Shifting the DB burden. De-risking: beyond bonds. September The knock-on effect of scheme deficits: p28

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1 pensions-insight.co.uk EVERYTHING THAT MATTERS IN PENSIONS September 2012 The knock-on effect of scheme deficits: p28 Taking a more adventurous approach to asset classes: p33 The background to Aviva s flight from bulk annuities: p37 Shifting the DB burden De-risking: beyond bonds 27_39_Special Report_Sep12_em2.indd 27 29/08/ :34

2 De-risk or bust The collapse into administration of woollen manufacturer Dawson last month has graphically underlined how British business is increasingly weighed down by pension deficits. To avoid falling into the same trap that snared the Dawson scheme, the need for pension schemes to de-risk becomes more compelling. This month s Pensions Insight special report focuses on de-risking. Mark Leftly of the Independent on Sunday looks into the factors pushing pension schemes and their sponsoring companies to de-risk (right). He has spoken to top equity analysts about the heavy DB deficits weighing down UK plc and how they are shaping investors perceptions of those companies. But although the case for de-risking has rarely been more urgent, the level of activity in the market is subdued compared to even a couple of years ago. While there is undoubtedly an appetite for de-risking in board rooms, any rush in this direction has to contend with the increasingly saturated state of the bond market. On current de-risking trends, the bulk of DB pension assets will be invested in bonds by But not enough bonds exist in the UK market to satisfy these demands. We therefore examine whether the methodology for measuring pension scheme valuations is fit for purpose (p33) and what alternatives schemes can seek out to bonds. The special report concludes with a look at the bulk annuities buy-out market in the wake of Aviva s decision to pull out (p37). Unfortunately, however, the direction of travel is clear, the road to de-risking looks set to remain a bumpy one. David Blackman, Editor Heavy The burden of historic defi ned benefit pension schemes on major employers is in focus as never before. The reason is a series of grim and gloomy statistics that come out month after month: in 2008, pension plans at British corporates were in surplus by June the defi cit was nearly 270bn according to the Pension Protection Fund; around 84% of UK DB schemes are in defi cit; meanwhile bond yields continue to fall as quantitative easing increases, putting pressure on pension liabilities. There s no clear-cut way of assessing just how much of a burden a large pension defi cit has on a company s share price, but recent data strongly suggests that any sort of defi cit is a drag on the stock. Earlier this year, law fi rm Freshfi elds Bruckhaus Deringer found that FTSE 350 fi rms that de-risked their DB schemes, such as selling them on at a heavy discount, saw their share price increase 1.7% on average against an average index fall of 0.2%. The sheer numbers involved could scare off investors. Take telecoms giant BT s 4.1bn black hole at the end of June last year, which will take a decade for the board to eliminate, including a 2bn one-off payment in March. Holidays group Thomas Cook and the UK s largest food producer Premier Foods have also struggled badly in the crisis. The companies had pension scheme defi cits equivalent to 220% and 160% respectively to their market value earlier this year. load Mark Leftly investigates the stock market s view on the pension scheme deficits weighing down UK plc DB schemes are a millstone around the necks of these companies, preventing stock from reaching its full value. Shareholders sell out, betting that the numbers simply don t add up. Deficits and the share price Freshfi elds pensions partner Charles Magoffi n says investors have now seen enough triennial valuations leisure group Intercontinental Hotels and engineers Hill & Smith and Meggitt are just a handful of those going through the process this year to be able to effectively judge how to price in any gaps or surpluses. He explains: Defi cits do weigh heavily on the share price. Certainly my perception is that analysts are taking much more notice of pension risks than, say, fi ve years ago. The market is much more educated on pension liabilities and having them show up in such a stark way on the balance sheet has pushed companies in the direction of taking risk out of the equation. 28

3 For instance, in 2011 about 7bn of liabilities were offloaded to insurance companies and other financial institutions, according to consultant Aon Hewitt, as companies feared that the costs were unsustainable as people lived longer. One high-profi le example was broadcaster ITV, which transferred around 1.7bn of longevity risk that had long been considered a reason for its underperformance on the stock market. Magoffi n also points out that a large pension deficit poses problems when a company is trying to sell up. Should the acquirer want, or be forced under competition rules, to offload any subsidiaries on purchase, it will be difficult to unravel where the various liabilities should fall. He argues: Pension liabilities can impose additional costs on any takeover and it can be a big pricing issue when trying to value the whole company. Last year, when investment bank Citi agreed to sell EMI s recorded music and publishing divisions, it could only do so on the basis that it retained a pension scheme that had around 1bn of assets but 1.1bn of liabilities. The bank has since been negotiating with trustees to invest hundreds of millions of pounds to secure the future of a scheme belonging to a company that it will no longer own. The effect on valuations Zafar Khan, a senior defence and aerospace analyst at Société Générale, agrees that pension scheme deficits hurt valuations. So, if a company has a 5bn market capitalisation but also a 5bn pension deficit, then the value of the enterprise would be costed up as 10bn. That is significant, as even with a small premium on the market capitalisation, a potential buyer might only think a company is worth 6bn to 7bn. That 10bn valuation would therefore put an end to any potential acquisition. Khan says: Although pension liabilities are very difficult to quantify in terms of the impact on the stock price, it is always a drag. If there s a big deficit, there s obviously a cash funding issue. A lot of the old British manufacturers, where there are a heavy number of former employees drawing a pension, have this problem. Invensys has an issue, GKN has an issue, and Illustration concept by Evelina Beckers 27_39_Special Report_Sep12_em2.indd /08/ :15

