The View

Understanding the issues you face as a trustee October 2011

Gilts, gold and governance 6

Asset-backed contributions 4

Opportunities to reduce risk 7

Living with uncertainty

Feature

2

Did you see? 8

02 The View

WelcomeWe know financial markets are uncertain, but accept it’s not possible to know the exact form and timing that uncertainty will take. The solution is to plan: plan for things improving, with safeguards in case things don’t go well.

The present economic and eurozone uncertainties will test your plans; and the job at hand is to re-evaluate whether adjustments are needed. In the words of Henry Ford II:

Nobody can really guarantee the future. The best we can do is size up the chances, calculate the risks involved, estimate our ability to deal with them and make our plans with confidence.

This edition of The View deals with the uncertainties you face as trustees. Martin’s piece to the right tackles uncertainty head-on. How TUI used their brands to bolster security is looked at by Richard. Graeme considers the lustre of gold, gilts and cheap(er) equities; and James highlights how some trustees have tackled longevity.

For help with your scheme’s plans, please speak to your usual Hymans Robertson contact or give me a call. Together we will achieve what John H Finlay desired of us:

Maturity of mind is the capacity to endure uncertainty.

Patrick Bloomfield, Head of Trustee Solutions [email protected]

“Sell in May and go away” goes the banking adage. Trustees who were closely monitoring their funding and de-risked in Q1 or Q2 will be very pleased with that decision now. The summer months have witnessed extensive turbulence in global capital markets. In economic terms there is little precedent for where we are. This is not a normal recession, it is an extraordinary one.

Living with uncertainty: Taking positive steps to manage risk in turbulent times

Achieving lower volatility in difficult markets DB scheme funding has been hit by the double whammy of lower growth asset values and higher liabilities due to lower bond yields. The same pounding has lowered the benefits that members can expect from their DC funds.

October 2011 03

Living with uncertainty: Taking positive steps to manage risk in turbulent times

What you can do: investments The turmoil in markets has thrown up some attractive investment opportunities for DC members and schemes to claw back some lost ground. The right mix will obviously depend on a scheme or member’s broader circumstances. For some, the right move could be rebalancing into growth assets or accessing more attractive opportunities in credit, while for others it will be insuring against further downside moves by seeking to better hedge liabilities. On the liability side, flexible drawdown or risk transfers such as buy-in, may now be more attractive than ever for removing volatility or cost from scheme funding, while providing attractive benefits to members.

What you can do: funding Where sponsor affordability is strained by wider business conditions, trustees might want to consider more flexible funding solutions such as asset backed funding. Richard Crowhurst sets out overleaf how this helped the TUI pension scheme. It is in both trustees’ and sponsors’ interests to keep schemes affordable, while maintaining protection for members.

What you can do: hedging While the summer has highlighted financial volatility facing schemes, it is important to take a broad view of risk. By reducing longevity risk, schemes avoid compounding financial volatility and also improving the effectiveness of their hedging. If life expectancies are out by just one year, an LDI strategy for a typical scheme would over or under hedge by 5%; food for thought.

Don’t act in haste and repent at leisure

However, there are many things trustees can do to weather this storm and reduce volatility and cost for sponsors and members. Fundamentally, it is about having a robust and affordable plan in place and being equipped to implement the right combination of actions at the right times.

Bad, but not as bad as 2008, yetWhile full funding could be further away than it was a few months ago, it might well be closer than it was a few years ago. Rather than acting in haste and repenting at leisure, trustees should benchmark against their long-term strategic plan. Any actions, for instance recalibration of triggers, can then be made in an informed light. The information can help set sponsors’ expectations, or for DC schemes members’ expectations, about likely costs of providing the desired benefits.

Martin Potter Martin is a Partner and also heads up our Edinburgh office. He provides Scheme Actuary advice to various pension trustee clients and also advises a number of corporate sponsors on the financial management of their pension arrangements.

Contact Martin for more information on 0131 656 5102 or on [email protected]

Targeting your governance on riskTrustees should ensure their governance framework highlights risks and the protection available, so either members or the trustees can make informed decisions. Through careful preparation, active monitoring and by knowing how you would react in different circumstances, trustees can seize opportunities to secure scheme funding and improve DC benefit outcomes.

