Underlying longevity and investment risks of final salary schemes could see more schemes using inflation swaps and bulk annuities to try and reduce their liabilities.
Research from Mercer Human Resource Consulting shows despite a fall of 38% in the pension scheme deficits of the FTSE 350 companies, dropping from £87bn in 2005 to £63bn in 2006, it warns there has been little change in the relative risk levels over the last four years.
The findings from Mercer’s report “Pension Scheme deficits and Trends – 31 December 2006”, which will be published later this month, point out over the last four years companies have tried to manage their pension risk by reducing the level of future benefits, either by cutting existing members’ benefits or by closing the scheme to new entrants.
However Mercer says although this can reduce future risks, it does not reduce the existing legacy exposure which it says mainly comes from a scheme’s investment strategy and the uncertainty surrounding member longevity.
And the consulting firm says in recent years changes to investment strategy have been more about making the risk-taking more sophisticated rather than reducing the overall investment risk level.
As a result Ralph Frank, principal at Mercer Investment Consulting, says the use of interest rate and inflation swaps by pension schemes continued to grow in 2006, and says Mercer expects “more of the same in 2007, primarily to improve the efficiency of risk-taking rather than necessarily to reduce it”.
Mercer also suggests there may be more activity in the bulk annuity market, which has seen a number of new companies specifically designed for the bulk buy-out market set up in the last year by former Prudential executives, including Paternoster and Synesis Life.
But Tim Keogh, worldwide partner at Mercer, says few companies decided to offload their pension liabilities in this way over the last year, and says “the critical question is whether we will see pension schemes transferring substantial levels of longevity risk. In 2006, trading among insurance and reinsurance companies continued to make up most of this market.”
In addition Mercer says the introduction of the Pension Protection Fund (PPF) levy is not necessarily the main driver for increased contributions to schemes, instead it says employers are more likely to have been swayed by tax advantages, strong cashflow and corporate deals.
Although the PPF has now announced the levy estimate for 2007/08 has been increased to £675m to make up for last year’s under-collection, Mercer says while this could see a burst of contributions before the levies are recalculated at the end of March, it warns it may not reduce the overall burden on the PPF.
As it points out financially weaker firms, most of which are outside the FTSE 350, are less likely to be able to respond to the levy with extra contributions and as they constitute the bulk of the risk Keogh warns “intentionally or otherwise, the PPF levy will encourage companies that can fund pension schemes by borrowing elsewhere to do so.”
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