A way through the maze: The challenges of maintaining UK pension schemes

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A way through the mazeThe challenges of managing UK pension schemes An Economist Intelligence Unit report

© The Economist Intelligence Unit 2008 1

A way through the maze The challenges of managing UK pension schemes

About this research

A way through the maze: The challenges of managing UK pension schemes is an Economist Intelligence Unit report that examines the risks associated with running UK pension schemes, and explores the approaches to governance, funding, investment, and scheme design that companies use to manage these risks. The report was commissioned by Towers Perrin. Phil Davis was the author of the report and Rob Mitchell was the editor.

The Economist Intelligence Unit bears sole responsibility for the content of this report. The Economist Intelligence Unit’s editorial team executed the online survey, conducted the interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of Towers Perrin.

Our research for this report drew on two main initiatives:● We conducted a survey of 206 C-level, or board-level

executives of UK companies in late summer 2007 as the credit crisis was emerging. Respondents were primarily chief executive officers, chief financial officers and chief human resources directors, although some other roles were also represented in the sample. The survey included companies, and pension schemes, of a variety of sizes, and from a wide range of industries.

● To supplement the survey results, the Economist Intelligence Unit also conducted a programme of qualitative research, comprising a series of in-depth interviews with trustees, advisers and other participants in the pensions environment.

We would like to thank the many people who helped with this research.

2 © The Economist Intelligence Unit 2008


● The risks associated with running UK pension schemes are becoming more severe. The majority of respondents questioned for our survey believe that the risks facing their organisation’s pension scheme have increased over the past few years. The key risks, according to respondents, are regulatory changes that could affect funding, which are cited by 48%, changes to mortality assumptions, which are cited by 47% and volatility of equities, which is cited by 40%.

● Better knowledge and understanding is a key risk management tool. When asked about the aspects of their scheme management that they are keen to improve in the next few years, items related to “knowledge and understanding” score highly. For example, improving their understanding of funding options is seen as the main priority, cited by 42% of respondents, followed by improving their understanding of long-term trends, which is cited by 36%. With new risks on the horizon, and new techniques to manage, mitigate or transfer them becoming available, keeping abreast of new trends and often complex concepts has become more pressing than ever.

● Performance management remains an important weakness. When asked about their strengths and weaknesses with regard to different aspects of scheme governance, respondents saw their strengths as the setting and monitoring of investment strategy and the managing of relations between trustees and the corporate sponsor. They were also fairly confident about their ability to put in place a formal process to identify risks and monitor those risks on an ongoing basis. The main areas of weakness were seen to be performance management—of investment consultants and trustees in particular—and enhancing

trustee competencies. Many companies, it seems, have difficulties in determining the metrics that apply to their scheme, and in conducting performance management based on outcomes.

● More innovative investment techniques have yet to enter common practice. Tools to optimise investment strategy, such as liability-driven investment or the use of derivatives, are widely discussed and written about in the business press, but they remain little used among UK businesses. Just 14% of respondents say that they already have liability-driven investment in place, and 17% say that they use derivatives to hedge interest rate and inflation risk. Appetites to use these tools in future are relatively strong, however, with 41% intending to apply liability-driven investment in the next three years and 39% intending to use derivatives.

● The idea of transferring liabilities has its appeal, but practical considerations are preventing take-up. Appetites for the concept of bulk annuity buy-outs seem relatively strong, with 60% of respondents saying that they would transfer at least some of their liabilities if they could do so at a competitive price with the full support of stakeholders. In reality, however, most respondents say that they would be unlikely to adopt this approach: just 19% intend to transfer liabilities to an insurance company over the next three years, and 61% say that they do not intend to explore this option. The main barriers are cited as being the reluctance of trustees to support such deals, and fears about reputational damage should the third party fail to meet its obligations. A significant proportion also believes that the economic cost of buy-outs is simply too high to consider it.

Executive summary



Pensions once inhabited an obscure corner of corporate life, ignored by everyone until it was their turn to accept the gold carriage clock and head out the door for retirement. How times have changed. Pensions talk is on the lips of employees, employers, politicians and the thousands of advisers that service retirement schemes. A perfect storm of volatile market conditions, stringent new rules and demographic change has created unprecedented uncertainty over pension provision. Many employers that blithely created final salary schemes years ago as a standard employee benefit now wish they had been more circumspect. And employees increasingly fear that the benefits they believed were rightfully theirs could be snatched away.

The fears are quantifiable. The majority of respondents questioned for the EIU/Towers Perrin survey believe that the risks facing their organisation’s pension scheme have increased over the past few years. A full two-thirds said that the risks had increased, compared with just one in ten

who said that they had decreased. Smaller schemes appear to be feeling the heat most keenly—four out of ten schemes with assets of less than $1bn said that risks had increased “significantly”, compared with three out of ten larger schemes. Arno Kitts, head of the investment council of the National Association of Pension Funds, says that the concerns of executives all centre on one issue. “Obviously the key risk is that the pension fund cannot pay pensions.”

The poor financial state of some pension schemes is clear to see. About 6% of company schemes surveyed had liabilities amounting to more than half of the company’s market capitalisation, while four in ten said that liabilities were over 20% of the market capitalisation. That represents a serious risk to the financial health of the scheme sponsor. Given that the majority of the schemes in the survey have assets of more than £500m, the effect on the overall economy is not insignificant, either.

Mr Kitts outlines the shock that many companies have suffered in recent years. “If you are a manufacturing company, you have realised that there is a large investment animal associated with your

The risk environment

Increased significantly

Increased slightly

No change

Decreased slightly

Decreased significantly

32

32

26

8

2

Over the past three years, how do you think the risks associated with managing your organisation’s pension scheme have changed? (% respondents)

Source: Economist Intelligence Unit survey, 2008.

Between 1% and 10% of market capitalisation





50% of market capitalisation or more

What is the size of your organisation’s liabilities in relation to its market capitalisation? Please choose the option that you think most accurately reflects your scheme. (% respondents)

32

29

25

6

3

6




business that can have a significant effect on it,” he says. This is leading companies to examine, perhaps for the first time, the risks posed by their pension schemes and how to manage those risks. “The biggest driver of change,” says Mr Kitts, “is when the financial director asks ‘Why is there this big, volatile number in my accounts and what can I do about it?’.”

