Laying the track for a smoother ride

Pension scheme investment volatility long pre-dates the current crisis. David Adams looks at how scheme design can be used to improve risk management

For all the doom-laden headlines about the world economy facing its biggest crisis in 70 years, the reality is that a switchback ride endured by pension scheme investments has already lasted for at least 30 years. That's one reason why pension schemes and employers all over Europe have been backing away from defined benefit (DB) schemes, and moving towards defined contribution (DC) schemes instead. It's why the bulk buy-out market has grown, as employers try to offload the risks that their pension schemes represent, and trustees start to find the idea of an insurer as a scheme sponsor more attractive than an often uncooperative employer. And it's the reason why some trustees ask whether it might be necessary to redesign their scheme and the way that it operates, to improve its risk management processes.

"For a long time companies have worried about their exposure to DB schemes, because of the way that they're accounted for on the books," says Kenn Taylor, head of life and pensions at Navigant Consulting. "Those liabilities can jump around and hit corporate profits. They're looking for ways to reduce that risk, either with better investment strategies, by cutting off the growth of liabilities by introducing DC for new staff and even for future accrual for existing staff if they can.

"But when investment markets are struggling it restricts the extent to which they can move. Asset [values] are down and liabilities don't change much. It's quite difficult to buy out the liabilities when there's no money in the scheme."
At the same time, there is also growing disquiet over problems related to DC scheme members approaching retirement. "There's been a reasonable amount of coverage about those problems, in that if equities fall 20 per cent you may be in a position where you can't retire when you wanted to," says Peter Bowers, worldwide partner at Mercer. "Although there is a strong move to DC, there aren't that many people reaching retirement with substantial DC accounts. If we move on 20 years or so this will become a major problem." Or, as Graham Finlay, a senior consultant at Watson Wyatt puts it, more bluntly: "I'm not sure that pure DC is sustainable in the long-term."

Reactive to proactive
So how else might a scheme be redesigned, to improve risk management and to share risk more effectively?
"Between pure DC and DB there are quite a lot of alternative designs, but very few companies have adopted them," says Bowers. In some countries, including the UK, most employers tend not to be very innovative in the field of pension scheme design. "It’s very much a reaction to the problems of having pure DB, and a lot of companies just move over to DC. Most of these scheme design alternatives are about trying to come up with some intermediate solution between pure DB and pure DC." He suggests the simplest way to do this is with a hybrid arrangement, whereby some members are effectively in a DB scheme and others in a DC.

Bowers also highlights the potential value of collective DC schemes, in which employers pay a fixed contribution into a collective fund instead of individual savings accounts, so risk is shared between members. The size of the pension rate is determined in the same way as in a career average scheme, but without guaranteed benefits.
There are a number of examples of schemes of this type in the Netherlands. There would be some obstacles to overcome in markets such as the UK, where there are high levels of state pensions and income increases.
The scope for innovation is also determined by local legislation, says Anne Stewardson, senior international consultant at Watson Wyatt. For example, in Germany, companies experiencing serious difficulties don't have to make cost of living increases (but must prove they are financially unable to do so).

Finlay has also seen examples of more bespoke changes being made to schemes, involving, for example, retirement ages being adjusted in response to changes in mortality tables. Every scheme is different and may be affected to a greater or lesser extent by various additional complicating factors. One is the fact that employees are more mobile, so many schemes have a higher proportion of deferred members than a decade ago, increasing longevity risk and the potential cost of buy-out.

There may also be complications if employees of multinational companies have worked in different countries. "If they are senior people and there are enough of them, companies put in special arrangements," says Bowers. But not many schemes implement pan-European arrangements, which he assumes is due to the problems encountered in creating a scheme that complies with legislation in every country where an employer has employees.

A place for equities
Then there's the extra element of uncertainty relating to longevity risk – another key factor driving scheme trustees to consider buy-out, or to use what has been a steadily growing market in the use of financial instruments to trade and hedge it. "We are beginning to see a market on longevity risks and swaps develop, although a squeeze on credit means it won't be as fast as we thought a few months ago," Bowers adds.

You might assume redesigning a scheme to improve risk management would mean a flight from equities. "Improving scheme design accelerates a move away from equities, but it's not as simple as that," says Bowers. "The fall of the equities markets has brought home that equities are inherently risky. However, because funding levels have fallen, it becomes a lot more difficult to get out of them."

"The challenges faced by DB schemes over the last few decades have lead to the introduction of more sophisticated risk management techniques," says Andy Frepp, corporate development director at Barrie & Hibbert. "But without robust measurement of risks and potential rewards, it is difficult to assess the merits of a scheme's current strategy and any potential risk management strategy.

"For example, focusing on equity risk in isolation may encourage risk management decisions that have a less than expected impact on overall risk due to the interactions with other inherent risk factors, such as credit and longevity risk. With the diversity and often complexity of the potential solutions available to DB schemes, a more holistic approach to risk management is needed."

"Of course, when markets are down it's not a good idea to be dumping lots of equity exposures," suggests Kenn Taylor. "Most markets can take a reasonably long-term view. For DB schemes, many have already shifted their asset allocation more towards bonds, because of issues around the volatility of equities. But often these are schemes where they've got more pensioners in there, and you would naturally have more bonds in the mix anyway."
Trustees' and investment advisors' views on the role that equities should play in asset allocation are also influenced by national differences, says Anne Stewardson. UK institutions have generally had higher equity allocations than those from other countries.

But she also recounts stories of professional contacts working for multinationals who reacted to the economic downturn by saying that their main concern was to ensure that cash assets were safe, "because that would be what individual members would be concerned about: were those cash funds really cash?"

The other option is the use of Liability Driven Investment (LDI), which entails a clear separation of return-generating assets from those acquired for the purpose of risk control, so that liabilities are matched with assets. But that approach becomes more effective if a scheme is well funded. "If you're not a well-funded scheme LDI will give you some help, but you'll always have a chunk of liabilities that has no asset backing it," says Bowers. "Still, LDI is better than doing nothing."

One final measure that a pension scheme could employ to reduce or improve the management of risk is to improve the level of expertise present among the trustees themselves, and that is available to them externally, as Dawid Konotey-Ahulu, a founding partner at Redington Partners, explains.

A simple step such as more frequent trustee meetings can also help. "These meetings tend to happen infrequently, and you have a lot of items on the agenda, so not much time is spend on strategy and tactics," he explains. "The other thing we're seeing is more use of joint working groups, made up of both sponsors and trustees, working on strategy, trying to come up with a game plan that suits both sides." In the end, better risk management is usually a happy by-product of better scheme management in general.

WRITTEN BY DAVID ADAMS, A FREELANCE WRITER