Aon Hewitt: Play it safe with strategic de-risking - Kevin Wesbroom, United Kingdom

Just when it looks like things couldn't get any worse for defined-benefit pension schemes, a new challenge arises. Pension funds, hoping that investment returns could help finance a good portion of future benefit payments, have had their hopes dashed by another round of quantitative easing. This comes against a backdrop of negativity.

The equity market is no longer a safe bet and yields from bonds have proved particularly disappointing. Fast-changing markets mean that pension calculations carried out in the 1970s and 80s are proving hugely wide of the mark, all underpinned by a workforce that is living longer and longer. In the view of Kevin Wesbroom, principal consultant at Aon Hewitt, many sponsors have had just about enough.

"On the face of it pension fund liabilities ended last year 30% higher than they were at the start," he explains. "The prospect of people living longer means that real benefit payments are getting worse and asset returns are volatile or non-existent. Many companies would like just to get on with things, to not think that their existence is to make sure there is enough money for the pension scheme."

Changes to the law have made it even more difficult to lighten the pensions load. In the past, most companies could choose to close their plans and walk away if the expense became too great. But a government rule change in 2003 means that if a pension scheme is closed, the full debt must be paid. In Wesbroom's view this has helped encourage a change in how workers perceive pension schemes, which has proved unhelpful.

"When this started out, most companies saw it as a case of best endeavours," he explains. "We are going to try and provide decent pensions for employees who have worked for us for a long period of time. Somewhere along the line it became a property right that cannot be taken away, cannot be changed and must be delivered. A lot of people are asking, 'when did I ever say that I was going to act like an insurance company?'."

The key for pension schemes now is to find a way of de-risking to the point of self-sufficiency, so that benefits can be paid without having to rely on a sponsor. This is a long-term consideration, with some especially troubled pension funds looking at close to two decades to get things in order. On the plus side, it seems that many companies have already started planning.

"We did a survey of mid-market pension funds and there are some good signs," Wesbroom explains. "Most have accepted that they will need a business plan to put their defined benefit scheme out of existence as far as the company is concerned. This is never easy. You have to balance the need to put in money and work the assets that are there, while coming up with a plan to take risk off the table. With many it is like St Augustine's prayer - 'grant me chastity, only not yet'. They don't want to take risks, but don't want to pay the price for not taking risk."

Calculated de-risking

When it comes to formulating a long-term plan, there are a few initial steps for pension funds to consider. Firstly, Wesbroom recommends some simple arithmetic. It is important to understand in as much detail as possible how much investment risk can be borne.

"If we set ourselves a target of being self-sufficient in 15 years' time, what does that mean for the contributions we have to pay?," he expands. "This needn't be a desperately complicated exercise, but just something to tell you that you are in the right ballpark. Then you can examine your options."

A recent survey by Aon Hewitt has shed light on some of the more popular de-risking methods. Innovative vehicles such as longevity swaps, which reduce exposure to pension holders living longer than expected, are gaining in popularity. Around a quarter of companies surveyed have or are considering placing caps on pensionable pay, which could save a considerable amount of money.

"In a final salary scheme, if you are lucky enough to get a 10% pay rise this year it means your pension is going to be 10% higher, not just in future years but up to that point," Wesbroom explains. "This is very difficult to finance now and so companies are increasingly looking to place limits on growth of pensions, say 2% or 3% per annum. It's a very useful tool."

Another option is the enhanced transfer, which has attracted some negative publicity in recent years due to a few poorly implemented examples. The tool is aimed at reducing the burden posed by deferred pensioners, individuals who no longer work for the company running the scheme. An enhancement to the cash transfer value can be offered in return for a deferred pensioner leaving their defined benefit scheme.

"In many countries if someone leaves a pension scheme they lose their benefits or only get a part," Wesbroom explains. "In the UK, you not only get the benefits you've built up but you get guaranteed indexation as well. For many schemes, this needs to be tackled. A total of 12% of the funds we surveyed said they'd either carried out enhanced transfer or seriously considered it. These numbers will have to increase if we are to tackle the volume of deferred pensions that are still in defined benefit pension schemes."

Trigger happy

According to a separate piece of research conducted by Aon Hewitt, the use of triggers is also becoming increasingly common. Around 40% of schemes surveyed had some form of trigger in place to take advantage of positive market conditions while they last.

"A lot of schemes are saying that if funding levels improve, they'd like to take less risk," Wesbroom explains. "For example, if the FTSE gets to 6,000, we are going to take 10% of our equities and put them into safer government bonds. They create a trigger that could either be completely automatic or require approval to be acted upon. We did some research on whether this was effective and found that, if you are disciplined, you do end up in a materially better funding position."

The underlying fact is that the way funds approach their assets has to become more flexible. Tried and tested methods, like placing total faith in equities, have proven unworkable and all alternative assets now need to be considered. According to Wesbroom, the outdated structure of many boards makes this especially difficult and has led many CEOs to look further afield for advice.

"Trustees are not paid experts and we have gone about it in an amateurish way on many occasions," he says. "Trustees often meet once a quarter, which frankly just isn't enough today. I can't remember what the world looked like three months ago. We are increasingly finding trustees setting the overall agenda, but delegating its implementation to an outside body. This is almost inevitable given the speed of the markets."

The challenges ahead are considerable. Many defined benefit schemes have become simply unaffordable and traditional ways of funding entitlements are proving ineffective. But with careful long-term planning and a creative approach to de-risking, it is possible to considerably reduce the pensions burden.