According to respondents, the most significant overall risk to their organisation from their pension scheme is regulatory changes to funding, which are cited by 48% of respondents. This is hardly surprising—regulation has stopped employers taking surpluses out of pension schemes to reinvest in the business. This means that any contributions, including extraordinary contributions, are unlikely ever to be available to the sponsor again.

At the same time, changes in accounting rules have forced assets held as long-term investments to be valued at prevailing market prices. As a result, at times of market stress, pension schemes appear hopelessly underfunded and a large one-off contribution may be required from the sponsor. The likelihood of this happening is not remote: four in ten

respondents said that special employer contributions would be necessary over the next three years.

The risks posed by improving mortality assumptions are cited by 47% of respondents. The main worry is simply that people are living longer, so are a bigger drain on the pension fund’s resources. Over the past 22 years, the expected average lifetime has risen by 2.7 years, or 3.5%, from 77.7 years to 80.4 years, according to the Credit Suisse longevity index. Women’s life expectancy is higher than that of men and has increased from 80.9 years to 82.7 years over the same period.

Moreover, people living longer is only part of the problem. The more taxing issue is predicting the rate of increase of longevity. Steven Haasz, managing director, wholesale, at Prudential, sums up the scale of the difficulties. “The risk of 75-year-olds living just a year longer is huge. It adds about 3% to a scheme’s liabilities, which may negate any aggressive investment strategy that has been put in place to increase returns.” The Holy Grail is to develop products that hedge out mortality risk—and several investment banks are working on it—but as yet such a financial instrument does not exist.

The volatility of equities was cited as the third greatest risk for retirement schemes, cited by 40% of respondents. Although many schemes have reduced their dependence on equities following the 2000-03 market downturn, an astonishing one in ten still have an equities allocation of 80% or higher in their portfolios. Even the most financially secure of companies, with a predominantly youthful workforce and few pensioners, would struggle to justify such an overwhelming dependence on the riskiest and most volatile asset class.

In general, it is apparent that survey respondents are most worried about the risks over which they have least control. After all, companies can do little about regulatory changes except to lobby against harmful decisions. And there is, as yet, no solution for managing longevity risk (or, indeed, a way to account

Regulatory changes affecting pension funding

Changes to mortality assumptions

Volatility of equities

Volatility of future inflation expectations

Potential future accounting changes

Reductions in expected future investment earnings due to changes in asset strategy

Increasing deficits

Volatility of long-term bond yields

Restrictions on desired corporate activity arising from regulatory changes

Which of the following do you consider to be the most significant risks to your organisation from your pension scheme? Please select up to three. (% respondents)

48

47

40

36

26

25

21

20

17




for a pharmaceutical company making a crucial breakthrough to prevent strokes).

The other principal risk, stock market volatility, is more manageable, through the use of derivatives for example. But while technical solutions are available, the result can be imperfect. Using fewer equities might, for instance, have the unintended consequence of reducing the likelihood of the fund meeting very long-term liabilities, since shares are generally considered a good hedge against inflation.

Risks associated with pension schemes can impact on a variety of corporate performance measures.

Among respondents to our survey, 43% say that the balance sheet is the most widely affected measure, followed by 25% for cash flow, 21% for earnings per share and 11% for credit rating.

When asked how effective they thought a number of strategies were at reducing the risk associated with their schemes, the answers varied depending on the corporate measure selected. While governance changes were seen as the most effective technique across the board, respondents who selected balance sheet as the most affected measure tended to favour benefit design changes and liability-driven investment—two approaches that can favourably impact the balance sheet. Respondents who were most concerned about cash flow had little time for bulk annuity buy-outs, perhaps a reflection of the high costs associated with these transactions. Conversely, respondents who chose credit rating as the measure most affected by pension risks tended to be more adventurous and be most likely to favour derivatives and bulk annuity buy-outs.

So pension schemes are becoming aware of many of the risks they face but do not necessarily have the tools to mitigate them. They are in the midst of a perfect storm and are urgently seeking perfect advice to navigate their way through it.

Balance sheet

Cash flow

Earnings (per share)

Credit rating

43

25

21

11

Which of the following corporate performance measures is most affected by risks associated with your pension scheme? Please select one. (% respondents)




Amid the gloom there are, though, beacons of hope. A surprising finding in the survey is that governance changes to improve decision-making are seen as the most effective measure to reduce the negative impact of pension scheme risks. This rates more highly than all other putative measures including benefit design changes and the use of derivatives. Why does this represent hope? Because governance is one of the few solutions that can be applied without great expense being incurred.

Chris Close, partner at Sackers, a specialist pensions law firm, says that, in the past, many trustee boards failed to realise they were pivotal parts of the pensions machine. “Governance is really important. Let’s not forget that some of the larger schemes are as big as major corporations,” he says. The Pensions Regulator, created in 2004, insists that an amateur approach is no longer acceptable and laid down governance guidelines earlier this year. It recommended that pension scheme trustees should focus on seven key points:

1. Trustee knowledge and understanding2. Conflicts of interest3. The employer’s covenant4. Monitoring professional advisers5. Keeping accurate records6. Offering adequate defined contribution

investment choices7. Ensuring proper procedures are followed

in wind-ups

The guidelines need to be adhered to if Maxwell-sized disasters are to be avoided in the future, says Mr Close. “If you have proper governance, it ensures that the key risks are constantly on the agenda and

improves the likelihood of trustees being able to provide pension benefits. It would be sad if there was another Maxwell lurking in the shadows and the trustees had not taken sufficient steps to introduce safeguards.”

Six out of ten respondents said that they are good at setting and implementing processes to identify risk. And a large majority of 67% said they are good at setting and monitoring investment strategy. Clive Gilchrist, managing director of Bestrustees, an independent trustee firm, says that investment strategy involves considerably more than appointing a set of investment managers. “Setting investment strategy means following the actuarial valuation, conducting an asset-liability exercise and selecting the investments in light of the covenant and risk.”

He adds that it is good practice to assess each manager’s performance every quarter and interview them at least once a year, so long as this does not lead to short-term decision-making. “Organising a beauty parade based on a single quarter’s performance is not advisable.”