Asset-backed contributions:Harnessing the value of a brand

Why is there a growing trend?At a time when market volatility is

creating larger deficits and cash flows are

under pressure, sponsors are finding these

arrangements increasingly attractive. This

is because they can use their assets to

reduce the annual cash payments to their

schemes, provide additional security to

the scheme members, and gain tax relief

on the initial cash contribution.

Companies are using their assets to fund DB schemes; Marks and Spencer used property and Diageo used barrels of whisky spirit. Richard Crowhurst explains how the Trustees of the TUI Pension Scheme (UK) Limited generated value using TUI Travel Plc’s Thomson and First Choice brands.

OutcomeThe result is that the sponsor’s initial cash position is unchanged, ownership of assets transfers to the SPV, the recovery plan is extended and the sponsor pays lower annual deficit payments. The recovery plan may be ‘back-end loaded’ if the PFP also provides a bullet payment at the end of the term.

04 The View

This mechanism has several useful aspects from trustees’ perspective. The security of the assets in the SPV can support an extended recovery plan (the assets would transfer to the Scheme from the SPV in a default event). Freeing-up cash also allows the sponsor to invest more in the business, improving the sponsor’s covenant.

Company

SPV

PensionScheme

How it worksAsset backed contributions are part of a Pension Funding Partnership (PFP) with your sponsor. In principle, this is how it works:

1. sponsor makes an initial cash contribution to the scheme;

2. trustees invest this cash in a Special Purpose Vehicle (SPV);

3. SPV purchases assets from the sponsor (using the cash);

4. sponsor makes regular payments to the SPV in relation to the assets;

5. SPV makes asset-backed contributions to the scheme (financed by the regular payments).

1.

4. 5.

3. 2.

Richard Crowhurst Richard Crowhurst is a partner at Hymans Robertson. He is Scheme Actuary to the TUI Pension Scheme (UK) and advised the Trustee on the financial implications of the ground breaking PFP involving the brands of the sponsor.

Contact Richard for more information on 020 7082 6202 or on [email protected]

October 2011 05

What type of regular payments will be made? This depends on the assets. For example Marks and Spencer pays rent for using the property assets; for TUI the payments are royalties for use of the brands; and Diageo pays premiums in relation to certain financial instruments (known as ‘call options’) which give it the right to purchase the whisky spirit back at a future date at a pre-determined price.

FundingWhat are the assets worth and how might their value change in a distressed sale situation? TUI appointed specialist brand valuers to answer these questions.

How much would the scheme rely on the assets in a wind-up? The different circumstances that could lead to a

wind-up are likely to affect the value of the assets to the scheme, particularly if there is corporate distress.

What is the value for Pension Protection Fund levy purposes? Ascertaining the impact on the levy and how this value could change in a volatile market will be useful.

Legal issuesThere are many legal questions surrounding how the PFP may work out in different future scenarios, such as:

x Is the documentation watertight?

x Can any of the terms be amended to improve security?

x What happens if legislation changes and the PFP becomes illegal?

GlossaryPension Funding Partnership (PFP)Term used to refer to the arrangement between sponsor and trustees.

Special Purpose Vehicle (SPV)Entity in the PFP which holds the assets and deals with the asset-backed contributions and bullet payment. May consist of two or more limited liability partnerships.

Asset-backed contributionsThe income stream within the PFP, generated from the sponsor’s assets.

Bullet paymentThe final payment under the PFP. Often related to the deficit at the time of payment, subject to an upper limit.

There are some important questions that trustees will need to resolve in agreeing this type of arrangement, for example:

CovenantHow is the sponsor covenant affected? Could the sponsor reasonably afford higher contributions instead? There may be simpler alternatives such as the contingent assets without a PFP structure. A covenant assessor can help clarify these questions.

InvestmentCan it be done? Does the PFP cause a breach of the 5% limit to employer-related investment? The SPV may include a Scottish Limited Liability Partnership to avoid this issue, but legal advice is certainly needed.

