Issue: September 2012 / November 2012
Risks in DB
Better understand them. Werner van Wyk, actuarial consultant at Liberty Corporate, suggests what companies and trustees should consider.
Internationally, defined-benefit (DB) pension funds have been the centre of much debate. The Pension Protection Fund recently revealed that the combined deficit of DB schemes in the UK increased by £95bn in just one month to a record £312,1bn at end- May 2012.
Van Wyk . . . various options
In SA, the DB pension funds have not been subject to such huge swings in deficits. But given the nature of these schemes, the sponsor (usually an employer) and trustees still face a number of significant risks.
One of these is the issue of longevity; a scheme needs to ensure that it has sufficient investments should members live longer than expected. In addition, it also needs to find investments that will grow in line with the liability.
The risks associated with DB schemes can be difficult to determine. Any misjudgements can also be costly to the fund and the employer. As a result, there is often a preference to transfer these risks to insurance companies that specialise in managing these kinds of liabilities. In the US, for example, General Motorsí recent purchase of a $26bn annuity transferred the risk away from the company and onto the balance sheet of a life insurer.
It is important for any employer that considers transferring such a risk to understand what de-risking solutions are available -- such as a cash-flow hedge, a buy-in or buy-out policy -- as the choice of product would depend on the amount of risk the company or trustees are willing to transfer.
A cash-flow hedge is where the fund purchases a series of future cash flows from an insurer. These cash flows are specified in advance and are usually based on the fund expectation of its future pension commitments. If the fundís projections are correct, the payments will exactly match its outflows. However, the fund bears the risk if the expected cash flows are incorrect.
A buy-in policy is where the insurer issues a grouped annuity policy based on the actual lives of pensioners in the pension fund. This policy acts as an asset of the fund, guaranteeing to pay benefits for as long as the pensioners are alive. Although the fund retains the ultimate liability, the policy acts as a hedge to its longevity and investment risks.
A buy-out policy is where the pensioners, not the fund, are the owners of the policy. If this policy is accepted by the pensioners (who have a right to decline), the pension fund will be released from its responsibility towards them. Instead, the relationship will be directly between the pensioners and the insurer.
Trustees who consider transferring the liability of a DB pension fund also need to understand the level of financial support the employer is willing to provide, should there be a shortfall.
The cost of such solutions depends heavily on prevailing market conditions, which can change rapidly. For any company or trustees considering the transfer of such a liability, it is critical that they carefully consider what options are available and employ the services of consulting and actuarial specialists who can guide them through the process.