While monitoring investment returns is a tried and tested process, just 51% of respondents said they are good at measuring their own performance and that of their consultants. Many ideas are being trialled to develop consultant and trustee benchmarks, although standardised objective criteria have yet to be established across the industry. Bestrustees, for one, is working on pilot schemes with several pension funds to enable trustees to measure their own effectiveness. On the simplest measure, the trustees are invited to rank their colleagues on two issues: how often they turn up at meetings and how much they pay attention. Mr Gilchrist says that these questions are more important than may appear at first sight.

Scheme governance



“You do not need to be Einstein to be a trustee and you do not have to generate lots of ideas. But you do need to listen and react with common sense to advice offered,” he says.

Administrators, too, should be monitored. Poor administration has let down a number of pension schemes, says Mr Close. “If record-keeping is poor, benefits can be over- or under-stated and this can harm the employer’s finances in the first case and reputation in the second.”

There are other issues that are often mistaken as meaningless detail but that are, in fact, critical to governance. Take the size of trustee boards: large boards of 15-plus trustees are considered inefficient because there is often too much discussion and insufficient analysis and decision-making. Equally, boards of just three or four are fallible. They need to be large enough to delegate time-intensive issues, such as investment, to specialist committees. Bestrustees believes that the average trustee board

should number five to 12, rising to between nine and 12 for larger schemes.

The managing of relations between the trustees and corporate sponsor is another important governance area and one in which many schemes believed they performed well. The good performance may be linked to the formalisation of the relationship, following pressure from the Pensions Regulator. “In the past,” says Mr Gilchrist, “discussions took place around a table. Now they are more often conducted in writing so there is an audit trail that could be shown to the regulator.”

Procedures to resolve disputes over funding or scheme strategy have also been formalised. The regulator is now able to act as a referee, although it has not empowered itself to pass judgment. This is a recognition that both parties must reach a compromise that they are happy with if they are to continue to work for the good of scheme members. “It is all about partnership—nobody forces a company

1 Very successfully 2 3 4 5 Not at all successfully

How successfully do you think your organisation manages the following aspects of scheme governance? Please rate on a scale of 1 to 5, where 1=Very successfully and 5=Not at all successfully. (% respondents)

Managing relations between trustees and the corporate sponsor

Setting and monitoring investment strategy

Managing administrative aspects of scheme management

Putting in place a formal process to identify risks

Monitoring risks on a regular basis

Speed of decision making and execution

Manager selection

Measuring performance of asset managers

Enhancing trustee competencies

Measuring performance of investment consultants

Measuring performance of trustee board


27 36 27 7 3

26 41 22 9 1

25 36 27 9 3

25 38 26 8 3

25 38 29 7 1

23 31 26 15 6

20 40 26 11 2

20 36 27 12 4

19 31 36 11 3

18 33 33 11 5

16 32 30 16 6



to set up a pension scheme,” says Mr Gilchrist. “It is there because the company believes that attracting and retaining people is important.”

At the same time, without distance between the trustee board and scheme sponsor, conflicts of interest can arise. For example, companies may use the same advisers as their trustees, and may be unaware that this is the case. Mr Gilchrist says that conflicts of interest are becoming less common. “It was usual for the financial director to be a trustee, but much less so now. The FD may attend meetings but it should be on the explicit understanding that it is in a company capacity.”

The issue of knowledge and understanding has risen to the fore in the wake of the Myners Report in 2001 and this is underscored by the survey.

When asked about the aspects of their scheme management they were keen to improve, aspects of “understanding” scored highly. Improving understanding of funding options, in particular, is seen as a priority, cited by 42% of respondents, followed by improving understanding of long-term trends, cited by 36%. As might be expected, there is a gulf between the knowledge base in small schemes compared with larger ones. For instance, just 14% of large schemes (those with £1bn-plus assets) said that they needed to improve their mastery of asset allocation in the next year, while 32% of smaller schemes said that this was a critical learning point.

Trustees are well advised to take training seriously. The regulator’s Trustee Knowledge and Understanding regime is free and voluntary, and there are compelling reasons to undergo minimum levels of training. Where problems arise in funds, the regulator has intimated that it would take a dim view of cases where basic knowledge levels were low and little attempt had been made to raise them.

Low levels of knowledge are the main reason why many in the industry wonder whether the whole model of lay trustees running pension schemes should be overhauled. Should, for example, pensions be run by professionals? After all, Myners recommended that employers paid trustees for their work. Surprisingly, Mr Gilchrist, a professional trustee, believes any changes could be harmful. “Being paid would not change anything for most trustees. They do the job because they want to do it,” he says. Lay trustees have much to offer, he believes. “They are not investment experts, lawyers or actuaries, but they know the company and its ethos, and they know the scheme and its members. It would be a great loss if things changed.”

Understanding of funding options (eg, use of contingent assets)

Understanding impact of long-term trends (eg, changes to longevity)

Asset allocation

Response to regulatory change

Performance management of fund managers

Understanding of investment trends

Management of interest rate and inflation risk

Relationships with members

Relationships with external advisers (eg, investment consultants and asset managers)

Speed of reaction to changes in capital markets

Other

Which of the following aspects of your pension scheme management are you most keen to improve in the next year? Please select up to three. (% respondents)

42

36

35

32

28

24

20

19

19

17

3




Investment is an imprecise art and few, even among the world’s best investors, end up with a masterpiece. Failure inevitably occurs and each occurrence instils fear and disillusionment in the minds of investors. For this reason, investment styles come and go with predictable regularity. As recently as the early 2000s, the majority of pension schemes employed a balanced approach, uniformly allocating 60% of assets to equities and the remainder to bonds. The sharp stock market downturn of 2000-03 inevitably threw many of those portfolios into disarray and, today, the old balanced approach is rarely seen.

But whether a high allocation to equities is desirable is less important than whether there is a coherent approach to investment. It is clear that, in the past, many pension funds thought little about what their investments were supposed to achieve. “The mindset of pension funds was focused on assets alone rather than assets relative to liabilities,” says Iain Lindsay, a senior portfolio manager at Goldman

Sachs Asset Management. This resulted in a mismatch of predominantly equities on the asset side, yet bond-like liabilities. “The strategy worked well in the 1990s, but then they came unstuck,” he adds.