Should it be done? Is the PFP an appropriate investment? Investment advice might conclude that it is appropriate because it is an additional asset rather than a replacement asset.

Are the assets unencumbered? What reassurances should the trustees seek that there are no higher ranking charges over the assets that could diminish the value of the arrangement for the scheme?

The due diligence we faced was immense. The proposal affected nearly every aspect of the Scheme and so taking advice was essential. Hymans Robertson did a great job explaining the funding implications to us.

Andrew John, Chairman of the Trustee, TUI Pension Scheme (UK) Limited

Are PFPs worth the effort?The extent of advice needed makes PFPs fairly expensive to implement, so they are only commercially viable if there is a significant value of assets available. However, if cash-flow and contributions are very tight for your sponsor, then a PFP which brings immediate funding benefit could be very attractive.

Over time PFPs may become more commoditised, which will reduce the time and effort required by trustees to put one in place.

06 The View

Life is pain, highness. Anyone who tells you differently is selling something.

William Goldman, The Princess Bride

Gilts, gold and governance

As equity markets inflict more pain on pension funds, other assets that have prospered, such as gilts and gold, can seem very appealing. They will have their advocates. Others will argue the merits of “cheap” equities. How should trustees respond to market upheavals? We would suggest by standing back from the welter of short-term comment and looking to their long-term plans.

Gilts Gilts are part of those plans for most schemes. With the economic outlook remaining uncertain, there could be a temptation to run for cover now. But that comes at a cost. Most funds still rely on investment returns to close funding gaps. Rushing into gilts will only work if something else replaces the extra return expected from risk assets. Additional contributions may be hard to come by, but other “defensive” assets might offer both return and risk reduction.

Gold The claims for gold are hard to avoid, but trustees need a clear rationale for investment. Does it fit strategically, offer premium long-term returns or provide valuable insurance? Our answer is no. Does it provide spectacular tactical opportunities for the speculator? Emphatically, yes, but not necessarily at the current price. Do trustees have the arrangements in place to accommodate and control that type of investment approach? Only when the answer is yes should exposure even be considered.

Equities Are equities cheap? Not particularly, in our view – we thought they seemed overextended earlier in the year. But they are as cheap relative to gilts as they have been for two years. Further, August’s downturn will have reduced equity exposure below strategic target for many funds. One of the disciplines of a long-term asset allocation strategy is to encourage purchases of assets as they become cheaper. We believe trustees should follow this discipline and buy equities to raise exposure up to target.

Fundamental questions trustees should ask themselves:

x How do investment and contribution strategies fit together?

x How does each asset earn its place in the portfolio structure?

x How should asset allocation respond to market movements?

A well-designed investment policy should aim to provide the long-term framework to answer these and other questions in both benign and turbulent conditions. Best-practice governance cannot promise freedom from pain, but it does provide a way to manage it effectively.

Graeme Johnston Graeme is a Consultant in our investment practice and is responsible for our Capital Markets Service. Prior to joining Hymans Robertson, he spent over 20 years in the fund management industry.

Contact Graeme for more information on 0141 566 7998 or [email protected]

October 2011 07

Opportunities to reduce pension scheme risk, despite tough market conditions

James Mullins James is a Partner and Head of Buy-out Solutions. He is a qualified actuary, with over ten years experience in the pensions industry.

Contact James for more information on 0121 433 4379 or [email protected]

The summer of 2011 has been a perfect storm for UK pension schemes, with:

x falling equity markets depressing asset values; and

x long-term interest rates at a near 100 year low, significantly increasing liabilities.

Whilst many of the more traditional approaches to reduce pension scheme risk will be put on ice, there are several options which are still attractive. Here are three examples:

1. A buy-in that insures older pensioners may be cheaper than the cost of buying gilts to broadly match the same pension payments. This is because insurers pricing often reflects the yields available on corporate bonds. As corporate bond yields have increased relative to gilts, this presents an opportunity to reduce risk and improve the pension scheme’s balance sheet position, for example by:

- selling £100m of gilts that provide only a reasonable match for pensioner payments (and provide no protection against longevity and other demographic risks); and

- buying a buy-in policy for £98m that fully matches the same pensioner payments.