4 You get to the point when the pension becomes an unaffordable millstone. The pension was the elephant in the room hurting our share price. David Bolton, chairman, Dawson International Rolls-Royce s defi cit has gone up, while BAE Systems has 4.7bn of liabilities. Many, if not all, of those companies would also point out that they can fund their scheme and that their balance sheet is strong enough to withstand the cost. Also, when equities eventually bounce back, massive defi cits should be wiped out with the scheme returning to surplus, making any outsourcing of pensions a costly, not to say pointless, exercise. The City s leading dealmakers counter that this long-term ideal has little impact on their calculations. When big money is involved, bankers often advise clients to focus on the current situation, rather than what a target company might claim for the future. One leading investment banker, who has been involved in deals worth tens of billions of dollars, says: My view has always been that people have to look at pension defi cits as a debt. If there is a $100m gap, that is a $100m debt and you need to look at it accordingly. If the defi cit is unfunded, then that money has to come from somewhere. Growth prospects can be affected James Hollins, an analyst at Investec Securities, adds that a large defi cit that requires a company to invest billions just to keep afl oat will mean that there is less cash available elsewhere. That could have an impact on research and development, and therefore the group s growth prospects, or push away investors who want to see good returns on their cash. Hollins says: A signifi cant pension defi cit means that companies have to fi nd ways to negotiate on funding it and where it is pretty signifi cant that can be a real problem. Clearly, if trying to fund that gap means there will be a reduction taken from investing in the company or money taken from shareholders in the form of dividends paid out to them. Recent research by Mercer suggests that this pain is likely to increase, as pension defi cits across Europe now account for nearly 5% of the value of multinationals up from 2.9% in On publication of the research, Mercer principal Julien Halfron said: Defi ned benefit pension plans are accelerating efforts to manage their pension risk and ultimately transfer it to external parties. However, this is a slow process and many companies still do not have proper oversight and governance of pension schemes risk. One fi rm that found transferring liabilities too slow a process was Dawson International, a 140-year-old cashmere fi rm that fell into administration this summer because of its UK plcs with big pension liabilities Company name Thomas Cook Group Premier Foods GICS industry group name pension fund defi cit. The Alternative Investment Market-listed group had nearly 3,300 members in its pension scheme but only 54 who were contributing to the scheme as active employees: a big legacy for fi rms that have become signifi cantly more effi cient as technology has replaced a mass labour force. Dawson s chairman David Bolton bemoans the fact that he tried to get the Pension Protection Fund to take over the scheme in exchange for a stake in the business for years. However, the regulator is so strict on ensuring that the scheme s defi cit is not recoverable that the process took too long to prevent the fi rm being crippled by the cash needed to fund it while those negotiations dragged on. Share price ( ) Market cap $m Net Pension Liabilities $m Consumer Services Food, Beverage & Tobacco Dixons Retail Retailing BAE Systems Capital Goods ,789 7, Greencore Group (NEW) Food, Beverage & Tobacco Mecom Group Media Costain Group Capital Goods Atkins WS Commercial & Professional Services , Mothercare Retailing Carillion Capital Goods , GKN Automotive & Components ,491 1, TUI Travel Consumer Services , Firstgroup Capital Goods , Invensys Capital Goods , Morgan Crucible Co Daily Mail & Gen Trust A Capital Goods , Media , Home Retail Group Retailing , Dairy Crest Group Food, Beverage & Tobacco Xchanging Software & Services Whitbread Consumer Services , Net pension liabilities as % of market cap Source: Morgan Stanley research, August 2012 Bolton says: You get to the point when the pension becomes an unaffordable millstone. The pension was the elephant in the room hurting our share price for some time at least the last four to fi ve years it was certainly an issue, like all companies with this pension legacy issue. The statistics can only show part of the story. Bolton s experience tells him that many other fi rms will follow Dawson into the mire, which will see many more shareholders elsewhere lose their shirts on these investments and others sell up in fear that this situation could be repeated. Mark Leftly is associate business editor at the Independent on Sunday 30