Scarred by this experience, many pension funds realised that asking their investment managers to beat an index or a rival manager had no bearing on the fund’s ability to pay pensions. This long-overdue realisation has dramatically changed the nature of institutional investment. In terms of asset allocation, the biggest shifts over the next three years are likely to be increased use of private equity and a reduced allocation to equities. Over one-fifth of respondents said that they expected to have a greater allocation to private equity in three years’ time, while more than one-quarter expected to have a smaller allocation to equities. Only 17% said they would have greater exposure to equities.

Barings Asset Management says that exposure to equities depends often on the financial health of the

Investment strategy

Greater allocation No change Smaller allocation Not applicable

In the next three years, what changes do you expect to your asset allocation? If you do not use a particular asset class and have no intention of doing so in the next three years, please select “Not applicable”. (% respondents)

Equities

Bonds/Gilts

Property

Private equity

Hedge fund (specialist trading approaches)

Hedge fund (long/short equity style)

Commodities

Other


17 52 26 4

18 55 21 6

17 44 15 24

22 30 8 40

17 22 10 51

15 25 9 51

11 29 11 49

3 25 7 65



pension fund. “I see a mixed picture,” says Jonathan Cunningham, head of international sales at BAM. “Some schemes are looking to add risk, investing in less efficient emerging markets where there are longer-term opportunities for alpha. Others use multi-asset funds to try to take risk or volatility out of the portfolio.”

Indeed, multi-asset funds are sweeping all before them at the moment, sucking in assets at a breathtaking rate. Their rise stems from many pension schemes’ realisation that they threw the baby out with the bath water when they ditched the balanced approach. They are now increasingly adopting a “new balanced” approach and employing multi-asset funds to implement it. The main differences between old balanced and new balanced is that the modern version uses a bespoke benchmark that relates to the liabilities, employs dynamic (rather than static) asset allocation and uses best-of-breed funds run by many firms rather than a single, monolithic balanced manager.

Financial innovation is also playing a part in the changed landscape. “Multi-asset funds now have more tools at their disposal,” says Mr Cunningham. “They

can allocate to hedge funds, property, structured notes and even products that provide returns from falling markets.” BAM’s Dynamic Allocation Fund, for instance, has a 23% allocation to international equities, 40% to UK equities, 20% to funds of hedge funds, 12% to property and 5% in cash. These allocations are adjusted depending on economic conditions.

Another popular investment approach that has gained prominence in the post-2003 era is popularly known as “core-satellite”. This is based on the belief that most investment performance comes from market “beta” and that active managers should be used opportunistically only. So, a large weighting is made to passive index-tracking strategies and a small “satellite” portion is reserved for active management, such as hedge funds.

But some schemes have come to believe that all existing investing styles are flawed. An increasing number is trying to remove investment benchmarks from the equation altogether. A large minority of respondents (43%) thought that liability-driven investment (LDI) is the best way of reducing the negative impact of pension scheme risk on the

1 Very successful 2 3 4 5 Not at all successful Don’t know

How successful do you think the following strategies are at reducing the negative impact of pension scheme risks on your chosen measure? Please rate 1 to 5 where 1 is very successful and 5 is not at all successful. (% respondents)

Benefit design changes

Liability-driven investment

Governance changes to improve decision making and control of pension issues

Use of derivatives or structured products to manage interest rate and/or inflation risks

Use of derivatives or structured products to manage equity risks

Bulk annuity buy-outs

Use of contingent assets, guarantees and other credit support tools

Alternative assets, such as private equity and hedge funds


24 30 23 13 3 8

23 20 30 9 4 13

21 39 20 11 3 6

20 26 29 11 4 10

17 27 28 15 4 9

17 21 26 14 8 14

16 28 27 12 3 14

14 24 31 16 7 8



company’s finances. This is perhaps a surprisingly high figure given that the term “LDI” has been in common currency for less than five years.

LDI aims to match liabilities with bond-like returns that hedge out the effect of inflation and interest rates. This is often done using a swap, since cash bonds and futures are too exposed to the vagaries of the market and do not have sufficiently long duration to match the very long-term liabilities of pension funds.

To some extent, LDI has been driven by mark-to-market accounting rules, which mean that a drop in value of a pension scheme’s assets imparts a nasty hit to the balance sheet of the sponsor. Equities, among the most volatile assets, are therefore less desirable. While they reduce a deficit in the good times, a short-

term market blip negatively impacts a company’s finances. Paul Bourdon, head of European pension solutions at Credit Suisse, puts it this way: “If you have 70% equities, over 20 years there is likely to be a premium. But, over five years, there could be swing of plus or minus 40%.”

Thus swaps, once little understood by most pension funds, are now firmly on the radar. Survey respondents revealed that derivatives to hedge inflation and interest rate risk are becoming popular—17% of respondents use them now and 39% intend to use them in future.

Whereas early LDI adopters tended to buy swaps to try to match all their liabilities, this has become less common. While more mature schemes may seek to match their remaining liabilities, newer schemes often

In 2003, a reversal of fortunes on the high street coupled with a very public private equity approach prompted UK retailer WH Smith to take a serious look at its pension strategy. With earnings down and despite the failure of a debt-laden buyout approach in early 2004, the board suddenly became extremely uncomfortable about the deficit in its defined benefit scheme, then running at about £152m.

In addition, 60% of the pension funds’ assets were invested in equities and 40% were in bonds. If the market took a turn for the worse, the deficit might balloon even further, putting cash flow at risk and threatening to scupper the shareholder dividend.

“It was pretty clear that we had to de-risk the pension scheme pretty significantly,” recalls Alan Stewart, WH Smith’s group finance director.

The board took a series of measures, including two one-off contributions totalling £170m, and a transfer of pension assets from equities and bonds to a far less volatile liability-driven investment (LDI) scheme.

The company made its first contribution of £120m into the scheme in 2004 and, around the same time, began to look at ways to escape the ups and downs of markets. It eventually settled on an LDI approach. “It was pretty clear from a relatively early stage that an LDI solution was one that fit our needs, but it took a lot of modelling to determine the optimum position,” says Mr Stewart.

