Risk of Ruin
Modelling the risk of defined benefit scheme members not receiving their benefits in full
RICHARD JONES MATTHEW CLAISSE ALEX BATES JOHN YARROW
July 2017
THE CONCEPT
What is success for a pension scheme? The purpose of a pension scheme is to pay the benefits specified in the trust deed and rules to its members as they fall due. If a pension scheme pays all benefit promises in full, that is success. If benefits need be reduced for any reason, that is failure, or ‘ruin’.
`` If the sponsor of a scheme remains solvent and does not are very long-term in nature, exposing members to the encounter extreme affordability issues over the lifetime long-term risk of the sponsor’s insolvency. of the scheme, members’ benefits will be paid in full. `` This long term nature, coupled with the difficulty of Alternatively, if the scheme reaches full funding so as to reaching the funding level required to be able to buyout be able to buyout all benefits with an insurance company, all benefits with an insurance company, makes the Risk of members’ benefits will also be paid in full. Ruin is very significant for a large proportion of the 5,800 `` If the sponsor becomes insolvent, or it encounters severe UK defined benefit pension schemes that remain. Since the affordability problems, members’ benefits will almost Pension Protection Fund (PPF) was first established in April certainly have to be reduced. 2005, already more than 10% of UK schemes have failed, the vast majority of which have had to significantly reduce `` We define the likelihood that members do not receive members’ benefits as a result of transferring to the PPF. their full benefits from the scheme as the Risk of Ruin. `` We can consider the Risk of Ruin across the 5,800 PPF `` The Risk of Ruin is a single measure capturing all three eligible schemes that remain by developing an ‘average’ drivers of benefit security: sponsor covenant, funding scheme to model and allowing for the expected insolvency and investment. risk of their sponsors based on the Pension Regulator’s `` As members’ benefits are expected be paid out over covenant strength bandings. The table below shows a period spanning several decades, pension schemes illustrative results from the model:
Example company Likelihood of insolvency (%) Approximate covenant Credit rating (of credit rating) Over 5 years Over 20 years categorisation Risk of Ruin
Aaa Microsoft 0.1 0.8 Strong 1% Aa Lloyds Bank 0.3 2.3 Strong 7% A GlaxoSmithKline 0.8 6.1 Tending to strong 14% Baa British Airways 1.7 10.7 Tending to strong 22% Ba Tesco 8.4 30.2 Tending to weak 51% B Toshiba 22.1 48.1 Weak 66%
Risk of Ruin | 3 KEY FINDINGS
Around 20% of UK schemes have a sponsor rated as ‘Strong’. Where sponsors are unable to increase contributions to meet They can be relatively relaxed about benefit security as the any future adverse deviation in the level of the funding deficit, risk of having to reduce benefits is modest. At the other the likelihood of having to reduce benefits and the Risk of Ruin extreme, some 20% of UK schemes have a sponsor rated increases significantly. as ‘Weak’. These schemes are more likely to fail and have to reduce benefits than survive and be able to pay full benefits. FUNDING AND PRUDENCE The impact of failure on members’ benefits will depend on when the failure occurs and the funding position of the One course of action available to the trustees of a scheme scheme at that time. The Risk of Ruin model allows us to seeking to increase members’ benefit security and reduce the consider the profile of losses that the members may be Risk of Ruin, is to try and get more money into the scheme expected to suffer. However, the losses that the scheme is from sponsor contributions than would otherwise be the case. required to consider are not the same as the benefit losses to members due to the presence of the Pension Protection Fund. Increasing the level of prudence in the funding valuation to create a larger deficit that requires higher deficit contributions We estimate that around a third of all the remaining defined from the sponsor does reduce the Risk of Ruin. However, the benefit schemes in the UK will fail to deliver their benefits changes are not transformational. in full. Increasing the funding liabilities of our example scheme by Whilst calculating the Risk of Ruin for a particular scheme is 20%, by increasing the level of prudence that is adopted, leads no doubt interesting for the trustees and the sponsor, a key to a doubling of the funding deficit and with it, a doubling use of the model is to try and manage the Risk of Ruin to of the deficit contributions required from the sponsor. The improve the security of member benefits. impact of this for an A rated sponsor is to reduce the Risk of Ruin from 14% to 9%. Whilst this is a worthwhile reduction in the Risk of Ruin from a trustee and member perspective, AFFORDABILITY ISSUES it comes at a very high price to the sponsor in terms of the cash contributions required. Insolvency of the sponsoring employer is the major risk driving the Risk of Ruin but problems can also arise if the funding Shortening the recovery plan length tends to not improve the deficit grows to such a level that the sponsor has no realistic Risk of Ruin significantly. possibility of