Key developments in Pensions De-risking. October 2014

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1 Key developments in Pensions De-risking October 2014

2 Transfer Value Exercises: the key points The March 2014 budget was a very exciting development for any sponsor of a DB Scheme Transfer value exercises are likely to be very popular again with Defined Benefit (DB) scheme members Take up rates may be much higher following the March 2014 budget changes to Defined Contribution (DC) pensions, which come into effect from March 2015 Running a transfer value exercise can reduce on-going liabilities on the Scheme Specific Funding basis, leading to lower deficits and funding requirements Liabilities on the buyout basis can be reduced by an even greater amount Transfer value exercises can be designed for any budget spend, as in many circumstances, no enhancements are still likely to remove some liabilities Larger enhancements will have a higher cash cost, but ultimately remove greater liability There may be ways to offset some of the additional costs of incentive payments A well received transfer value exercise may make the ultimate goal of full buyout a possibility for many Schemes in a reasonable timeframe Grant Thornton UK LLP. All rights reserved. 2

3 Developments after the 2014 Budget The March 2014 budget provided a huge positive change for defined contribution pensions and retirees from these schemes The final decision not to ban transfer values was a very favourable legislative decision for sponsors of DB pension schemes March 2014 Budget In March 2014 the Chancellor shocked the pensions world by proposing that from April 2015 all members of defined contribution (DC) schemes could access their funds with no restrictions once they reached the minimum retirement age (currently 55). This instantly changed the DC world in two ways: It was no longer necessary (as it previously was for all practical purposes) for most DC members to purchase annuities at retirement, which had always been unpopular DC members were now much more likely to manage their own income flexibly in retirement It also led to two unintended consequences which were helpful to sponsors of defined benefit (DB) Schemes in an unexpected way Sales of individual annuities were expected to fall dramatically With the additional flexibility now available under DC, DB pensions did not appear quite as superior as immediately before the announcement. Subsequent consultation The Government correctly anticipated that the new flexible DC regime would be very popular. Perhaps popular enough to make DB members consider a transfer to a DC scheme to gain this flexibility. They were unsure at the time of announcement of the potential economic consequences of this and sought feedback from the pensions industry. As soon as the announcement was made, the Government issued a consultation on whether transfers from DB to DC should be permitted to continue. Decision time Although the consultation gained little mainstream press or commentary it was potentially one of the largest decisions ever to affect employer sponsors of DB schemes as: banning transfer values would confirm that the only way an employer would be able to remove any pension liability would be by paying the buyout price to an insurer allowing transfer values would provide schemes with a route to remove liabilities at substantially below this level, which was likely to prove very popular with members. In July 2014 employers with DB schemes should have breathed a collective sign of relief when the Government advised it would not ban transfer values and would only require members taking one to have received independent financial advice Grant Thornton UK LLP. All rights reserved. 3

4 Effect on funding deficits Before considering any de-risking exercise, it is important to understand how deficits can be removed from a Scheme There are only two ways outside of additional contributions to reduce deficits - excess investment returns and liability management. Understanding pension deficits Many schemes have a deficit on their Scheme Specific Funding (on-going) basis and virtually all have a deficit on the Solvency (buyout) basis Aside from paying additional contributions, there are only two ways in which these can be removed: Outperformance of the assets over the liabilities or Removing liabilities at a discount to their value under these bases. How has the budget helped The Chancellor's budget changes have unintentionally led to very favourable outcomes for employers looking to reduce these deficits. Buyout pricing Many individual annuity providers have seen demand for their products fall dramatically. This has made those already operating in the bulk annuity market keener to expand in this area and those currently outside looking to see if it is a market they can enter. Bulk annuity pricing is therefore currently as competitive as it has ever been and competition is likely to continue to stay very keen. Liability management Liability management can take many forms, but is primarily where employers offer their deferred members an incentive to transfer out of the DB scheme. These exercises used to be popular, but once it was no longer possible to offer the incentive as cash to members, they became less so. Take up rates were far lower when it was only possible to offer an enhancement to the actual transfer value rather than cash, as members would still need to take this transfer value and purchase an annuity in the open market. From April 2015, any member over 55 can take a transfer value however they choose with complete flexibility and there are also now very appealing tax benefits for those that die before age 75 whilst in a defined contribution fund. This will likely make these exercises very popular again with members, especially among those members already over 55 who are able to access all of this flexibility immediately Grant Thornton UK LLP. All rights reserved. 4