At the end of September 2005, the company moved 94% of its pension assets into a large, liquid cash fund, hedging against inflation and interest rate rises with derivatives. “There really is no risk in the

major cash portion, that 94% of our assets,” says Mr Stewart. Six percent (about £50m) was invested in equity options. The total portfolio is expected to return just above the expected liabilities.

Pension liabilities are far more predictable now, too. In April 2007, the company capped its service accrual for 2,500 current employees who are still part of the defined benefit scheme, which was closed to new members 11 years ago (most employees are part of the company’s defined contribution plan). In effect this means the risk to the company has gone down, because it is easier to predict the expected cash flow needed to cover payments for the 18,000 past and present employees currently covered by the closed plan.

The result has been dramatic—today the deficit is down to £42m and falling, and the board feels confident that the LDI approach has the company’s £635m in assets sufficiently hedged against a bear market. “In truth I don’t think I could have asked for a better outcome in terms of what we sought from our strategy,” says Mr Stewart.

CASE STUDY

Liability-driven investment at WH Smith:Easing up on equities drives down pension risk



wish to test the water and match just a part of them. “Schemes typically implement partial LDI solutions to begin,” says Mr Lindsay. “They look to get comfortable with the LDI strategy before deciding whether to extend the match to a greater proportion of the liabilities.” Hedging interest rate and inflation risk with swaps typically consumes 60% of the scheme’s assets, leaving 40% free to invest in “alpha-seeking” strategies that can offset longevity risk and, in the best-case scenario, produce a surplus for the fund.

Nevertheless, LDI remains a relatively unloved strategy—just 14% of respondents said that they already use it, although 41% intend to apply it in the next three years. “LDI is talked about a lot more than it is actually implemented,” says Mr Lindsay. The resistance is often behavioural—trustees find it hard to conceive of foregoing any windfall that comes from rising interest rates or falling inflation. “In many conversations with trustees they are concerned about being locked in to the LDI strategy at the wrong point in time,” he adds.

In addition, matching assets to liabilities is a precise technique that may not deliver precise results

given shifting mortality assumptions. “Some schemes forego the precision of matching for the promise of strong long-term equity returns,” says Mr Lindsay. “It’s a balance and there is no obvious right or wrong.”

For others, the issue is more black and white. Raj Mody, a partner and actuary at the pensions practice of PricewaterhouseCoopers, believes that LDI can be a crude, unreliable and expensive approach. He advocates a proprietary strategy that he calls “covenant-driven investment”, whereby companies regard their pension schemes as fully-fledged subsidiaries. Decisions about the pension fund are no longer taken in isolation but in relation to other business activities. Mr Mody believes that for some sponsors this approach negates the need to hedge out inflation and interest rate exposure. “If inflation goes up, you may have the opportunity to pass the costs onto your customers. This provides a natural hedge for the pension fund rather than buying expensive inflation instruments. The same applies when interest rates fall—yes, your pension deficit tends to rise, but lower rates are good for the company as a whole because it can borrow money more cheaply.”



Pension scheme finances have improved immeasurably in the past five years. Final salary schemes of FTSE 100 companies had a combined surplus of around £12bn in mid-July, according to actuary Lane Clark Peacock, compared with a deficit of £59bn in October 2002. But trustee boards have long memories and funding remains a major preoccupation. Indeed, understanding funding options was the aspect of the scheme that most survey respondents said they would like to improve over the next year, with 42% citing it. This was way ahead of improving asset allocation and investment trends.

The eagerness to keep on top of this issue is hardly surprising. Passed in November 2004, the Pensions Act demands that each scheme sets a target funding figure. But this number depends on several variables and is open to negotiation. Trustees, living

in heightened fear of making mistakes for which they could be later held accountable, often open negotiations with an aggressive view of the funding levels required.

Some trustees will adopt an overly cautious approach to funding issues. On occasion, trustee boards have even asked for schemes to be funded to insurance buyout levels, significantly higher than a fully-funded ongoing scheme. Although they have little chance of succeeding, at least the trustee board’s minutes will record an attempt to extract the maximum contributions from the scheme sponsor. But such excesses are not only likely to fail—they also risk damaging trust between the sponsor and the scheme. One approach that can prevent the whole relationship unravelling is for scheme sponsors to take the lead in funding negotiations, rather than simply reacting to a call for cash.

Funding

Already in place Intend to use in next three years Do not intend to use

Which of the following strategies have you used in the past three years, and which do you intend to use in the next three years? If you have no intention of using a particular strategy, please select “Do not intend to use”. (% respondents)

Closure of defined benefit scheme to new members

Increased employee contributions

Special employer contributions

Transfer of liabilities to life insurance company

Closure of defined benefit scheme to future accrual

Transfer of liabilities outside of traditional insurance sector

Use of derivatives/ structured fixed interest products to hedge inflation/ interest rate risk

Liability-driven investment approaches

Use of contingent assets to support scheme funding


46 22 31

37 37 26

35 40 24

20 19 61

19 31 50

17 23 60

17 39 44

14 41 46

8 38 54



Once funding has been agreed, both sponsor and scheme need confidence that it can be delivered, even if the company’s operations falter. So when asked about the areas of their scheme that survey respondents were keen to explore in the next three years, the use of contingent assets was seen as a priority.

Contingent assets give the pension scheme a claim on physical or financial assets owned by the sponsor in the event that the company collapses or is weakened to the extent that it cannot continue to fund the scheme.

Just 8% of respondents said that they already have contingent assets in place, but 38% intend to use them over the next three years. There is a wide choice of assets that can be called on in a contingency, including money in escrow, a letter of credit from a third party, property, receivables and loan issue notes. There are also a number of trust-based solutions, such as the approach that Marks and Spencer announced in January 2007 whereby property assets were placed into a partnership formed with its pension scheme.

