The flight from defined benefit pension provision over the last few years has been dramatic. But it is hardly surprising when you consider the variety of factors that have made defined benefit schemes so unattractive to employers. They include dramatic falls in equity markets, falling bond yields, continued improvements in life expectancy, increasing compliance costs – and let us not forget the chancellor’s tax raid on pension scheme equity investments.
At the same time, the new accounting standard FRS17 and the imminent arrival of IAS19 raise the prospect of very large and volatile pension scheme deficits directly hitting balance sheets.
Closing the scheme to new entrants has been the most common and natural way for companies’ financial managers to attempt to put a cap on their pension liabilities. But many are now starting to realise that closing the scheme to new members has given them a new set of issues to grapple with.
One of the fundamental characteristics of an open defined-benefit scheme is the opportunity to smooth out financial risks between successive generations of members. As a result, open schemes have traditionally been financed on the basis of long-term, average assumptions for future financial experience, with plenty of time to correct things if those assumptions are not borne out.
Once the scheme is closed, the supply of future generations is cut off.
This means that the impact of unfavourable experience will fall either on the dwindling last generation of members, or on the company.
Following closure, the prospect of winding-up the scheme starts to become a reality. This brings the scheme’s end-point into sharper focus and shortens the timeframe for managing the financial risks.
The government’s proposed pension reforms, announced in the pensions bill currently going through parliament, mean solvent employers must ultimately provide all the promised benefits, either through the pension scheme or by buying annuities from an insurance company. Given the cost of annuities, the price of failing to manage the risks successfully through the scheme can be very high.
Investment strategy is the most powerful tool in a pension scheme’s armoury for managing financial risks. Responsibility for investment strategy lies with the trustees, although they are required to consult with the employer, and it is essential for companies’ financial managers to take a keen interest.
Following closure, we know the name of every individual who will ever receive a pension from the scheme. It is therefore possible to predict all the future payments from the scheme with much greater certainty.
Benefit payments escalate as more members retire and as pensions in payment receive their annual increases. Payments then fall away as pensioners begin to die off. In simple terms, the job of the closed pension scheme is to have the right amount of cash at the right time to meet these payments.
So why not design the scheme’s investment strategy to do exactly that?
A cashflow-based investment strategy means that pension payments which fall before a ‘horizon point’ (for example, 15 years into the future) are matched with a high degree of certainty with a mix of cash, gilts and corporate bonds.
Payments that fall beyond the horizon point can be backed by higher-risk investments, typically equities, which aim to deliver superior performance over longer periods.
The advantage of this approach is that the scheme can meet its cashflow obligations for several years without having to sell investments with volatile market values such as equities, and without abandoning the prospect of higher long-term returns. It therefore helps to find the right balance between risk control and affordability.The specific features of the strategy – most importantly the period to the horizon point – should be set by reference to the trustees’ and employer’s objectives and the scheme’s own circumstances. The strategy is dynamic, as it evolves automatically with the ageing of the scheme.
By then, the proportion of remaining pension payments that fall within the next 15 years will be greater. The proportion of the scheme’s investments that are held in low-risk assets will also be greater. The strategy therefore automatically reduces the risks as the scheme approaches its end-point.
Care must be taken in setting the rules for switching from equities to bonds, to avoid being forced to sell equities at inopportune times to buy the necessary bonds.
When a DB scheme has been closed to new entrants, it becomes much more important to understand and manage the residual financial risks. Following closure, the pattern of pension payments that need to be made for the remainder of the scheme’s lifetime can be established with reasonable certainty. The company’s financial managers and the scheme’s trustees can then map out a plan for how those cashflow obligations are going to be met.
Dynamic investment strategies, designed to meet those cash flows and evolve in line with the scheme’s ageing process, are a valuable tool for managing the risks.
- Aaron Punwani is a partner at Lane Clark & Peacock LLP.
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