5 Expert View Insurance Linked Securities Francois Divet answers questions on the insurance linked securities market and explains how pension schemes can benefit from this asset class What are Insurance Linked Securities (ILS) and how and when did they emerge? The market is young. It started in the mid- 1990s following major natural events in the US, namely Hurricane Andrew in 1992 and Northridge earthquake in The insurers who were exposed to these disasters began looking for greater reinsurance capacity. Within ILS there are different asset types but the most famous one is the catastrophe (cat) bond. These assets do not carry any credit risk but have losses related to natural catastrophes or related to an insurance event. Appropriately the sponsors of these assets are insurers or re-insurers. These institutions are trying to hedge part of their risk following a major natural catastrophe. They will define what is called a layer, then if the amount they have to pay to their insureds is above a certain threshold they will recover some of their losses from cat bonds. A cat bond is very similar to a re-insurance layer you are covering a loss above a certain threshold and up to another threshold. Each cat bond covers one or several specific catastrophes, for example, an insurer will decide to issue a cat bond covering European windstorms. In the occurrence of an event and when losses breach pre-determined levels, the investors will lose some or 100% of their investment. The underlying risk earthquake, typhoon, wind-storm is very specifically defined, as is the geographic area, such as France only or Europe for example. There are three main parameters that can be used to diversify an ILS portfolio: the underlying risk, geographical area covered, and the value of the layers in the cat bond. How do ILSs fit into the fixed-income universe and what are the diversification advantages? For a fixed-income investor this is a very interesting asset class because cat bonds are uncorrelated to other risk. Conventional fixed-income carries credit risk but this is not the case with ILSs. Financial turmoil has no impact of the occurrence of natural disasters so cat bonds have no correlation with economic markets. However, the reverse is not always true. We have carried out some research that shows that the fixed-income asset class has not suffered a major impact from natural disasters, whereas other asset classes, like equities, suffered a short-term impact. What types of investors have found ILSs particularly appealing and what are the characteristics of an investor? On the whole there are three types of investors: pension funds, because of the diversification benefits, life insurers, and family offices. We are seeing more and more pension funds coming into this asset class. Over the last ten years, especially in 2008 and 2011, the cat bond market has performed relatively well. That was despite 2011 being a particular bad year for the insurance and reinsurance markets. The ILS class still outperformed other asset classes and notably the return for ILSs in 2008 was positive despite the economic crisis. [ ] We are seeing more and more pension funds coming into this asset class. Over the last ten years, especially in 2008 and 2011, the cat bond market has performed well It s a growing market and there are two reasons why cat bonds are attractive to insurers over traditional reinsurance. The advantage to the sponsor is that there is no credit risk, the cash will be posted in a specific vehicle (SPV) and, if there is a major event and it matches the constraints set by the cat bond, the sponsor can recover the money very quickly and without any credit risk for investors. With reinsurers there is always the risk that the reinsurer will default on the payment when it is needed. Solvency II will come into effect in the next few years and require insurers to buy extra capacity to cover their underlying risk. They will have to find this additional capacity in the market and so the financial markets, via cat bonds, are a good alternative. The outstanding secondary market is worth about $15bn so it is relatively limited in comparison to other asset classes. But with cat bonds advantages, and the imminent requirement of Solvency II, we think insurers and reinsurers will issue more cat bonds in the future. How are cat bonds priced, and how does this differ from more traditional bonds? Since January 2002, Swiss Re has produced an index for the cat bond market. The return for cat bonds from January 2010 and July 2012 was roughly 7% and volatility was low, about 3.5% comparing favourably to equities. When issued in a primary market, most of the time a cat bond is given a rating. But it is Expert not exactly the same View as ratings used for traditional fixed-income. The agencies provide a rating mainly related to the duration, typically three years, and the probability of incurring a loss over the duration. Most cat bonds have a rating of BB, BB- or BB+, there are very few cat bonds with a A+ rating or above. Cat bonds are floating-rate notes so there is no risk related to changing interest rates as the floating rate yield is adjusted quarterly. How liquid are ILSs? This is difficult to determine because there is little public information. According to Swiss Re, one of the main ILS players, in the secondary market on a yearly basis, $4bn or $5bn of assets are trading. This represents about 30% of the outstanding secondary market and roughly the same size as the primary market. There are perhaps ten or so brokers working in this space through which you can buy or sell cat bonds in the secondary market. Francois Divet Senior Portfolio Manager, AXA Investment Managers 31

