries': first to actively manage demands for funding from the trustees, and second to ensure that any further capital injections, assuming they can be afforded, are used in the way that best suits the business.
This involves preparing for the next valuation ahead of time – and do not forget that many trustees will be thinking hard about whether they should be conducting out-of-cycle valuations, or at least giving greater weight to the findings of interim funding assessments.
So, the following are all essential preparatory steps for the next funding discussions:
Just as covenant and affordability have become an integral part of the funding discussion, employers should ensure that investment strategy is in the mix too. Historically we have seen trustees and employers agree on a funding valuation report, and then trustees commission an asset liability study on the back of the results; however, there are real merits to building asset modelling into the valuation process in a collaborative manner. Agreement to some of the demands for increased cash from trustees can be traded to obtain a real voice for sponsors at the table when taking investment decisions (after all the sponsor underwrites the investment risk). Only by linking together the investment strategy with the cash funding plan will an acceptable funding outcome be achieved.
Figure 2 | Planning for separation and ultimate settlement
Even in the absence of a formal valuation, we expect companies to take a stronger interest in the investment arrangements of their schemes to ensure they reflect the new conditions faced by the company during the course of the recession. Whatever balance of return and risk was previously seen to be appropriate, it is likely to require review during 2009.
It is clear that most DB schemes (certainly those closed to new entrants and future accrual) are on a path to independence from their sponsor. The only debating point remaining is over what period this will occur. Those that have already secured most or all liabilities with an insurance company, taking advantage of the competitive market that emerged in the first half of 2008, may appear to have been winners, but the number of players in the buy-out market is such that we believe it is inevitable that favourable terms will emerge again. We are likely to see greater innovation in this area, as insurers seek to offer trustees and companies paths into settlement during a period of depressed and volatile markets. Hence, phasing of transactions, payment by instalments and seeking to lock in terms for a period of years, are all areas where we expect further developments to be seen.
For some schemes settlement will not be an attractive proposition in the foreseeable future. However, even here, companies will be looking to manage the legacy risk as aggressively as possible within any budget constraints. Hence, we will see more use of matching assets, the introduction of the first longevity swap for a pension scheme, and greater use of 'dynamic journey plans', which enable trustees and companies to quickly lock into favourable funding positions.
Whatever the route to final settlement, for many employers it is now a question of getting their pension scheme into shape (tidying up data, and trying to clarify and codify discretionary terms where possible) and making operational plans with the trustees so that they are best placed to take advantage of the market opportunities that arise in the future. Investment and funding strategies should have at least an eye on this objective, even if the immediate cash requirements are based on shorter-term funding targets that are a stepping stone to ultimate separation and settlement.
The planning and preparation for settlement involves a complicated integration of all aspects of pension scheme management – administration, governance, investment strategy and communications are all facets. Above all, it needs company and trustees to be working together to a common goal – and the immediate challenge is to agree what that goal should be.
Looking to the longer term, beyond the immediate pressures, there will be yet more issues to be addressed: the introduction of Personal Accounts, levy demands from the Pension Protection Fund, and new powers of the Pension Regulator, are just a few of the matters that companies will need to contend with over the coming years. Those companies able to plan ahead will reap the benefits in due course; for others, this will not be a practical option in the short term.
It is clear that the next year will present massive challenges for many companies: first in their business activities, but also in managing their legacy pension schemes; in some cases, the control and management of their schemes will be critical to the future survival of the company. There are no magic bullets, but a clear strategy that is executed in the most effective manner will give the greatest likelihood of success.
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