Of course, for those employers that have switched all or part of their pension schemes onto a defined contribution basis, funding is less of an issue. The number of members in defined contribution schemes exceeded those in defined benefit schemes for the first time at the end of 2006. Nevertheless, while the switch to DC rids companies of one set of risks, another set come into play. For example, employees may fail to make adequate payments into their pensions, choose inappropriate investments and end up with insufficient retirement income. A survey by the National Association of Pension Funds published in 2007 found that 81% of DC scheme members failed to make proactive investment choices and were placed in the default option. Mr Mody is concerned about the long-term repercussions: “I’m not sure if companies should be dumping all the risk on to the employee who often does not understand the choices available. In a decade or so, people in DC schemes will start retiring in numbers and we may see a backlash as the problems become clearer.”



Over the past decade, it has become customary for large companies to sell off non-core areas of their business in order to concentrate on activities that they understand and can manage profitably. The same rationale is also being increasingly applied to pension funds. Transferring schemes in their entirety to insurers is not as straightforward as divesting a business unit but the market, spearheaded by Legal & General and Prudential, has nevertheless been buoyant. Prudential has completed more than 425 deals on its own, worth over £4bn in total. Some are small transactions of just £1-2m but there have been several £400m-plus deals including Ferranti and Dalgety in 1999, and C&A in 2002.

Certainly, appetite for the concept of bulk annuities seems strong: in our survey, 60% of respondents said that they would transfer at least some of their liabilities if they could do so at a competitive price with the full support of stakeholders. This supports Prudential’s belief that there could be deals in the near future that dwarf the C&A buyout. “In the next 12 months, there are likely to be fewer but larger deals getting done,” says Ted Clack, bulk annuities director at Prudential.

At least ten new entrants (see boxout) to the market in the past 18 months are hoping to take deals that could break the £1bn level for the first time. This would inject pace into a sector that previously focused on schemes of insolvent companies. “This used to be a winding-up business after an employer got into difficulty,” says Mr Clack. “That has changed in the past couple of years.”

A number of factors have combined to make the environment for bulk annuity buy-outs more fertile. First, the 2004 UK Pensions Act imposed new taxes on defined benefit plans and established a regulator

with powers to impose penalties on companies that did not reduce their deficits. Second, changes to accounting standard FRS17 forced companies to be more transparent in reporting their pension liabilities, leaving their balance sheets exposed to fluctuations in the market. Finally, life expectancy is improving, making it more difficult to account for future liabilities.

As a result, healthy schemes and healthy companies are now looking at buyouts as a derisking option, rather than as a last resort. Trustees, for example, may seek a buyout because they are concerned about the sponsor’s stability, particularly if it is a highly leveraged company, possibly following a private equity takeover. Alternatively, a company may conduct a wide-ranging review of its activities and decide that it no longer wants the operational and regulatory risk of running a pension fund.

Financial innovation is helping to facilitate buyouts. In the past, many schemes could not consider buyouts because the hefty deficits made

Transfer of liabilities

Yes, they would transfer all of our liabilities

Yes, they would transfer some of our liabilities

No

18

42

40

If your organisation’s senior management could transfer all or some of the organisation’s liabilities to a third party at a competitive price with the full support of stakeholders, do you feel they would choose to do so? (% respondents)




them too expensive to effect. Today, some buyout vehicles allow payments to be spread over, say, five years. If the total cost of the buyout is £100m, the company may pay £50m up front and £10m a year for five years. Companies are starting to consider partial buyouts too. “You can just take a block of lives out of the scheme,” says Mr Clack. “It doesn’t have to be an all or nothing approach.”

Despite the mushrooming of providers and strategies, most respondents said that they were unlikely to attempt a buyout. Just 19% intended to transfer liabilities to an insurance company over the next three years. Slow take-up is rooted in long-term structural issues—one of the main barriers cited was concern about reputational damage should the third party fail to meet its obligations.

In addition, a significant proportion believes that the economic cost of buy-outs is too high. Bruno

Paulson, analyst with Bernstein Research, estimates that the cost to a company to make the transfer is equivalent to about 30% higher than the number it must legally report on its balance sheet. Some, such as Mark Wood, chief executive officer of Paternoster, one of the new breed of bulk annuity buy-out players, dispute this figure, but even Mr Wood acknowledges that the perception of a high premium has dampened corporate enthusiasm for bulk annuity transfers.

One company that has looked at buy-outs but is currently adopting a wait-and-see approach is Stolt-Nielsen, the UK shipping firm. “We keep watching that market, but it’s just not deep enough right now,” says Homiyar Wykes, group financial controller at the company. “Unless you are keen to do it for very pressing reasons like a management buyout or a takeover, it’s not a cheap way to hand over your liabilities.”

Until a couple of years ago, only two names were associated with pension buyouts: Pru-dential and Legal & General. That has now expanded to about a dozen buyout firms, many of them launched by former Prudential executives. For example, Paternoster was set up in 2006 by Mark Wood, the former chief executive of Prudential’s UK life busi-ness, with backing from Deutsche Bank. Lucida was founded at the end of last year by Jonathan Bloomer, former chief execu-tive of the Prudential. Synesis Life, another 2006 launch, is headed by a group of former senior Prudential managers.

In addition, there is The Pension Insurance Corporation, founded by Duke Street Capital, the private equity firm headed by Edmund Truell. AIG, Citigroup, Aegon, Aviva, Scottish Equitable and

Goldman Sachs all have offerings, too.While many of them go head-to-head

in pitches for new business, most claim to offer a niche service that will win them significant market share. Citigroup, for instance, eschews the normal practice of using scheme assets to buy annuities. It has decided to manage the schemes it buys as ongoing concerns. It does this by buying the sponsoring company in its entirety and then selling on the operating company and retaining the pension scheme. This was the model for Citigroup’s August 2007 buyout of Thomson Regional Newspapers’ pension fund. Scheme members have effectively swapped the Thomson covenant for a Citigroup covenant and now have recourse to Citigroup’s considerable balance sheet as a safety net.

While it is novel, not everyone is convinced by the strategy. Mr Clack at Prudential, says:

“The acquirer still has to honour the liabilities so it is not clear where returns will come from. Perhaps they are planning to take a share of any surplus, if that is allowable.”