6 Working together to meet your toughest pension challenges Who s helping you? With new challenges facing our industry, BNY Mellon s pension professionals are helping clients successfully respond. We offer bespoke guidance and solutions in several key areas of pension provision from asset management to transition management, global custody to treasury, and risk management analysis to pension payments. Our clients benefit from the breadth of our investment capabilities, including our leading investment platform and administration services. We re delivering the next generation of pension-based products and ideas with our clients success in mind. For more information, please contact: David Calfo +44 (0) Brian Leddy +44 (0) The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When the investment is sold the amount received could be less than that originally invested. This advertisement is a financial promotion and is not intended as investment advice. The information provided is for use by professional clients and should not be relied upon by retail clients. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation. Products and services may be provided in various countries by the subsidiaries, affiliates and joint ventures of The Bank of New York Mellon Corporation where authorised and regulated as required within each jurisdiction. Not all products and services are offered in all locations. This material is not intended, and should not be construed, to be an offer or solicitation of services or products or an endorsement thereof in any jurisdiction or in any circumstance that is contrary to local law or regulation. To help us continually improve our service and in the interest of security, we may monitor and/or record your telephone calls with us. Issued by The Bank of New York Mellon Corporation with respect to services other than investment management. Issued in EMEA, with respect to investment management, by BNY Mellon Asset Management International Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No Authorised and regulated by the Financial Services Authority. BNY Mellon Asset Management International Limited is ultimately owned by The Bank of New York Mellon Corporation The Bank of New York Mellon Corporation. All rights reserved. CP (12M)

7 rnatives re griculture forestry operty CORPORATE DEB forestry ternatives ASTRUCTRE With the bond market facing saturation, where are the safe harbours for pension scheme assets, and is a regulatory overhaul just overkill? Louise Ashford investigates PROPERTY INFRASTRUCTRE corporate debt alternatives forestry infrastructure property agriculture property INFRASTRUCT rastructure rnatives forestry perty corporate debt property CORPORATE DEBT forestry ternatives STRUCTRE corporate debt alternatives forestry property corporate debt rastructure INFRASTRUCTRE Plan B A row is brewing over the most fundamental problem in pensions. Schemes must fi nd assets to match their spiralling defi cits but it is proving an impossible task. Could it be as much the fault of unwieldy regulation as fl awed investment strategies? Since the introduction of the Minimum Funding Requirement and later the Pensions Act of 2004, pension funds have been required to hold suffi cient assets to fund the pensions they have promised to scheme members. If a scheme fi nds itself with a shortfall, it must fi nd a way to achieve the requisite level within a set timeframe. This sounds straightforward enough. But delve deeper into the underlying methodology which is used to measure schemes assets and liabilities, and layer upon layer of complexity emerges. As it stands, schemes assets are calculated through two different valuations: funding and accounting. The funding valuation establishes how much money the sponsoring employer needs to put into the pension scheme. The accounting valuation demonstrates the impact the pension scheme has on the sponsoring employer. So the fi rst valuation has a material impact on what a scheme needs to do, while the latter is purely for fi nancial reporting purposes. The main issues arise when it comes to the funding valuation. The pressure of matching ever-growing liabilities with assets is driving PROPER alternat alternatives forestry PROPERTY INFRASTRUCTRE agriculture SPECIALREPORT CORPORATE DEB infrastruc PROPERT proper property alternativ INFRASTRU defi ned benefi t schemes to de-risk as quickly as possible to avoid further volatility and allow sponsors to take their eyes off their pension schemes, with many seeing insurance buyouts as the ultimate goal. As a result, huge sums of money are fl owing into the bond market. In a recent paper, the Society of Pension Consultants predicted this trend will continue, resulting in the bulk of DB pension assets being invested in bonds by The SPC believes this is leaving other long-term investment strategies neglected, with the bond market overstretched and unable to deliver good performance. The way assets are valued exacerbates the problem. Basing valuations on mark-to-market prices leaves schemes vulnerable to short-term market fluctuations. Equity bubbles or the effect of artifi cial monetary stimuli can skew a valuation, making a defi cit appear far larger than it actually is. Tim Gardener, global head of consultant relations at AXA Investment Managers explains: The short term market valuation may be inappropriate for the long-term investor. The CBI recently weighed into the debate, showing what an important issue spiralling scheme defi cits has become for UKplc. John Cridland, the CBI s director-general, said: We re urging the government to act to address this important issue by taking three steps: stop the rollercoaster defi cits by smoothing the measure of the gilt yield for businesses; halt a possible 25% rise in PPF levies next March; and P 33

