Difficult age
1 Jul 08
The last Tommy to serve at Passchendaele is 110, but our increasing longevity is not always good news. Robert Outram looks at the problems it poses for company pension funds
by Robert Outram
Last month Harry Patch celebrated his 110th birthday. Patch, who fought at Passchendaele, is the last surviving Tommy from World War One, but when the survivors of Dunkirk and D-Day reach a similar age they are likely to see more of their old comrades surviving. Brits are living longer and, while it is clearly a welcome development, that adds to the pressures that occupational pension schemes face.
You only need to look at the number of subjects receiving the traditional telegram from Buckingham Palace on their 100th birthday.
In 1952, when Elizabeth II became Queen, she would have sent out around only 250 telegrams. During 2008 the number is likely to be 5,000, and should Her Majesty herself reach the age of 100, in 2026, the expected number is more like 15,000.
Longevity (or “mortality” as it used to be called before actuaries decided to improve their dour image) is a huge issue for pension schemes. Clearly, if their pensioners are living longer, the call on the scheme’s assets is greater. Importantly, the rate of improvement in longevity is itself accelerating, so assumptions about a fund’s long-term liabilities made some years ago are unlikely to be realistic.
Now, under new proposals from The Pensions Regulator (TPR), the office that oversees occupational pension funds, any assumptions that are less prudent than TPR’s national figures – known to actuaries as the “long cohort projection” – will trigger a higher level of monitoring for the scheme.
The National Association of Pension Funds has already responded, expressing alarm that this approach will end up being too prescriptive.
The NAPF’s director of policy, Nigel Peaple, says: “This latest proposal goes one step too far in trying to ensure trustees adopt prudent assumptions… using the long cohort mortality assumption as a trigger for further regulatory scrutiny will push trustees into using it regardless of the specific circumstances of their scheme.”
Douglas Anderson, a partner with actuaries and consultants Hymans Robertson, says: “There is no such thing as an ‘average person’ as far as longevity is concerned. There are significant social, gender and regional differences. The UK is a patchwork.”
Anderson’s firm is trying to make sense of that patchwork by accumulating its own data. This year it launched “Club Vita”, which aims to gather a million data sets, with the offer of a free, bespoke analysis report for all the schemes taking part.
Having more detailed data on individuals by gender, income range and location makes it possible to develop credible assumptions on a scheme-by-scheme basis.
For example, a scheme whose members are mostly blue-collar workers and pensioners in the poorest outskirts of Glasgow should be able to bank on less longevity than a building society on the south coast of England.
Anderson stresses that such factors make a huge difference to scheme funding.
He says: “UK pension schemes have around £1 trillion [£1,000 billion] in assets. On average, we gain 10 weeks each year in terms of increased life expectancy. That implies a cost to pension schemes of £5 billion each year, so each year, pension funds need to improve their investment returns by half a per cent just to pay for that.”
Gerry Devenney, principal with actuaries Punter Southall in Edinburgh, says that the regulator’s assumptions do not factor in the difference in longevity between Scotland and England. He says: “There is a danger that people are over-reacting to recent trends.”
Devenney adds that there are now investment banks offering “mortality swaps”. Rather like an interest rate swap, the bank undertakes to guarantee the actual payments to pensioners and the scheme pays the bank the expected rate, plus a fee.
That acts as a hedge against changing longevity, but it is still a fledgling market. Unlike interest rate swaps, there is no clear counterparty on the other side of the equation who might, for example, want a hedge against longevity rates declining.
The number one issue for pension funds remains the state of the markets, though Devenny argues: “There has been a beneficial side to the credit crunch for pension funds, because bond yields have increased so deficits have been shrinking.”
Concerns about pension liabilities exercise not only company boards and scheme trustees, but also players in the mergers and acquisitions market.
Gary Squires, head of the pensions practice with consultants Kroll, says that M&A transactions can rapidly run into problems if the pensions issue has not been thought through.
Squires says: “A take-over by a private equity firm of a listed company is likely to involve gearing, and high levels of debt could impact on the interests of the pension scheme. Trustees might look for ‘mitigation’ – in other words, improved funding.”
Murdoch McKillop, also a partner with Kroll and a past president of ICAS, says: “There have been highly leveraged transactions where the acquirers did not look carefully enough at the impact on scheme funding, and at the effect that high leverage has on the employer’s ability to meet its financial commitments to the scheme.”
One example – not involving Kroll’s clients – is the takeover bid for supermarket giant J Sainsbury last year. When a Qatar-backed investment fund, Delta Two, mounted a takeover bid for Sainsbury in the autumn of 2007, a key sticking-point for the deal was the status of the pension scheme and how much the acquirer would need to put in to ensure its security.
The scheme trustees and the Sainsbury family were asking for more assurances than the bidders were willing to give and eventually the bid was dropped.
A prospective takeover, for example, by a private equity fund, is one of the factors that could trigger extra scrutiny by TPR.
Gerry Devenney says TPR is taking a “purist” line on some issues but overall, he believes the regulator has been “pragmatic”.
He adds: “The trigger points set by TPR have been seen as targets, but they are not. Companies may have a good reason to have different targets from the regulator but they will have to be prepared to explain them.
“TPR follows risk-based regulation, so it is more targeted than OPRA [the Occupational Pensions Regulatory Authority, its predecessor].”
