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Home > Balance Sheets Best Practice > Pension Schemes: A Unique and Unintended Basket of Risks on the Balance Sheet

Balance Sheets Best Practice

Pension Schemes: A Unique and Unintended Basket of Risks on the Balance Sheet

by Amarendra Swarup

Solutions on the Horizon

Company finance directors must feel victimized. Constrained by ever-growing liabilities on the balance sheet and a volatile pension asset portfolio, they often find themselves on the wrong side of the window when it comes to securing their retirees’ benefits. Changing interest rates, rising inflation, and ever-increasing allowances for longevity mean that the liabilities are often a fast-moving target. Throw in a worsening economic environment, and keeping apace is complicated by potentially thorny negotiations with trustees and retirees for additional injections.

So how are trustees and sponsors to manage these new, troubling risks? It’s hard enough to judge market returns over the next few years, without crystal ball gazing to estimate the lifespan of all the scheme members under your responsibility—past, present, and future.

The answer today is that it is largely a dark art. The current trend is unlikely to be your friend here; longevity improvements have repeatedly defied the hopeful shackles of successive actuarial models, despite the most Orwellian filtering of data by job, medical history, and even postcode. The latest models—even if true—give scant comfort. For example, by 2050 a 65-year-old UK male might live to be between 86 and 97 years old, up from 83 today.

However, there are options. Like any other risk, these uncertainties can be managed, and even reduced, once understood. The key is to have a proactive and realistic approach to the risks that are being carried on the balance sheet. Sponsors need to engage actively with trustees and walk a fine line between investors’ expectations and the funding needs for the pension scheme.

Unique solutions are now appearing in the market. A whole industry has now sprung up in the United Kingdom offering full insurance buyouts, where the pension liabilities are transferred away to dedicated specialists. This can often improve the situation for pension scheme members, as these specialist insurers are tightly regulated, operate within strict investment and asset/liability guidelines, and have to hold capital against any extreme losses.

It also helps troubled sponsors: Securing pension liabilities away from balance sheets improves their ability to raise finance, and removes the situation where, in a falling equity market with a commensurate fall in the valuation of a scheme’s assets, a sponsor looking to invest in the business might also find trustees coming cap in hand. Above all, it enables management to get on with running the business, free from the peripheral distractions of administering a pension scheme.

However, insurance buyout valuations use more cautious longevity assumptions and paint a truer picture of the hidden arrears, increasing the liabilities and the premiums required significantly. Like customers outside a Ferrari showroom peering in through the window, it is simply unaffordable for many companies and not available in many countries.

But there are alternatives to help transfer risk. Schemes can execute partial buyouts for some of their liabilities, such as current pensioners. If that overshoots the budget and the deficit is still too large, or the options are not available in your jurisdiction, there are now innovative corporate solutions to help transfer risk, ranging from taking on the entire scheme and its myriad liabilities, to specific solutions for specific risks.

For example, trustees and sponsors can implement bond or swap-based hedging strategies to nullify the impact of interest rates and inflation on their liabilities, and thereby on the balance sheet. There is even a growing market in longevity swaps, allowing people also to hedge this idiosyncratic risk. Although they introduce new risks in lieu, such as the health of the counterparties on the other side of the swap, these steps are cost-effective and can ensure that the larger part of a scheme’s risk—its volatile liabilities—is better constrained, while precious assets are freed up to invest in assets with higher returns.

Another alternative is to delegate the holistic management of all the scheme’s assets and liabilities to a third-party fiduciary manager, who will manage them on a real-time basis within tight guidelines agreed with the trustees. These specialists will typically hedge all the liabilities where possible and diversify the assets among a range of best of breed providers. This ensures that the funding position is improved, and its ultimate targets, such as a full buyout, are reached in an efficient and structured manner. The asset/liability management approach has proved popular in countries such as The Netherlands, where it has significantly improved funding positions.

It’s a rapidly evolving environment, and, with new solutions appearing fast, corporate sponsors can be hopeful of finding innovative ways of managing these new risks on their horizon. Most importantly, they can go back to finding and building businesses—not reading horoscopes.

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