8 Top alternatives Infrastructure Fashionable but still nascent Property Interesting, but beware of bubbles A range of alternatives The right asset selection is crucial and schemes can do very well but alternatives are taking a while to shake off their highrisk, opaque image ensure The Pensions Regulator takes account of businesses ability to grow. The status quo Disagreements arise over whether a full overhaul of the valuation methodology is warranted and if so, what ought to change. Some experts argue that today s calculations are not to blame for schemes increasing over-reliance on bonds. I don t think changing the methodology is necessarily the right thing, says John Dewey, managing director within BlackRock s multi-asset client solutions team. Once you start moving away from the market price of your liabilities and into something a bit more subjective, it s a dangerous path to go down. Once you ve moved away from mark to market and taken a view that the valuation is wrong, where do you stop? There s quite a bit of leeway allowed in the funding basis that you use, says Paul Sweeting, J.P. Morgan Asset Management s European head of strategy. The accounting basis is more likely to encourage people into bonds because if you re discounting your liabilities using a corporate bond discount rate, then investing in corporate bonds is likely to reduce accounting volatility. Others believe that a combination of discount rules, mark to market accounting, the introduction of IAS19 (which will make equity investing less attractive to pension schemes), and general regulatory infl exibility is pushing schemes into bonds, with potentially toxic consequences. A good benchmark needs to be investible, says Natalie Winterfrost, an SPC council member and It wasn t such a problem to discount against bonds when so many schemes were still quite happy to invest off benchmark. Natalie Winterfrost, member, SPC Council one of the authors of the report. By discounting against bonds, you are saying that is the liability benchmark. It wasn t such a problem to discount against bonds when so many pension schemes were still quite happy to invest off benchmark and keep some risk allocations, but now, particularly at a time when there s been quite a demand placed on gilt markets and quantitative easing, you can see how much money is shifting from pension schemes. You have a benchmark that is falling over. Understandably, pension schemes are frustrated by the situation. Alan Carey, an actuary and principal consultant with Alexander Forbes Consultants & Actuaries, explains he has witnessed schemes funding positions worsening in recent years, despite the fact that asset values have improved overall since When you re talking about a 30-40% increase in the value of liabilities, purely because we re being asked to slavishly follow a structure which looks at gilt yields, it seems crazy. When you compound [the wish to avoid volatility] with the PPF calculation approach again, it strongly encourages you to invest in bonds, against your better wishes, he adds. In the long term, you wouldn t touch bonds at their current yields with a bargepole. But the way the regulator behaves, the PPF levy, the long-term desire to de-risk your portfolio anyway, all drive you towards the bond approach. Strictly speaking, bonds are not the only way schemes can offset their liabilities. Much of the industry believes trustees should invest in other low-risk asset classes to make up their liability matching requirements, but what fits the bill? 5 4 Agriculture and forestry Interesting, but a relative unknown Corporate debt Hardly undiscovered and if buying long-term debt at today s rates, will this mean locking in low returns? INFRASTRUCTURE Infrastructure is the asset class of the moment. The SPC is supportive of the nascent pension infrastructure platform (PIP), which is being developed by the National Association of Pension Funds and the Pension Protection Fund, among others. It would be very easy for it to be put into the too difficult category but it mustn t be; the challenges and difficulties must be overcome, says Roger Mattingly, the SPC s president. Today, the main barrier is lack of clarity. Those developing the new infrastructure platform have yet to explain whether pension funds will be encouraged to invest in greenfield or brownfield projects (a vast gulf of risk separates the two) and basic points such as whether schemes will access infrastructure through equity or bonds. The infrastructure industry does not feel it has been sufficiently consulted: I ve struggled to find the finer details of PIP. Whoever s involved in setting PIP up needs to be talking to the construction and infrastructure industries to work together to set it up, says Jamie Fry, assistant cost manager in cost assurance at Turner Townsend, a professional services firm which advises the infrastructure industry. 34

9 How IAS-19 changes are expected to increase balance sheet volatility Expert View 8,000 Balance sheet liability no smoothing Balance sheet liability smoothing Best interests 6,000 4,000 2, ,000 4,000 6,000 8,000 Source: OECD paper on new IAS-19 exposure, Morgan Stanley research Exploring your options Schemes should also consider commercial property and social housing as alternatives to bonds, says the SPC. Asset managers are already capitalising on these opportunities. M&G started buying commercial property 10 years ago and putting long-lease tenants into the buildings, ensuring that rental payments were linked to infl ation. So you end up with a bond-like return that is secured not only on the creditworthiness of the company, but also the building, concludes an M&G spokesman. Outside property and infrastructure, People are striving to look at other [bond alternatives] and agriculture and forestry, among others, are being considered, says the SPC s Winterfrost. Another potential source of high income-generating fi xed income is by direct lending to companies that have had diffi culty borrowing since the fi nancial crisis. Graeme Delaney- Smith, head of mezzanine at Alcentra, says: Banks see this as being positive because they d like to be in a position to de-lever their balance sheet and it allows them to focus on other aspects of their business. It s a win-win for the market. Winterfrost believes that trustees can be