2. Longevity swaps can materially reduce longevity risk, without the need to lock into gilts (or other matching assets) at very low yields. This is why most longevity swap deals have transacted when financial market conditions have been tough. ITV’s £1.7 billion point longevity swap with Credit Suisse at the end of August 2011 is an example of this and we expect more household names to complete longevity swap deals in the coming months.

It’s vital for trustees to understand their scheme’s longevity risks as accurately as possible to be able to evaluate longevity

hedge pricing. ClubVita’s longevity analysis can provide these insights very cost effectively.

3. Hedging inflation risk is beginning to look attractive for the first time since 2008. It’s important to test how these strategies affect the volatility of your scheme’s funding, but after several years of worrying newsfeeds on inflation, hedging this risk may be appealing.

If you’re interested in exploring actions that could de-risk your scheme, don’t be deterred by gloomy financial markets and speak to your usual Hymans Robertson consultant.

Club Vita offers unparalleled insights into longevity risk.

www.hymans.co.ukHymans Robertson LLP and Hymans Robertson Financial Services LLP One London Wall London EC2Y 5EA T 020 7082 6000 45 Church Street Birmingham B3 2RT T 0121 210 4333 20 Waterloo Street Glasgow G2 6DB T 0141 566 7777 Exchange Place One 1 Semple Street Edinburgh EH3 8BL T 0131 656 5000 A member of Abelica Global

This communication has been compiled by Hymans Robertson LLP, and is based upon their understanding of legislation and events as at October 2011. It is designed to be a general summary of occupational pensions issues and is not specific to the circumstances of any particular employer or pension scheme. The information contained is not intended to constitute advice, and should not be considered a substitute for specific advice in relation to individual circumstances. Where the subject of this document involves legal issues you may wish to take legal advice. Hymans Robertson LLP accepts no liability for errors or omissions. Your Hymans Robertson LLP consultant will be pleased to discuss any issue in greater detail. Hymans Robertson LLP and Hymans Robertson Financial Services LLP are limited liability partnerships and registered in England and Wales with registered numbers OC310282 and OC310836 respectively. Authorised and regulated by the Financial Services Authority. 2007/MKT/The1011

© Hymans Robertson LLP. Hymans Robertson use FSC approved paper.

08 The View

Did you see...?Our 60 Second Summaries and Current Issues aim to bring you up to speed with topical pensions issues as and when they arise. Paul Maclean highlights the main issues from the last quarter.

Paul Maclean Paul is a Research Consultant within our research and technical support team, providing support on law and regulation as well as editorial copy for a number of our publications.

1 New PPF Levy Framework

The Pension Protection Fund has published near-final details of proposals for its 2012/13 levies. Notable changes include smoothing of asset and liability values to ease the effects of short-term financial volatility, a revised method of assessing employer insolvency risks, an amended policy on guarantees given by other companies in the sponsor’s corporate group, and the inclusion of investment strategy risks as a factor in the calculation. Trustees can expect that the new rules will prompt discussions with sponsors and advisers.

2 Statutory Employers

The Pensions Regulator has emphasised the importance of trustees being sure which employers are legally responsible for meeting various statutory obligations in connection with defined benefit schemes. From November 2011 onwards they will be required to identify them when they submit scheme returns to the Regulator. The Regulator counsels trustees to be on the lookout for events—corporate re-organizations and other transactions—that might result in schemes being cut adrift from their statutory employers. The consequences of inattention can be dire: the loss of protection under the funding, employer debt and PPF legislation.

3 Default Retirement Ages & Discrimination

The likelihood of employees being compulsorily retired at pre-determined ages is now considerably less, with the completion of the phasing out of the ‘default retirement age’ on 1 October 2011. Employers that continue to apply compulsory retirement ages will need to be prepared to justify the discriminatory practices in court, and may find it difficult to do so. Trustees are likely to see more members continuing to work beyond their schemes’ normal retirement ages, and may need to re-assess late retirement terms, money purchase ‘lifestyling’ arrangements, and insured death benefits.

Our 60 Second Summaries and Current Issues can be found in our ‘Knowledge Centre’ at www.hymans.co.uk