As well as scrutiny from TPR, however, occupational pension schemes have to pay a levy to support the Pension Protection Fund, which was set up under the 2004 Pensions Act to compensate members of schemes in the event of an employer’s insolvency
The PPF is funded by a levy on all eligible occupational schemes, based on the size of the scheme and also on the assessed risk level, so a prudently funded scheme should face a smaller levy.
Fraser Smart is director, northern region, with pensions and benefits specialist Buck Consultants.
He says: “Last year the PPF said it aims to raise £675m.
“It seems so far that the levy is set to be around double what was previously estimated, especially for smaller businesses.”
Iain McClay, senior associate in the corporate department with solicitors Paull & Williamsons, agrees that the PPF levy is shaping up to be another concern for schemes. He says: “My understanding is that the size of the bills that businesses are getting is much bigger than they expected. Many of them are looking at whether they keep their final salary pension scheme at all.”
The PPF’s chief executive, Partha Dasgupta, said in May this year: “When working out this year’s scaling factor [3.77, the factor applied to each scheme’s liability based on its size and assessed risk], we had to take account of the significant volatility we have seen in scheme risk during the past 12 months – and make sure that we still collect the £675m we said we need.
“In the short term, we have seen scheme funding and insolvency probabilities improve.
“But it is the long-term risk that we have to protect ourselves against, particularly as we are in the middle of a credit crunch which can only mean a lot more uncertainty for the future.”
Despite the fears of a major increase, the PPF says that 58 per cent of schemes are expected to pay a lower risk-based levy as a percentage of their assets in 2008/09 than in 2007/08.
If the heat is on employers, it is no less onerous for pension fund trustees, who increasingly find themselves on the front line.
For example, TPR now requires that trustees assess the employer’s “covenant” – the employer’s ability to meet its obligations to the scheme.
Kroll’s Murdoch McKillop says: “The company commits to a promise and the trustees have to look at assumptions about investment returns and liabilities, as well as the company’s own financial strength. The question is, if investment returns don’t work out as predicted, can the company afford to write the cheque?”
Sheila Fazal, head of pensions assurance in Scotland with PricewaterhouseCoopers, believes that employer covenant reviews are becoming a major issue for trustees. She says: “Trustees are often unsure how far they need to go or how costly the review needs to be.”
Fazal is a member of an ICAS working party drawing up guidance for pensions trustees to help them tackle this question.
She adds: “There is often a perceived conflict of interest for trustees, for example a finance director who may feel under an obligation, as a trustee, to share confidential information about the company and its financial position with the other trustees that, as a director he should not discuss outside the board.”
But Fazal does accept that the new regime is “more rigorous”.
“Trustees have always wanted to do the right thing, but now they have to show that they are doing the right thing.”
Paull & Williamsons’ McClay also believes that trustees are facing an increasing burden. He says: “It’s getting harder and harder to find member nominated trustees. They have so many obligations and many people say: ‘Why should I take all this on?’
“Also, more and more existing trustees are feeling conflicted, especially if they are expected to look after the interests of scheme members but also want to keep a good relationship with the company.”
A survey earlier this year from Deloitte implies that one issue trustees are not paying enough attention to is the “end game” – in other words, how the pension fund will finally settle its liabilities.
Based on a detailed survey of 37 pension trustees responsible for schemes with a combined value of more than £37 billion, Deloitte’s study The End Game found that two-thirds of the trustees surveyed were not actively considering their approach to the final settlement and 60 per cent did not expect
to see the employer concerned use any other method to settle liabilities than the usual pension benefit payments.
Only 28 per cent of the trustees in the survey believed that any form of buy-out might take place in the future for their scheme, but according to Deloitte, for some a buyout could be a viable way out of the risks that a pension scheme poses.
As reported by Stephanie Hawthorne in CA Magazine’s May 2008 issue, the market for insurers and other parties buying out company pension schemes and taking on the liabilities they represent now has many more players than a few years ago, when only Prudential and Legal & General were active in it.
Deloitte partner Andy Green says: “Both companies and trustees are more aware of the risks facing their pension schemes. The question is whether they can manage those risks, especially when they believe those risks are hard to control, such as mortality or employer covenants.
He adds: “New players in the pensions buyout market have created new opportunities and this has led to more attractive pricing, but buyouts won’t be the right solution for the majority of pension funds.
“In many cases the company will not have the capital available to fund a buyout and many funds are now working instead on strategies to mitigate risk rather than offload it.”
Kroll’s Gary Squires says: “It is an expensive exercise to get out of a defined benefit scheme. Most companies could not afford to buy out a scheme with annuities.
“There are new entrants in the buyout market so the cost has fallen in the short term, but it may not last. As capital gets taken up, those players will be unlikely to pursue deals with the same vigour.”
Gerry Devenney says: “There are alternatives to a buyout, such as making an offer to deferred members, either with a cash incentive or an enhanced transfer value. Trustees must undertake due diligence and scheme members should be offered help with financial advice, which could cost as much as £1,500 a head, but it could still be cheaper than a buyout. However, if the company is in trouble and its scheme is underfunded, a transfer or buy in could be in the members’ interests.”
It’s a fairly safe bet that as this century goes on, more of us will be living to the same ripe old age as Harry Patch. What our pension provision will look like, however, is considerably less certain.