unduly cautious in their defi nition of low-risk assets. With [pharmaceutical company] Roche you can buy the fi ve-year bond on a yield of 0.7%. Or you can buy the equity and get a dividend yield that is getting double-digit growth of 4.5%, which is more than six times the bond yield. One may be in the low-risk bucket of being a bond, but you can only expect capital losses on it whereas the other is giving you a nice income stream, and this is a diversifi ed pharmaceutical business, so it s not a high-risk company. Joe McDonnell, who heads Morgan Stanley s Alternative Investment Partners portfolio solutions group, agrees, suggesting schemes should diversify across a range of alternative assets instead of de-risking into bonds. I don t know over the next 20 years if forestry s going to do very well, or infrastructure s going to do very well. But if I can build a portfolio of say 10 or 12 of these different return drivers, the majority will achieve what I m trying to achieve and therefore as a majority, the portfolio will achieve its objectives. Would this land them in hot water when their valuation date looms? I don t believe a trustee would ever be criticised for diversifying their portfolio across the different strategies I ve mentioned, McDonnell argues. I think they would get criticised if they simply bet the house on equity. Being able to react to interest rate changes is vital, says Ashish Kapur The future of interest rates Interest rates are at an historic low and the deleveraging measures invoked by governments internationally continue to suppress any prospect of an upward surge in the short term. Compounded by a lack of growth in the equity markets, this has been a major cause of rising deficits in defined benefit (DB) pension schemes. A return to growth is impossible to predict with any certainty as a resolution to the current economic turmoil rests predominantly on political rather than economic factors. Meanwhile, it is conceivable in the interim that we could witness further falls before the situation improves. After all, the 50bn in additional Quantitative Easing (QE) announced by the UK government in July will place further pressure on gilt yields. Positioning for change Whatever their view, pension schemes should have a strategy in place on how to exploit interest rate changes to their advantage. Should interest rates begin to rise, it may be advantageous to invest in short duration or higher yielding bonds, unconstrained/ absolute return bond funds or reduce allocation to fixed income. In a falling interest rate environment schemes may benefit from investing in alternative fixed income assets (e.g. infrastructure and emerging market debt) and unconstrained/ absolute return bond funds. Such actions may assist in preserving the value of pension funds assets. However, to manage the volatility of the present value of liabilities, pension schemes should consider setting de-risking triggers to manage their interest rate hedges. These can be funding level related whereby switches are made according to changes in the funding level or market related in which switches are made according to pre-agreed market changes. They can also be automatic where authority is provided by the pension scheme to an investment or fiduciary manager for changes to be made without reconfirming their decision or manual whereby the pension scheme is consulted every time a trigger is reached before a change is made. Partnering with a professional An issue for many schemes looking to adopt this style of approach is that they are unable to devote sufficient time and resources. Schemes hindered by such issues may benefit from using the services of an experienced investment professional such as a fiduciary manager. By using a fiduciary manager, trustees can delegate responsibility for managing assets relative to the liabilities according to their comfort levels. This can free up more time for them to focus on strategic issues that affect the most important aspect of the scheme, the funding level. The future of interest rates remains uncertain but it is crucial that trustees have a plan of how to manage their schemes in the current environment and are ready to act quickly and decisively when the catalyst for growth arrives. For more information about how your scheme could benefit from a Fiduciary Management approach please us at or visit Ashish Kapur, European Head of Institutional Solutions, SEI 35

10 Expert View Clear charges Transparent charging structures are critical to the success of auto-enrolment, says Jamie Fiveash 36 In October 2012, the first tranche of an estimated 10 million employees will be auto-enrolled into workplace pensions. For many of those individuals, it will be the first time they have been a member of a pension scheme. Pensions have not enjoyed the best of mainstream press coverage in recent years, and ensuring that employees understand and trust this new approach to saving is crucial to its success. In order to build that trust and understanding, it is critical that individuals understand what benefit their pension can bring and how they are paying for it. However, our research into the charges used in the pensions market found over 30 different types of charges in use at present. B&CE has launched The People s Pension specifically to meet employer s autoenrolment requirements. In creating this new scheme, we have put a focus on the need for clear, transparent product charges. We believe that complex fee structures can put off consumers, undermining the objectives of auto-enrolment. Transparent pension charges help employers select the right provider for their workforce and make communicating fees to employees much easier. Hidden costs It is fairly standard practice to quote an Annual Management Charge (AMC), which is taken as a percentage of the individual s fund under management. However, there