Pension certainty carries a cost

Neil Copeland

or Subscribe to Feed

It was Douglas Adams who noted the irreconcilable human desire for “rigidly defined areas of doubt and uncertainty.”

Finance Directors abhor uncertainty.

“Final Salary pension scheme” is practically a synonym for uncertainty. Any company operating one of these high risk ventures is exposed to a variety of risks, for example, investment risks, inflation risks, legislative risks and mortality risks. There have been a spate of recent pensions articles highlighting the uncertain nature of Final Salary Pension Scheme liabilities.

Many Finance Directors, and indeed trustees, seem intent on pursuing rigidly defined areas of doubt and uncertainty in relation to pension scheme funding, spending hours debating the “right” inflation rate, discount rate or whatever, to allow them to arrive at the “right” measure of their deficit. I’ve railed previously at the futility of this exercise.

Occasionally clients fortunate enough in a position to do so believe that if they write you a big cheque for their ongoing pension deficit that their pension problem is sorted.

If Finance Directors want to achieve certainty in respect of their Final Salary pension scheme then they have only one option – to transfer the risks to another party. There are lots of strategies out their which will allow schemes to manage their risks but, for as long as the scheme continues in existence, companies remain exposed to the series of risks I have mentioned, to a lesser or greater degree no matter how well managed.

Risk is really only transferred from companies when schemes fully discharge their liabilities and wind up. The change in the debt on the Employer regulations in 2003 makes this a daunting prospect for many. However, given that many SME sector Final Salary schemes are closed to accrual, employers need to engage with their trustees to put a plan in place that will eventually result in their liabilities to the Scheme being discharged.

Risk is transferred away from the company either to the members, by means of transfer values or to a provider who is prepared to assume the risks carried by the employer by means of buyouts, buyins or longevity swaps. Either way the cost of certainty is not cheap. Members transferring out of a final salary scheme need to be incentivised by transfer values that genuinely give an opportunity of delivering the benefit being given up, and providers will have a profit margin that needs delivered.

There is also usually an advisory cost to be paid by the Company to help it achieve certainty. If anyone thinks that such advice is costly, capitalise your current pension advisory costs over the next 10 years to get an idea of what the failure to act might cost. Most clients find that a particularly sobering exercise.

I don’t entirely agree with Richard Jones’ recent blog on the future of the annuity market. He may be correct about the absolute size of the market, as larger schemes explore alternative options available to them.  Many of these more sophisticated options are not currently available to smaller or medium sized schemes and, if their sponsoring employers crave certainty, buy-out will remain an option. Having said that there is nothing on the horizon that suggests that buy-out is going to become less expensive in future, indeed, the reverse is probably true. That is the cost of certainty.

The key point is that there are a variety of routes, timescales and options available to companies as they work their way through to their particular Pensions Endgame. Hymans Robertson has carried out some research recently that identifies Q3 of 2009 was the highest quarter ever for DB risk transfers of all types.

The one option that you don’t really have, it would appear, is to do nothing.

Neil Copeland

Post by Neil Copeland

Director, pensions consultant and adviser to trustees and employers on all aspects of work based pension schemes.