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Pensions Watch - December 2009

LDI gains traction

According to SEI, half of the UK’s DB schemes now use LDI strategies, principally as a result of increased market volatility and uncertainty over the future direction of interest rates and inflation.  However, whilst liability driven investment (LDI) has traditionally focused on the removal of interest rate and inflation risks from defined benefit (DB) scheme liabilities, the term has since been extended to include hedging longevity risk and the diversification and hedging of a scheme’s asset mix.  

Inflation causing concern

Despite currently being in negative territory, Watson Wyatt are predicting that the Retail Prices Index (RPI), to which most DB scheme member liabilities are linked, looks set to rise to about 3% to 4% in the medium to long term.  The consequence of this has been to dramatically push up the price of hedging inflation risks whether via inflation swaps or index-linked bonds.  For instance, inflation swaps that provide three years of inflation protection require pension funds to lock into an inflation rate of 3.02% against 0.07% at the beginning of the year.  Interestingly, the Bank of England Staff Pension Scheme was reported to have held 88% of its assets in index-linked gilts earlier this year. (The Bank’s Monetary Policy Committee is responsible for keeping inflation in check).  

Towers Perrin has separately calculated that by incorporating higher future assumed inflation rates into the value of DB scheme liabilities, the size of FTSE 100-sponsored DB pension scheme deficits have more than doubled from £31bn to £72bn over the course of 2009.   In addition, the NAPF, in its annual survey of members, found that 79% of schemes were seeking flexibility over increasing pensions in line with inflation – a move supported by consultant Mercer who, more generally, advocates the sharing of risks assumed by DB scheme sponsors with its members. 

Hedging longevity

With people thought to be gaining an average of six hours a day in life expectancy, it probably comes as no surprise that the cost of insuring against unexpected improvements in DB scheme member longevity has doubled in the space of nine months.  According to Lane, Clark and Peacock, what cost around 3% of scheme liabilities in March, costs about 6% today.  Credit Suisse and Rothesay Life, which engineered the longevity swaps for Babcock International and Royal Sun Alliance respectively during 3Q09, are reported to have been approached for nearly £60bn of quotes over the past six months, £10bn of which are expected to convert into new business.

Gilt issuance

In its latest annual survey of members, the NAPF found that 80% of members believe that increased issuance of long dated and index-linked gilts would most help them in stemming the widening of DB scheme deficits.  The Debt Management Office (DMO), which issues gilts, insists it has been responsive to the needs of pension funds.  Indeed, according to the Orga­n­isation for Economic Co-operation and Development (OECD), the average maturity of a British government bond is now 14.23 years compared with 10 years in 1998 when the DMO was created.  Some £76bn in long-duration and inflation-linked debt has been issued so far in the 2009/10 fiscal year, or 34.5% of the overall £220bn planned issuance for the year. That compares with £38.4bn two years ago, although this represented 66% of the £58.5bn issued overall.

Shutting up shop

Vodaphone and Telent are to follow in the footsteps of Barclays, Morrisons, Whitbread, Fujitsu, IBM, Costain, ITV, Trinity Mirror and Dairy Crest, in closing their DB schemes to future accrual.  By means of compensation, Vodaphone, in closing its £755m scheme, will offer its remaining 4,000 active DB members a choice of a one-off lump sum equal to 15% of pensionable salary or two annual payments of 10% and 5% respectively into the firm’s defined contribution (DC) scheme.  Vodaphone will also match employee contributions to the DC scheme on a two times basis up to a maximum 6% employer contribution. 

Telent, the rump of the former GEC Marconi business, having agreed a 15 year recovery plan with the scheme’s trustees to address the scheme’s deficit of £495m, is in the process of setting up a new DC scheme for its 1,300 active DB scheme members.  Separately, the NAPF, in its annual survey of members, found that 30% of DB schemes still open to future accrual intend to close, whilst of those 23% of DB schemes that remain open to new members, 38% expect to close to new members.    

