DEFINED benefit (DB) pension schemes are rarely out of the news these days – the latest headlines being from Shell, which has become the last of Britain’s biggest companies to scrap its final salary scheme for new entrants. And while the death of DB – which has been predicted from as far back as 2004, when I joined The Pensions Regulator – may not be upon us quite yet, it is clear that rising longevity, poor investment returns and, some would argue, increased regulation, have resulted in the provision of DB pension schemes becoming too costly for many to bear.
Scheme closure does not remove a company’s obligation to pay its previously accrued liabilities, however, which means the need to manage risk remains. Left unmanaged, DB pension risk can seriously impact the core business with implications for both shareholders and scheme members: its credit rating, share-price, and ability to attract capital can all be affected, for instance. And it is not an exaggeration to say that, in certain cases, DB pension liabilities are so large and volatile they can pose a serious threat to the financial viability of sponsoring companies. Indeed, the FTSE 100 is home to no fewer than 10 companies with pension liabilities greater than their market capitalisation. And other companies are pensions zombies: they really only exist to support their pensions schemes.
The buyout market – which essentially allows a pension scheme to transfer the risk over to an insurance company – seems to offer an answer to the DB problem. Yet the statistics paint a sorry picture. Since 2007 (when buyouts seemed to be doing well), the buyout market has seen only £25bn of business (and this figure includes buy-ins) – equivalent to just 2.5 per cent of the total value of DB liabilities sitting alongside the balance sheets of private UK companies. For the buyout market to fulfil its potential, the insurance industry has to come up with a better proposition than is currently available to chief financial officers and trustees.
A PENSIONS SHAKE-UP
There is no better time than now to address this issue. With the cash position of UK PLC looking remarkably healthy – UK companies’ cash flow has grown 40 per cent since the depths of the financial crisis – most chief financial officers are looking for investments to put their cash to good use.
But to make the most of this, the whole industry needs a shake-up. Shareholders must pressure sponsoring companies to treat pension risk disclosure in line with that afforded to all other corporate risks on the balance sheet. Meanwhile, companies must embrace new technologies to improve their understanding and ability to manage pension risk.
First of all, however, insurers need to innovate to reduce the costs of buyouts. Traditionally, buyouts have been priced at about 140 per cent of the valuation of a scheme’s liabilities on an IAS19 basis – a price greater than most chief financial officers are willing to pay. And while it would be unfair to lay the blame for this solely at the door of the insurance industry (insurance companies are constrained by the solvency capital regime required within the regulated insurance sector) there has been a lack of innovation targeted towards making solutions more affordable.
Certainly, even where a pension scheme is fully funded to IAS19, it seems improbable that many will be reaching for their chequebooks to pay a 40 per cent premium to an insurance company to take the risk away – especially given that the premium will be an immediate hit to the sponsor’s profit and loss.
A CAPTIVE SOLUTION
One way forward may be via the world of captive insurance, where a company forms its own insurance company subsidiary to carry its risks. Used by many large companies to insure their property and casualty risks, captives – if set up by a pension scheme – would naturally retain the profit that would otherwise be paid to an insurer. But a pure captive solution for delivering pension buyouts would also consolidate the pension liability on the sponsor’s balance sheet – compounding the problem. A solution is therefore required that delivers the economic benefits of a captive through a mutually owned insurance company, which removes the need to consolidate the liability. It may also tackle perhaps the greatest barrier to a buyout – the cost. Pension schemes conducting such a buyout could ultimately reduce the price they have to pay by as much as 20 per cent.
Current economic conditions, many would argue, may mean that such innovations will struggle to solve the buyout conundrum. Yet companies may have to accept that the heady days of 2008 – when schemes could transact at a price just over the value of their liabilities – may never be seen again. And that leaves the way clear for new entrants to offer innovative solutions to the DB pensions issue.
David Norgrove is the former chairman of The Pensions Regulator and the current chairman of Long Acre Life.