5 Example transfer value exercise Funding Effects A illustrative typical Scheme, closed to accrual, may have the following assets and liabilities valued under the Scheme Specific Funding (SSF), Buyout and Cash Equivalent Transfer Value (CETV) bases. Pre Transfer Exercise SSF Buyout CETV Pensioners Over 55 Deferreds Under 55 Deferreds Expenses 2 1 Total Liabilities Assets Surplus/(Deficit) (8) (35) 3 The employer then undertakes a transfer value exercise for deferred members. We have assumed that without enhancements take up rates would be: 10% among members over 55 5% among members under 55 Then for every 5% enhancement these would improve by 10% among members over 55 5% among members under 55 The table below show the changes to on-going and buyout liabilities and the effect on the deficits of a transfer value exercise using these assumptions for both 10% and 20% uplifts. Post Transfer Exercise SSF 10% uplift Buyout 10% uplift SSF 20% uplift Buyout 20% uplift Pensioners Over 55 Deferreds Incentive exercises are likely to be very popular and could remove a significant amount of the ongoing and buyout deficits Under 55 Deferreds Expenses 2 2 Total Liabilities Assets Surplus/(Deficit) (6) (28) (4) (23) 2014 Grant Thornton UK LLP. All rights reserved. 5

6 Example transfer value exercise (continued) Costs involved There are two costs involved in undertaking a transfer value exercise: additional contributions required to top up the transfer values the advisory fees (including the IFA advice) in running the exercise. The chart below compares possible reduction in the ongoing and buyout deficits against the total costs of the exercise, assuming the uplifts and take up rates are as previously shown. The deficit improvements compared to the costs of the exercise are usually very attractive. If the costs are still prohibitive there are options to reduce or mitigate these. In this example the cost of the exercise is 1.0m for a 10% enhancement and 2.6m for 20%. This achieves reductions in the on-going deficit of 2.2m and 3.7m respectively and also reductions in the buyout deficit of 7.2m and 12.0m respectively. Actual costs and the buyout savings achieved will obviously vary depending on the incentives offered, take up rates achieved and the difference between the transfer value and on-going basis methodologies. If cash cost levels are prohibitive, there are ways in which these can be reduced or mitigated, such as; The employer should consider the methodology of the current transfer basis with the trustees and consider if higher transfer values are affordable from the current scheme assets alone With a generous transfer value basis it may be possible to achieve reasonable take up rates with no incentive at all, only a communication exercise with paid financial advice, for those members over 55 It may be possible to offset a proportion of any enhancements paid against the contributions required under the current schedule of contributions, if the solvency ratio of the remaining benefits improves as a result of the exercise Grant Thornton UK LLP. All rights reserved. 6

7 Our leadership Darren Mason Partner Darren heads the Pensions Advisory team and is a chartered accountant and an insolvency practitioner with over 20 years experience in corporate transactions, restructuring and risk mitigation. He has led over 100 assignments which delivered stronger funding and lower risk for defined benefit pension schemes on behalf of their trustees, employers and lenders. Assignments have included changes in covenant as the result of a transaction, clearance applications, employer covenant in SSF valuations, contingent asset solutions, covenant monitoring and restructuring involving scheme sponsors. In 2005 Darren led the team from Grant Thornton that designed and implemented tpr's approach and intervention strategy to under-funded defined benefit pension schemes and their associated employers. Kevin Hollister Associate Director Kevin is an actuary with around 15 years experience on advising employers and trustees on de-risking defined benefit schemes. He has undertaken many asset liability modelling exercises to identify and quantify individual risks in schemes and advised on the most cost effective solutions to mitigate these, including investment strategy changes, annuity purchases and liability management. He has led around 25 bulk annuity projects ranging from partial pensioner buy-ins to full buy-outs and wind ups on a solvent basis. Contact Darren Mason T +44 (0) M +44 (0) E Contact Kevin Hollister T +44 (0) M +44 (0) E 2014 Grant Thornton UK LLP. All rights reserved. 7

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