are no consistent regulations governing AMCs, which are often quoted as the scheme s sole charge. In reality, the AMC can be the tip of the iceberg in terms of the total charges levied on an individual s pension pot. There is often a variety of additional deductions, including administration fees, sub-fund charges, as well as entry and exit fees. Some providers, for example, increase the management charges for deferred scheme members who have left the employer, but who have not transferred their pension pot into another scheme. We are all familiar with the great weight of legislation that surrounds pensions. But despite all these rules and regulations, the fundamental principle that consumers should be able to understand what they are being charged and why is not being enforced. This makes it very difficult for employers and consumers to make easy comparisons. If we want to increase confidence in pensions, we need to understand what is being charged for them. At present, there is nothing governing what is included in an AMC, and what might be added on as extra charges. A simple, transparent charging structure with no hidden charges, no fees on transfers and no additional charges for employers or scheme members is the approach that we operate at B&CE. Simplicity in charging structures is a key driver to safeguard consumers, help employers and improve consumer engagement. Jamie Fiveash, Director of Customer Solutions, B&CE Bu Buyo B Buy B

11 y-in In July Britain s biggest insurer, Aviva, announced that it was withdrawing from the 50m-plus bulk annuity purchase market. In a message to shareholders, the company s new chairman, John McFarlane, unveiled a new strategy for the company. The thrust of the proposal was a streamlining of Aviva s many business arms in an effort to build up capital reserves and increase returns. Aviva s UK large-scale bulk annuities business was one such division: cut because it is currently producing or will prospectively produce returns below the group s required return. Is this the death knell for the bulk annuity market or merely a symptom of Aviva s recent troubles? The end of the market? According to Aon Hewitt s bulk annuity market monitor (BAMM), since July 2011 bulk annuity purchasing of pensioner liabilities has been more attractive than gilts to pension schemes seeking to match their liabilities. The BAMM, a suite of graphs, compares market pricing to notional scheme profiles with static liabilities. The bulk annuity market encompasses both buy-ins and buyouts, with the former strategy enjoying far more frequency with schemes because of the speed, simplicity and cost at which it can be transacted. A buy-in takes the form of a contract between an insurer and trustees who, in turn, pay benefits to members. Conversely, a buyout removes the trustee intermediary and thus is subject to a vast and lengthy rigmarole of regulation as responsibility passes out of trustees hands. Jay Shah, co-head of business ut out uy-in origination at Pension Corporation, agrees that for the average scheme pensioner buy-ins have become cheaper but that full buyout has gone the other way, becoming costlier over the same period. Full buyout tends to require the sponsoring company to make available a reasonable amount of cash to fill the gap between the cost of the buyout and the scheme s assets, he says. The economic outlook remains difficult and this, coupled with continued low interest rates, will drive down appetite in 2012, according to Wayne Daniel, buy-in uyout chief executive of MetLife. In this climate it can Bulk business Sam Brodbeck looks at whether Aviva s decision to exit the large bulk annuity purchase market reflects troubles at the insurer or is symptomatic of a slowdown in the sector in general be diffi cult for trustees and decision makers to commit to transactions, he says. There are two quite separate considerations for schemes to make when purchasing bulk annuities: the relative attractiveness of purchasing annuities in comparison to the return on gilt yields, and how effective they can be in helping scheme funding levels. One of Aon Hewitt s senior consultants, Kevin Hollister, explains that according to the latest BAMM report, purchasing annuities from an assets perspective looks like a bit of a free lunch at the moment. From the assets viewpoint selling gilts in favour of annuities looks like good value, he says, you get more risk reduction for the same, or better, implied yield. Every scheme will have a different set of technical provisions depending on the investments it holds and its longer-term B B funding strategy. If a scheme holds a high proportion of fi xed-term gilts, or corporate bonds, this will infl uence how appropriate a buy-in is at any one time. Paul Jayson, partner at actuarial consultants Barnett Waddingham, says that schemes often only get a single quote before deciding that buy-in is too expensive. What they should do, he says, is wait, and the likelihood is that more attractive deals will become available eventually. Aviva s announcement Shah thinks Aviva s was an interesting announcement and slightly surprising, given We don t come across as ultra-competitive for the large cases because we are not prepared to chase market share at any cost. Wayne Daniel, chief executive, MetLife the number of transactions it had completed recently. All of which points to internal troubles at the insurer spilling over into the bulk annuity business. Reports in August of the company s plans to sell its US life insurance division for an 800m loss point to the idiosyncrasies of the fi rm, rather than a weakening market as being behind the move. That said, MetLife s Wayne Daniel understands the decision. We have a very strict view on return on capital, he says. We don t come across as ultra-competitive for the large cases because we keep our pricing consistent and are not prepared to chase market share at any cost. Daniel adds that strategies on competitiveness will vary between specialist insurers and monoline insurers. Adam Gillespie, head of buyout and de-risking research at Punter Southall, suggests that insurers tend to associate themselves with certain types of trade. Some are happy to make lots of small deals, say 5m- 10m, he says. As a rough guide, deals smaller than 20m can be considered small and transactions over 100m large. Profits do not necessarily emerge any quicker, Gillespie says, but the smaller deals involve smaller amounts of data to process, and some insurers, like Aviva, seem happy to mop up the business at the lower echelons of the market (see table overleaf). Legal & General, Prudential, Pension Corporation and Goldman Sachs risk transfer division, Rothesay Life, tend to be the players 37