Aegon also claims a unique selling point in its joint venture with investment bank UBS. Its idea is to transfer scheme risk gradually, automatically buying annuities if and when funding levels improve. UBS is responsible for managing the assets to try to produce the returns needed to execute the next annuity purchase. Aegon admits the market is crowded but believes there will be a shake-out. Colin Beattie, head of Aegon Trustee Solutions, says: “Some players have been around for a year and won no business because they have overestimated the money available in the market in the short term.”

Overview of the bulk annuity market



Mr Wykes is confident that the company can predict cash requirements pretty accurately for the next five years, and reckons that the cost will be far less than the current price for a transfer. “If we do want to pay a 30% premium, why don’t we just put that money into the pension fund?” he asks.

Another reason preventing buy-outs, cited by the survey respondents, was that trustees might be reluctant to support buyouts, although Prudential disputes this. “Trustees are there to make sure a

scheme is well run. Any action that can secure benefits is looked on favourably,” says Mr Clack.

While widespread approval of buyouts may be some way off, the expanding market is convinced that enticing opportunities do exist. As Mr Mody says: “These guys don’t need much activity in the market to do well. They are playing in an industry with £1 trillion of assets and billions of pounds could be available in a single prize. That’s worth waiting for.”

In 2006, when Fiat subsidiary Iveco decided to close part of its UK heavy truck division, Seddon Atkinson, the company had to find a home for the pension plan, which covered some 2,000 current and past employees.

It should have been a relatively straightforward transfer to one of two big UK insurers, Prudential or Legal & General, which had cornered the market on pension buyouts. The fund itself was healthy—sometimes running a small surplus—but because the company was shutting down, UK law forced Iveco to make a suitable transfer.

The quoted price from one of the two insurers, however, gave Mike Blackmore, who was finance director at the time, reason to pause. It came in at 80% higher than estimated prices and far higher than the amount for which he had budgeted, and this was a cost that Iveco would have had to swallow in its profit and loss.

“It gave me severe indigestion,” says Mr Blackmore, who has since become finance director for Ceridian, a UK payroll and HR outsourcing company. “The fact that there were only two people in the market caused us some grief. We booked the bad news when we announced the closure based on the actuary’s estimate, and then found out we had a lot more bad news. It didn’t make me very popular at headquarters in Turin.”

Fortunately for Iveco, the market for pension buyouts, or bulk annuities, was in the midst of a big shake-up because of changes to UK pension regulations, with several start-ups challenging the two established players. Although the start-ups were primarily after business from solvent companies, Blackmore started to get quotes for buying Seddon Atkinson’s scheme.

“Suddenly we started getting some competitive quotes, and we were able to

drive them down by playing one off against the other.” In the end, they went with one of the start-ups, Paternoster, for a price very close to Mr Blackmore’s original budget.

With more offers to choose from, it was not necessary to delve into the detail of actuarial tables and life expectancy. Mr Blackmore could focus on the bottom line—price. Having the right data to hand, however, helped Paternoster to make calculations that ultimately drove down the quote. “The fewer assumptions they have to make the better,” says Mr Blackmore. “They all adjusted their price according to the additional data when it came in.”

Are bulk annuities for everyone? Blackmore understands why CFOs who aren’t forced to transfer their funds might wait until the price drops even further. “It’s a big decision to make because it’ll cost you a lot of money today when the probable bad news will happen a long time in the future, based on probable improvements in life expectancy,” Blackmore says. “I personally believe it’s the right thing to do in the long term. It’s better to bite the bullet now.”

CASE STUDY

Seddon AtkinsonCompetition comes to pension buyouts



While no one knows the exact shape of pension provision in years to come, the one certainty is that it will have evolved significantly. The stakes are too high for the status quo—in which pension schemes represent a largely unrewarded risk for companies—to remain. The search for new financial wizardry to combat demographic and macroeconomic risks is likely to bear further fruit. The drive for better governance is unstoppable and the controls put around investment strategy and funding will inevitably tighten.

But, in the final analysis, it is likely that many companies will baulk at the expense and complexity

involved in implementing these solutions. Many already have the sneaking feeling that in trying to bolt every door, they will fail to notice when the roof blows off. Given these concerns, many finance departments will insist on taking as much uncertainty out of the equation as possible. This may lead to greater take-up of LDI solutions, but companies could well head down the more radical path of closing or selling off their pension schemes. This ultimate transfer of risk may not delight employees and unions, and it may be expensive in the short-term, but at least executives and trustees will sleep better in their beds.

Conclusion


Appendix: Survey results A way through the maze

The challenges of managing UK pension schemes

AppendixIn August 2007, The Economist Intelligence Unit surveyed 200 board level, or C-level, executives of UK companies from a wide range of industries. Our sincere thanks go to all those who took part in the survey. Please note that not all answers add up to 100%, because of rounding or because respondents were able to provide multiple answers to some questions.

Increased significantly

Increased slightly

No change

Decreased slightly

Decreased significantly

32

32

26

8

2

Over the past three years, how do you think the risks associated with managing your organisation’s pension scheme have changed? (% respondents)

No

Yes

Don’t know

51

39

10

Do you think that optimising your pension scheme’s risk automatically leads to lower levels of risk? (% respondents)

Regulatory changes affecting pension funding

Changes to mortality assumptions

Volatility of equities

Volatility of future inflation expectations

Potential future accounting changes

Reductions in expected future investment earnings due to changes in asset strategy

Increasing deficits

Volatility of long-term bond yields

Restrictions on desired corporate activity arising from regulatory changes

Which of the following do you consider to be the most significant risks to your organisation from your pension scheme? Please select up to three. (% respondents)

48

47

40

36

26

25

21

20

17

Understanding of funding options (eg, use of contingent assets)

Understanding impact of long-term trends (eg, changes to longevity)

Asset allocation

Response to regulatory change

Performance management of fund managers

Understanding of investment trends

Management of interest rate and inflation risk

Relationships with members

Relationships with external advisers (eg, investment consultants and asset managers)

Speed of reaction to changes in capital markets

Other

Which of the following aspects of your pension scheme management are you most keen to improve in the next year? Please select up to three. (% respondents)

42

36

35

32

28

24

20

19

19

17

3


Appendix: Survey results A way through the maze The challenges of managing UK pension schemes