Bean counters push for risk-free rate

To prevent DB schemes appearing stronger than they really are, the Accounting Standards Board (ASB) continues to push for risk-free gilt yields to replace the current AA-rated corporate bond yield as the basis by which to value DB scheme liabilities.  In response, the NAPF has calculated that the effect would be for the reported liabilities of a young scheme to rise by 100% and for a mature scheme by 25%.  It goes without saying that, if implemented, this proposal would almost certainly accelerate the closure of DB schemes to new and existing members. 

Pensions constrain corporate activity

In a global survey of 400 pension scheme managers, trustees and sponsors, Hewitt Associates found that 80% of employers expect to make increased contributions to their DB schemes at the next funding review.  In one in six cases, these extra contributions were thought likely to significant impact the sponsor’s business.  Separately, the Confederation of British Industry (CBI) and Watson Wyatt, in their survey of 194 UK companies collectively employing more than 1m staff, found that one third of DB sponsors reported pension costs as having a significant effect on internal reorganisations, merger, de-merger and acquisition activity, with 56% reporting pension costs as constraining profits.  These findings lend some weight to the CBI’s continuing attempts to have section 75 of the Pensions Act 1995 repealed as this prevents employers closing or selling a subsidiary without first making good any pensions deficit. 
However, the survey also reported that 75% of respondents believed pension benefits helped recruit and retain staff, whilst 59% said pensions enhanced the company’s reputation.  Interestingly, the Office for National Statistics (ONS) found that, for the first time since 2002, employee contributions to funded occupational pension schemes, at £42.5bn in 2008, exceeded those made by private sector employers and local authorities at £40.6bn. 

Dial L for levy

Aside from being the UK’s largest DB scheme with £41.9bn of liabilities, the BT pension scheme continues to be one of the most newsworthy.  This month, BT, the scheme’s sponsor, the UK’s leading fixed line phone operator, is proposing to raise the prices it charges its wholesale customers (those who rent the landlines to sell phone and broadband services to consumers), by up to 4% per annum.  This levy would supplement BT’s recently increased annual £525m contribution to the scheme, as a means by which to service the £9.4bn deficit. 

Whilst this mirrors current practice in the electricity, gas, water and postal industries, Ofcom, the telecoms watchdog, is currently seeking views from BT’s wholesale customers.  One discontented BT wholesale customer commented “[it’s] plain wrong [to] bail out BT for the mismanagement of its pension fund…BT has made some aggressive investment decisions…and systematically under-contributed towards the cost of pensions.”  In a separate move, the BT pension scheme is reported to be allocating an additional £300m to global equities.

Hot topic

Railpen, the £17bn pension fund for railway employees, in adopting a 77-question audit created by HSBC and Linklaters, has asked its advisers and 40 fund managers to disclose the risks climate change poses to their businesses and investments.

‘ello, ‘ello, ‘ello

Fresh questions about the viability of public sector pensions have been raised after it was disclosed that the taxpayer is funding the Police pension scheme to the tune of nearly £0.5bn a year.  A police constable retiring after 30 years on a final salary of £36,000 can look forward to an annual index-linked pension of around £24,000.

Hi Ho, Hi Ho, off to work we go

The Chartered Institute of Personnel and Development report that 71% of 2,000 workers aged over 55 plan to work beyond age 65, as a result of pension funds, savings and house prices being hit by the recession.

And finally….

Pensions by any other name

An insurance company, that shall remain nameless, launched a competition to find a new name for pensions.  The reason?  Research showed that 18% of people find the term off-putting given its associations with “being grey”.  The prize?  £4,953 – ironically the equivalent of the single person’s annual state pension.  It’s that word again.  Incidentally, the winning entry was 'Save Now, Play Later'.

On that note, the Investment Tutor team would like to thank all of our readers for their comments and observations throughout the year.   We wish you all a very Merry Christmas and a Happy, Healthy and Prosperous New Year and look forward to bringing you more of the latest on pensions in 2010.