12 *Aon Hewitt Bulk update Q buy-in Bulk annuity deal monitor Case study: General Motors pension scheme In June 2012 Prudential Financial and General Motors announced that they had signed an agreement to transfer $26bn of liabilities from the car giant s pension scheme. The deal due for completion by the end of the year will be the first US bulk annuity transaction worth more than 1bn since the 1980s. Around 118,000 white-collar (salaried) staff who retired before December 2011 will have their benefits covered by the insurer (which has no connection to the UK Prudential company) while 400,000 blue collar (hourly) in the larger deals and that s a fair amount of competition, says Pension Corp s Shah. MetLife s Daniel cites a case in the US that exemplifi es the kind of deal that his company fi nds harder to compete with. In June motoring behemoth General Motors transferred $26bn of its pension liabilities to Prudential Financial (see case study). Daniel watched the deal trade away from MetLife as other providers cut prices to maintain their competitive edge. While MetLife, Aviva and Aegon (who pulled out of bulk annuities two years ago, likewise citing falling returns and increased competition) are moving out of the top end of the market, Pension Corp has made moves to bolster its reserves. In July the company secured a 400m investment from Reinet Fund and hedged 300m of its longevity risk with Munich Re. Bucking the trends across the bulk annuity Q Rank Bulk annuity Q Q providers (2011 year ranking in brackets) Cases written Value ( m) Cases written Value ( m) 1 PIC (4) Prudential (6) MetLife (5) Aviva (2) L&G (1) retirees remain under GM s responsibility. GM s purchase of the bulk annuity contract is reported to require a $3bn cash premium on top of an asset transfer. Punter Southall noted that the liabilities covered by the deal will eclipse the total value of all bulk annuity transactions involving UK schemes since By comparison, the two largest UK bulk annuity deals written in the second quarter of 2012 were a 272m pensioner buy-in for West Midlands Integrated Transport Authority with Prudential, and a full buy-in of the Gartmore scheme s 160m liabilities with Pension Corporation. Prior to the deal, General Motors total pension liabilities totalled well over $100bn. Paying an insurer a premium to meet its 15% return on capital requirement is destroying shareholder value for sponsoring corporates Hugo James, chief executive, PensionsFirst Capital market, over 50% of Pension Corp s business in 2012 has been in the form of full buyout, according to Shah. However, as Aon Hewitt s BAMM shows, the past year and a half has seen buyouts become less affordable and buy-ins more so. Over the past 18 months, in pound note terms, prices have increased 20-30% but that s largely because long-term interest rates have fallen, explains Shah. All insurers prices have increased by that magnitude. Schemes holding perfectly matched assets (domestic debt of the right duration and proportion) will fi nd that their assets have risen by the same amount. However, most schemes aren t perfectly matched. They ll hold some equities, property and gilts of the wrong duration. Over the past year, as prices have gone up, these schemes assets have not risen at the same rate, says Shah, which is why buyout costs have risen. What has kept buy-ins attractive is the return insurance companies can make by holding other assets that outperform gilts but that satisfy the stringent capital reserve requirements to which insurers are beholden to. For instance, corporate bonds are enjoying strong returns compared to gilts and as long as this is the case, deals are to be had. But if that spread becomes compressed, says Aon Hewitt s Hollister, then you don t get such reasonable pricing. Long Acre Life, a subsidiary of PensionsFirst, targets very large deals (more than 500m) with its recently launched alternative to the traditional bulk annuity transaction. Borrowing the captive insurance method used by companies to manage other risks, Long Acre believes it can incentivise risk transfer by offering fi rms a share in the risk reward of an annuity product. PensionsFirst Capital s chief executive Hugo James explains: We think one of the reasons why the very large transactions aren t happening is because from a shareholder value perspective, paying an insurer a premium to meet its 15% return on capital requirement is destroying shareholder value for sponsoring corporates that are achieving a lower return on their capital. For these corporates, it makes sense to put up their capital to capture the same return for their own shareholders. Only time will tell whether the idea really catches on. What is for sure is that the bulk annuity market although trundling through a slow patch has a long way to go before burning out. As long as there are defi cits, there will be business. Which providers will be catering to which end of the market is harder to predict. 38

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