1 Very successful 2 3 4 5 Not at all successful Don’t know

How successful do you think the following strategies are at reducing the negative impact of pension scheme risks on your chosen measure? Please rate 1 to 5 where 1 is very successful and 5 is not at all successful. (% respondents)

Benefit design changes

Liability-driven investment

Governance changes to improve decision making and control of pension issues

Use of derivatives or structured products to manage interest rate and/or inflation risks

Use of derivatives or structured products to manage equity risks

Bulk annuity buy-outs

Use of contingent assets, guarantees and other credit support tools

Alternative assets, such as private equity and hedge funds

24 30 23 13 3 8

23 20 30 9 4 13

21 39 20 11 3 6

20 26 29 11 4 10

17 27 28 15 4 9

17 21 26 14 8 14

16 28 27 12 3 14

14 24 31 16 7 8

1 Very successfully 2 3 4 5 Not at all successfully

How successfully do you think your organisation manages the following aspects of scheme governance? Please rate on a scale of 1 to 5, where 1=Very successfully and 5=Not at all successfully. (% respondents)

Managing relations between trustees and the corporate sponsor

Setting and monitoring investment strategy

Managing administrative aspects of scheme management

Putting in place a formal process to identify risks

Monitoring risks on a regular basis

Speed of decision making and execution

Manager selection

Measuring performance of asset managers

Enhancing trustee competencies

Measuring performance of investment consultants

Measuring performance of trustee board

27 36 27 7 3

26 41 22 9 1

25 36 27 9 3

25 38 26 8 3

25 38 29 7 1

23 31 26 15 6

20 40 26 11 2

20 36 27 12 4

19 31 36 11 3

18 33 33 11 5

16 32 30 16 6




Balance sheet

Cash flow

Earnings (per share)

Credit rating

43

25

21

11

Which of the following corporate performance measures is most affected by risks associated with your pension scheme? Please select one. (% respondents)

Already in place Intend to use in next 3 years Do not intend to use

Which of the following strategies have you used in the past three years, and which do you intend to use in the next three years? If you have no intention of using a particular strategy, please select “Do not intend to use”. (% respondents)

Closure of defined benefit scheme to new members

Increased employee contributions

Special employer contributions

Transfer of liabilities to life insurance company

Closure of defined benefit scheme to future accrual

Transfer of liabilities outside of traditional insurance sector

Use of derivatives/ structured fixed interest products to hedge inflation/ interest rate risk

Liability-driven investment approaches

Use of contingent assets to support scheme funding

46 22 31

37 37 26

35 40 24

20 19 61

19 31 50

17 23 60

17 39 44

14 41 46

8 38 54

Yes, they would transfer all of our liabilities

Yes, they would transfer some of our liabilities

No

18

42

40

If your organisation’s senior management could transfer all or some of the organisation’s liabilities to a third party at a competitive price with the full support of stakeholders, do you feel they would choose to do so? (% respondents)



Greater allocation No change Smaller allocation Not applicable

In the next three years, what changes do you expect to your asset allocation? If you do not use a particular asset class and have no intention of doing so in the next three years, please select “Not applicable”. (% respondents)

Equities

Bonds/Gilts

Property

Private equity



Commodities

Other

17 52 26 4

18 55 21 6

17 44 15 24

22 30 8 40

17 22 10 51

15 25 9 51

11 29 11 49

3 25 7 65

Fewer than 500 500 to 1,000 1,000 to 5,000 5,000 to 20,000 +20,000

Approximately how many members are there in your pension schemes? (% respondents)

Active

Deferred

Pensioners

37 15 18 17 13

43 23 19 10 5

52 22 14 6 6

0-19 20-39 40-59 60-79 80-100 Average allocation (%)

What is your current asset allocation, approximately? (% respondents)

Equities

Bonds/Gilts

Property

Private equity



Commodities

Other

8 36 30 23 2

15 39 27 17 3

57 32 9 1 1

88 11 1

94 6

94 4 2

90 10

93 4 1

41

36

16

6

3

4

5

5




Reluctance of trustees to support such deals

Reputational damage if third party fails to meet obligations

Economic cost of buy-outs is too high

Responsibility of sponsor to scheme members

Lack of market development

Internal buy-in challenge

Impact on credit rating

Unfavourable market reaction

Impact on earnings

Other

In the current environment, which of the following do you think are the most significant barriers to prevent companies from transferring their liabilities to third parties? Please select up to three. (% respondents)

51

51

44

36

24

22

18

14

13

2






50% of market capitalisation or more

What is the size of your organisation’s liabilities in relation to its market capitalisation? Please choose the option that you think most accurately reflects your scheme. (% respondents)

32

29

25

6

3

6

Open to existing employees but closed to new entrants

Open to all employees

Closed to all employees

55

31

15

What is the current status of your main (largest) defined benefit pension scheme for current employees? (% respondents)

£500m or less

£501m to £1,000m

£1,001m to £2,000m

£2,001m to £5,000m

£5,000m +

44

16

18

9

13

What is the value of your total pension funds’ assets? (% respondents)



About the respondents

Financial services

Manufacturing

Professional services

Consumer goods

IT and technology

Energy and natural resources

Healthcare, pharmaceuticals and biotechnology

Construction and real estate

Entertainment, media and publishing

Government/public sector

Automotive

Logistics and distribution

Chemicals

Transportation

Education

Agriculture and agribusiness

Telecoms

What is your primary industry? (% respondents)

21

11

10

8

7

6

5

5

5

4

3

3

3

3

2

1

1

29

25

20

10

15

$500m or less

$500m to $1bn

$1bn to $5bn

$5bn to $10bn

$10bn or more

What are your organisation’s global annual revenues in US dollars? (% respondents)

CFO/Treasurer/Comptroller/Finance director

CEO/President/Managing director

Other C-level executive

CHRO/HR Director

Other

Which of the following best describes your title? (% respondents)

47

23

18

8

5

Whilst every effort has been taken to verify the accuracy of this information, neither The Economist Intelligence Unit Ltd. nor the sponsor of this report can accept any responsibility or liability for reliance by any person on this white paper or any of the information, opinions or conclusions set out in the white paper.

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A way through the maze: The challenges of maintaining UK pension schemes

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