Managing defined benefit risks (Sponsored)

Aon’s Nicholas Hatherley explains why risk is the key word for trustees today, and outlines how the risk management toolkit for Irish trustees is growing.

Life has become a lot more complicated since most defined benefit (DB) schemes were first established back in the 1960s and 1970s. Back then, interest and inflation rates were persistently high, longevity was relatively stable, scheme members’ rights were quite restricted, and people tended not to move roles very often.

Almost none of that is true today, and DB scheme trustees have to contend with various risks that barely featured on the agenda just a few decades ago.

“Risk is the key word for trustees today,” says Nicholas Hatherley, Senior Investment Consultant and Actuary – Retirement & Investment at Aon. “That’s been the case for around ten years now. Falling interest rates have made it much more expensive for DB schemes to provide the promised benefits, even against a backdrop of strong equity and bond returns. Interest rates have been falling through the floor, and we now have negative rates in Europe. Fortunately, the risk management toolkit for Irish trustees is growing, with our market following the UK in the approach to locking down risks.”

Increased longevity is one of the key factors driving up the cost of benefits. “One of the big issues over the last number of years is how everyone is generally living longer,” Hatherley notes. “That’s good news for those involved, but not so good news for their pension schemes, which will need to fund pensions for longer. This represents a risk, even though the rate of improvement in life expectancy has slowed a little in recent years.”

The other big challenge is falling interest rates, which have depressed bond yields and driven up the cost of pension provision. In some cases, the cost has risen to such a level that it is no longer feasible for schemes to provide benefits on an ongoing basis, and trustees have decided on closure.

“The first step many sponsors take is to close the scheme to future accrual,” says Hatherley. “Existing members retain their accrued benefits, with future contributions diverted to a defined contribution (DC) scheme, which new employees also join. At the more extreme end, companies have closed down schemes completely. Smaller schemes are winding up at a fairly steady rate. The number of DB schemes in Ireland now stands at around 550. Five years ago, there were more than 700.”

According to Hatherley, closure to future accrual is a strategy seen across the Aon client base. “But by moving future contributions to a DC arrangement, the risk transfers from the sponsor to the member.”

Interestingly, the statutory minimum funding standard (MFS) is no longer seen as fit-for-purpose in many cases. Its assumption of a 6% interest rate for those yet to retire means that even schemes that meet the standard may not be in a position to meet their liabilities. “We have been working with trustees and sponsoring employers to look beyond the MFS and focus on the longer-term. They have to decide if they want to continue paying out pensions until members die, or if they want to de-risk the scheme by buying them out before then.”

In that regard, many schemes will emerge from funding proposals agreed with the Pensions Authority over the next few years. Longer-term planning will need to begin now for many of them. “They have to balance the short-term hurdle of meeting the MFS against the long-term needs of the scheme.”

Of course, trustees must also pay attention to equity markets. “The bull run on equity markets has been quite phenomenal over the past ten years. And that includes the quite dramatic fall of more than 20% at the outset of the COVID-19 pandemic in 2020. As Aon forecast, markets bounced back very quickly. On the other hand, liabilities are increasing due to falling bond yields. We encourage trustees to buy more bonds to help match liabilities while investing in growth assets where required to fill any deficit. The investment journey evolves as schemes mature, and trustees should re-evaluate it every three years at least.”

Trustees are also adopting other methods to manage risk. One of these is the buyout of pensioner members’ benefits through the purchase of an insurance policy. This effectively sees the insurance company taking on longevity and other risks. It makes no practical difference to members, but trustees must decide if the insurance company is as financially sound as the scheme’s sponsoring employer.

In some cases, where schemes are in difficulty, the trustees can use the Section 50 mechanism to reduce the pension benefit payable to members.

“Buyouts are quite strategic,” says Hatherley. “Schemes with big pension liabilities on their books can shift a large amount of risk to an insurance company, often at a lower value than they are reserving for. As a result, they are no longer exposed to market or longevity risk for the group of members concerned.”

Some schemes are also seeking to offer deferred members enhanced transfer values to remove further liability from the books. While many sponsors are considering this option, the role of the trustees is to facilitate the process rather than encourage it, according to Hatherley. “Typically, enhancements vary from scheme to scheme. It depends on how willing sponsors are to get the liabilities off the scheme’s books. Success tends to be dictated by member take-up and the effectiveness of the communication exercise.”

A buy-in has the same key objectives as a buyout but works differently. Instead of shifting the pension liability to an insurance company, the scheme purchases an insurance policy to match some or all of the scheme’s liabilities. Pension payments from the scheme to covered members are exactly matched by a payment from the insurance company to the scheme for as long as those members live. The asset and the liability remain on the books. This can be simpler from an accounting perspective, and therefore more attractive for sponsors.

Aon carried out research with its DB clients in recent months to explore what they are doing to manage pension scheme risk. Many are considering closure to future accruals, others are considering buyouts and buy-ins, while investment risk is also being addressed.

“From our perspective, we are encouraging trustees to be ready for opportunities that may arise to manage risk better,” Hatherley concludes. “For example, if investment markets move in their favour, as they did earlier this year, that they are prepared, they can move quickly and nimbly to take advantage and reduce risk, often at a lower cost than would otherwise be possible. We are seeing many trustees putting automated frameworks in place to cater for that, and this is very encouraging.”

For more information, visit www.aon.com/ireland

Nicholas Hatherley is Senior Investment Consultant and Actuary – Retirement & Investment at Aon.