do you know which risks you’re facing?
1 June 2017
The Pensions Regulator’s 2017 funding statement, published in May, made it clear that trustees should be proactively addressing the risks in their schemes. In particular urging trustees of smaller schemes to “ensure they complete sufficient analysis to understand their risk exposure and take a balanced approach when considering the risks they run”.
We fully support this as we believe smaller schemes who have been focussing on their investment risks might benefit from taking a fresh look at the current balance of risks they’re facing. The results can be surprising. In fact, using our longevity risk tool, LCP LifeAnalytics, we have found that for smaller schemes that are well along their investment de-risking path that longevity risk is often the biggest single risk.
When is longevity risk likely to be dominant?
Longevity risk tends to be more significant for a small membership. This is partly because predicting mortality for a small group of people can be hard. On top of that, if you have a high concentration of your liabilities focused in a small group of individuals (eg retired board members), you may find longevity risk is even more significant.
Let’s look at a typical smaller scheme with liabilities of around £150m in the chart below.
This scheme has already undertaken some investment de-risking, they have a mature membership, and are paying a small number of large pensions. You may be surprised to see that for a scheme like this longevity risk is at around 50% of total risk.
A smarter move for them would be to focus on addressing the longevity risk, rather than further investment de-risking.
How can longevity risk be addressed?
An effective way to reduce longevity risk is through investing in bulk annuity policy. This is commonly referred to as a “buy-in”.
The policy is held as an asset of the trustees and provides income that exactly matches the pension payments due to members. This means it completely removes the investment, interest rate, inflation and most importantly the longevity risk in respect of those members insured under the policy. The trustees then pay members with the proceeds of the policy through their normal payroll.
Because the buy-in policy is actually an asset of the pension scheme it can be used for the pension payments of all members, not just those members insured. So investing in a buy-in policy allows trustees to treat all members equally.
Now might be a good time to explore how your scheme might benefit from investing in a buy-in. Recently we have been seeing some of the most attractive pensioner buy-in pricing relative to gilts since 2011. At current pricing many schemes could expect to see a funding improvement by swapping their gilts for a buy-in, all the while tackling their longevity risk. (You can learn more in our recent de-risking update)
Innovation for smaller schemes
There has been a lot of innovation in the de-risking market which smaller schemes can benefit from. For example, small schemes now have access to enhanced pre-negotiated contracts which provide terms normally only available to larger transactions. This allows smaller schemes to maximise insurer engagement, and achieve better pricing as a result. Since 2011 LCP has helped 24 smaller schemes de-risk using our streamlined buy-in and buy-out services (securing over £610m of pension liabilities).
Another area that we’ve seen a lot of interest around is top-slicing. If your scheme has a particular concentration of larger paid pensions one option could be a top-slice buy-in where a scheme insures its largest liability pensioners. By insuring these pensioners, the scheme is left with a more regular shape of liabilities which traditional insurers would find more attractive, paving the way for further de-risking using a full buy-in or buy-out in the future.
Bearing the Regulator’s statement in mind, now might be a good time to take a fresh look at your de-risking approach, starting with understanding the longevity risk in your scheme. Find out if you’re thinking about your longevity risk in the right way - start here.