20 January 2014

Ireland, Dublin

The period since the banking crisis and subsequent collapse of stock markets in 2008 has brought profound change to Irish pensions. During that time, plans have not only endured the consequences of asset losses but also grappled with higher funding requirements caused by increased pension regulation and falling interest rates. Past experience shows that trustees and employers struggle to protect the financial position of their schemes in volatile conditions.

Although interest rates remain persistently low, equity markets have recovered and, after years of tremendous uncertainty, pensions legislation seems to have found a stable footing. As we head into 2014 in a period of relative calm and optimism, it is a perfect time to take stock of defined benefit (DB) pension plans and identify how funding has fared in recent years and what opportunities or threats remain. With this in mind, Mercer identifies10 pension risk management tips for 2014.

1) Benefit strategy review

The Irish pensions landscape has changed utterly in a short period. The circumstances and views of the employer may also have changed – particularly given the increased cost of funding future DB service-related benefits in a low interest rate environment. Employers need to ask themselves if this level of benefit remains appropriate and affordable. Trustees need to feel sure that what is being promised is sustainable and will be delivered. Members need to weigh up the greater certainty of a DB pension against the greater retirement flexibility of alternative models. In other words, all parties need to consider whether the current arrangement remains fit for purpose and whether a better alternative exists.

2) Risk reserves

When carrying out a review, consider the additional requirement to fund for a risk reserve post-2016. Depending on their vintage, some funding plans will not yet have incorporated this recent change into regulation. The impact can be mitigated if addressed over a longer period, so it makes sense to understand the financial consequences now rather than wait until 2016.

Risk reserving should be considered in the context of the plan’s investment strategy and funding level. Non-cash funding options such as putting in place contingent assets or other funding vehicles may also play a part. These approaches have not been as popular as conventional funding solutions but risk reserves may be viewed differently – why spend cash for the rainy day that may not materialise if other options are available?

3) Choice

Members, particularly former employees and higher-paid individuals, are increasingly seeking greater control over their pension planning and may prefer to be “unhitched” from the confines (and sometimes worries) of a DB plan. When choice is available, a growing proportion of members opts for transition to a personal defined contribution pension. Such transitions can represent win-wins for members and sponsors given increased flexibility on such features as early retirement, investment and income drawdown post-retirement and the potential for significant reductions in pension risk and cost.

4) Investment risk

Most pension schemes are targeting a return to a fully funded position but some may be assuming more investment risk than necessary to achieve this. Is a traditional equity/bond split still appropriate? Trustees and employers should consider whether a more diversified or targeted approach will provide a more secure outcome.

5) De-risking approach

Recovery plans commonly target a much “safer” bond-oriented investment strategy over the longer term, often planning to be 70% in bonds at the end of their funding recovery period. Historically, the switch from “growth seeking” assets (equities etc) to “liability matching” assets (bonds etc) occurred on a pre-agreed systematic basis eg with a specific percentage of equities converted to bonds each year.

Nowadays, even small pension schemes are using increasingly sophisticated plans to de-risk more efficiently, putting in place bespoke de-risking plans or “glide paths” with triggers based on funding level. This allows schemes to convert to a more matched (but lower yielding) investment strategy without sacrificing potential investment gains and/or to achieve end-state investment strategy more rapidly than under a traditional model.

6) Governance needs

A key focus in 2014 is to determine the appropriate implementation approach once a strategy such as glide-path de-risking has been chosen. These complex strategies require integrated governance structures to take full advantage of all opportunities and deal with any threats as they arise. Many employers, especially those with limited internal resources, have decided to delegate these functions so as to focus on their core business. This ensures they are more prepared than before and, crucially, enables far quicker implementation – ideally involving daily monitoring and execution within 24 hours of a trigger point being reached.

7) Optimising growth assets

Another way of reducing risk, without necessarily reducing returns, is to optimise the growth portfolio by adding new asset classes and investments other than traditional equities. A diversified growth portfolio can have a risk level that is up to one-third lower than a traditional equity portfolio. This allows a plan to take a step or two along its de-risking glide path without lowering expected return. Again, solutions are available to suit smaller funds.

8) Optimising matching assets

The merits of moving to a matching bond strategy may be appreciated by sponsors and trustees but often with an understandable hesitation given current ultra-low bond yields. In other words, a common reaction is: “Not at these prices!” Mercer anticipates that employers and trustees will increasingly use a two-pronged approach to this dilemma – embracing trigger-point de-risking for funding levels and emphasising interest rate triggers within the bond portfolio. This avoids locking into expensive bond prices while systematically capturing interest rate increases if they occur and dampening the risk of future interest rate volatility.

9) Short-term tactics

Immediate steps may exist to better manage pension risk and cost. For instance, now that funding levels have generally improved, transfer options may be available to former employees without any discouraging solvency adjustments. In such circumstances, it may make sense to remind members of their transfer options or even offer an incentive to encourage take-up.

10) The long game                                                                                   

As most pension schemes are closed to new entrants and an increasing proportion has ceased future DB accrual for current members, plans will inevitably become pensioner-dominated over time. This begs the obvious question of how the scheme will ultimately be managed. Thinking about the long-term objective and starting to plan accordingly should be a focus for 2014.