Pensions World

Fraser Smart, Buck Consultants, explains why trustees and sponsors should work together on managing defined benefit liabilities

With so many schemes moving into the “end game” phase as they close to future accrual, the key issue is how long it will take for sponsors to eliminate all of the liabilities. For some businesses, this has become a major focus since they recognise the premium placed by financial markets on eliminating such risks. The success of those arriving at the party first has encouraged others to join in and they are looking to reduce pension risk aggressively now and over the coming years, often encouraged by their pension advisers.

This is supported by a survey conducted by the Economist Intelligence Unit last year, in which 27% of respondents indicated that they plan to de-risk pension scheme portfolios within the next three years and 10% expect to transfer all liabilities off their balance sheets within three years. Tellingly, 73% of companies predict that defined benefit (DB) schemes will no longer exist in ten years. Yet companies often have trouble implementing de-risking solutions. This article examines the reasons and suggests a process to overcome them.

Different perspectives

Although the focus in much of the specialist press is now (quite reasonably) on private sector schemes in the end game phase, there is still a small proportion of schemes open to new entrants and a much larger number still open to future accrual. In my experience, it is difficult for directors of businesses, particularly listed ones, not to follow the crowd in the face of overwhelming “evidence”. In practice, that explanation does not always translate well when presented to trustees or employees at the start of a consultation exercise. So, if such a change is necessary, sponsors would be well advised to provide objective as well as subjective justification for their plans.

There can be a disconnect between the outcome the sponsor expects to achieve based on advice from its corporate adviser and an outcome that the trustees would consider to be acceptable from a members’ perspective. If the trustees respond to a proposal by saying they have a contrary view, formed with help from their own adviser, the sponsor might wish to consider very carefully whether its own advice is entirely reasonable before proceeding. However, the trustees may have a different perspective and not be seeing the sponsor’s point of view.

Conflicts of interest should not be ignored. The appointment of an independent trustee, usually with extensive experience of liability management, makes life much easier. Failing that, the conflicted trustees could withdraw from involvement in the discussions. My experience suggests that, as a general rule, this becomes even more important as the size of the scheme diminishes.

I am not suggesting that liability management exercises are bad for schemes; rather, that they are likely to be doomed to failure if some basic components are not in place (see Box).

So, if we have all of the components in place, does that make the de-risking process straightforward? In my opinion, it helps considerably in that the amount of time required for negotiation and, consequently, professional adviser fees are both considerably reduced.

Common interest

Many de-risking programmes have been delivered piecemeal in the last few years without any clear long term plan for where or when the process will finish. It could be argued that it is because trustees lack in depth knowledge of long term liability and investment implications, which means they are difficult to engage in a proactive future focused approach, so one off exercises are more achievable.
In addition, wider appreciation that there is a common interest in trustees and sponsors working together to agree de-risking strategies would go a long way to breaking down the barriers. One approach to achieving this is to collaborate on an open process.

Define the risks

The starting point for a coherent plan must surely be for both trustees and sponsor to agree a common language for the risks both sides face. Fully securing members’ benefits is a goal for each, so any dialogue should aim to identify differences of understanding and/or philosophy. For example, if the sponsor has a large budget for long term liability management, the discussion might reasonably be around the balance between using the money to reduce the deficit and undertaking a transfer incentive exercise.

A risk attribution modelling exercise would assist in developing an understanding of the current investment and liability risks. Without such a starting point, it is extremely difficult to identify short to medium term objectives, far less how to achieve long term ones, then to put these into a realistic time frame. Failing to spend sufficient time on this part of the process can seriously reduce the effectiveness of the following steps.

Develop a long term plan

There are numerous ways to de-risk a pension scheme, though those available in any given situation will depend on the strength of the sponsor, as well as the benefit structure and maturity of the scheme. However, cash rich and asset rich sponsors have considerably more flexibility than those struggling to service the interest on the deficit and Pension Protection Fund levies.

Being a trustee is getting harder all the time as the range of de-risking solutions becomes more complicated. Joint training for trustees and sponsors is an effective way to ensure that the common language agreed at the outset is developed at the same pace. Any bias in favour of the trustees or the sponsor in relation to a particular de-risking solution can be discussed openly at this stage rather than in an adversarial way later.

Arguably, it is only once a good understanding of the various solutions is achieved that a long term plan can be agreed. Any plan must recognise that the company has a legal obligation to secure accrued benefits, so any liability management exercises must also have a benefit for members.

The Pensions Regulator’s consultation on transfer incentives last summer gave a strong indicator of one of the sources of tension that can exist between trustees and sponsors. The phrase “trustees should start from a presumption that such exercises are not in the members’ interests” was particularly telling. To an extent, this was explained in the introduction to the consultation, with the comment that there has been a “box ticking” approach that has led to exercises (to date) being run without due consideration of the needs of scheme members. Unusually, the pensions industry has been generally consistent in its response saying that, on this issue, the Regulator has overstepped the mark. It is clear, though, that if trustees understand that such an exercise can have a benefit to members in the right circumstances, the process will be easier.

Navigate through the variety of de-risking solutions

Very few groups of trustees will be able to consider all of the options effectively at any one time. A methodical approach targeting the biggest risks that the sponsor has the means to implement (as identified in the attribution analysis) will allow progression towards the agreed objective based on a reasonable set of priorities.

The position should be reviewed regularly to measure progress against plans, including looking at funding updates and risk attribution analysis.

New risk reduction techniques are appearing all the time and this process is, in most cases, likely to take a number of years, so time should be built in for a constant reappraisal of the approach. As new ideas emerge and some of the older ones become less relevant – transfer incentives might now fall into this category – then the original plan should be revised.

Simplicity in communication to sponsors and trustees is critical. Difficult concepts need a clear, concise and simple explanation without removing the appropriate level of detail required to make decisions.

Communication with members

Any process of this type may raise concerns with members that their promised benefits are under threat. Early communication of plans, which should be in their interests, is to be encouraged and regular progress updates will go a long way to allay their fears.