Managing pension liability: risky business

The pensions regulator estimates that there are 10,800 defined benefit
schemes in the UK and it now has detailed scheme returns on 5,772 of these
representing over 50% of schemes by number and over 85% of the total
liabilities.

In March 2006, it was estimated that these 5,772 schemes had aggregate assets
of £635bn. On a FRS17/IAS19 valuation there were £724bn of liabilities giving an
accounting deficit of £89bn. If the companies had to pay an insurance company to
take the liability away (known as a ‘full buy out’) the liability was estimated
to be £1,076bn giving a shortfall of £441bn.

It’s not just the sheer magnitude of the numbers that is so compelling, but
also their volatility. Watson Wyatt estimates a regular valuation of the FRS 17
deficit of the FTSE 350 companies. The estimated deficit was around £43bn in
June 2002 but then took a dive to over £100bn in March 2003. It then ran at
around £60bn to £80bn for a couple of years but at the end of March 2007 it was
estimated to have reduced to £30bn. And it often falls to the finance director
to assess, understand and help manage the underlying economic risks.

Much of the volatility of the accounting measurement relates to movements in
the market value of assets and in the corporate bond yield rates used to
discount the pension liability. But to focus on these risks alone can result in
insufficient attention being placed on the simple fact that we are living
longer.

It would seem that much of corporate UK is not yet fully aware of the
longevity risk in terms of current mortality assumptions and, perhaps more
importantly, likely future trends. David Norgrove, chairman of the Pensions
Regulator, recently sounded a wake up call and highlighted that just one
additional year of longevity can increase a typical defined benefit pension
liability by 3% to 4%.

A recent analysis published by actuaries Lane Clark and Peacock looked at the
longevity assumptions made by the 33 companies in the FTSE100 that reported them
in their accounts. The average assumption was for a man retiring at 60 to live
to about 85, with three companies assuming 82 or under.

Only two companies used a figure consistent with what’s known as the ‘medium
cohort’ projection – which places the figure at 87. Even then, some experts
consider that the medium cohort projection may be underestimating likely future
improvements. As Norgrove said ‘the average company assumption is two years
below a projection that itself may be an understatement’.

Pensions Capital Strategies, part of the Jardine Lloyd Thompson group,
estimates an IAS19 deficit of the FTSE 100 companies of £35bn as at the end of
December 2006. It goes on to suggest that an underestimate of mortality of two
to four years would move the deficit towards £100bn.

CIMA recently published guidance and a checklist, developed in conjunction
with our Pensions Advisory Group.

The guidance is unique in that it includes a checklist of questions designed
to ensure the board as a whole is aware of the pension liability risks and that
these risks are proactively managed. The mortality assumption is one area that
the checklist suggests a FD should robustly challenge and understand. This is a
complex area as a standard assumption may not be appropriate for a specific
scheme.

Even when understood, the longevity risk is the least susceptible to hedging.
A new market is, however, developing in ‘mortality bonds’, ‘longevity bonds’ and
‘longevity derivatives’ which, in time, may help companies and pension scheme
trustees offset some of the risk. Increases in retirement age can also help
address the situation.

BAE Systems has taken an innovative step with pension scheme members having
agreed to take responsibility for 40% of any future increase in liabilities
resulting from employees living longer – either by retiring later or by taking
benefits at a reduced rate.

The latest information from the pensions regulator was released in December
in what it refers to as The Purple Book. The report will be published annually
to allow the regulator, PPF and employers and scheme trustees to track changes
to risk.

CHECKLIST

The CIMA guidance and the associated checklist, developed in conjunction with
the Pensions Advisory Group, provides a framework to help you with support from
your advisers to find the answers to the following questions:

• What do I really need to know about the current regulatory framework for
defined benefit pensions?

• What are the risks to implementing a chosen business strategy arising from
the pension liability?

• How can I better understand these risks?

• What actions can I take to manage the risks once they are understood?

• How should I report to the board and shareholders on how the risks are
being managed?

• Are the mortality assumptions up-to-date?

• Is the pension scheme population large enough to carry out a meaningful
study of mortality?

• Do you know how your pension liabilities split between different workforce
groups manual, clerical, management and executive?

• Do you have other information, which would be useful in assessing whether
the standard assumptions should be adjusted?

• Do the mortality assumptions make allowance for future improvements in
longevity and, if so, how much?

Richard Mallett is director of technical development at
CIMA