making good the shortfall (generally where a recovery plan of more than 25 years in length is required). Paying an immediate lump sum contribution, even to the extent of paying off the whole funding deficit up front, does The average UK pension scheme is using an eight year not significantly reduce the Risk of Ruin. This is because its recovery plan and therefore there remains considerable principal benefit is that the recovery plan contributions that scope for increasing the length of the recovery plan, even would otherwise have been payable over the next eight whilst keeping contributions unchanged, to cover any future years are guaranteed to be received immediately, rather than increases in the funding deficit. An affordability constraint being at risk of the sponsor’s insolvency. The Risk of Ruin that still allows an eight year recovery plan to be adopted to of a scheme is barely affected by receipt of a large one-off begin with has little impact on the Risk of Ruin. cash contribution in lieu of recovery plan payments, except for those who have sponsors with lower credit ratings and Generally however a sponsor who is struggling to afford their even then the reduction is relatively slight, particularly when scheme will not agree an eight year recovery plan but one compared to the size of the contributions considered. In very that is considerably longer. As the length of the recovery plan broad terms, paying off the funding deficit is only receiving adopted is pushed out by affordability issues the ability of the money early that the scheme would almost certainly have sponsor to absorb any future increases in the funding deficit received anyway. falls considerably. The impact of reducing the level of prudence in the technical Recovery plans that are in excess of 15 years in length due to provisions, as expected under the funding regime where the affordability constraints increase the Risk of Ruin significantly. sponsor’s covenant improves, has a very modest impact on A scheme with a BBB rated sponsor with no affordability the Risk of Ruin when compared to the reduction driven by the constraints on future contributions would have a Risk of Ruin covenant improvement itself. The current funding position of of 22%. The Risk of Ruin increases to 36% where affordability a scheme is less important than the strength of the covenant constraints require a 16-year recovery plan to be adopted to supporting the scheme: covenant is key to the likely success begin with, and to 47% where affordability constraints require of the scheme (as measured by aiming to pay all members’ a 20-year recovery plan. benefits in full).
4 | Risk of Ruin `` De-risking
100%
90% All bonds 80% 20% DGF 70% 40% DGF 60% DGF This chart shows the impact on 60% 80% DGF the Risk of Ruin for differing levels 50% of allocation to risk assets through Risk Ruin of 40% a diversified growth fund. 30%
20%
10%
0% Aaa Aa A Baa Ba B Credit rating
INVESTMENT STRATEGY in which the scheme is invested and in CASH FOR DEALS? our case, the choice of economic scenario Using our example scheme as a guide, generator used in our stochastic modelling. Liability management exercises are deals under our basic Risk of Ruin model, de- in which the members are offered the risking the investment strategy is observed Investment strategy can have a major option to change the form of their pension to have virtually no impact on the Risk of impact on the range of benefit outcomes benefits and have become increasingly Ruin, even when we reduce the allocation for scheme members where Risk of Ruin commonplace in the UK. Such exercises to risky return-seeking assets from 60% occurs. A high risk investment strategy benefit the scheme by reducing the risk to to zero. Likewise, re-risking the investment may have a lower Risk of Ruin overall, but the employer whilst allowing members to strategy has virtually no impact on the result in a significantly higher likelihood take their benefits in a way which is more Risk of Ruin for our example scheme. The of members experiencing a significant suited to their needs. chart above shows the impact on the Risk reduction in full scheme benefits than of Ruin for differing levels of allocation under a lower risk strategy. These deals can lead to improvements in to risky, return-seeking assets (through the Risk of Ruin, although the improvement Given the modest impact on the Risk of increasing investment in a diversified depends on the exact terms offered to Ruin for our example scheme and the fact growth fund at the expense of a lower scheme members and how many scheme that the employer bears the investment level of investment in bonds). members take up the deal. risk, investment strategy may be a more These results are largely a function of important issue for sponsoring employers A liability reduction exercise is likely to be the assumptions made in our example than it is for scheme trustees. a much more effective way of improving scheme under the basic Risk of Ruin model. benefit security than simply putting the cost Trustees should therefore be pro-active in This assumes no affordability constraint of the exercise into the scheme as cash. engaging with their sponsoring employer applies to the sponsor’s contributions on investment strategy. over the life of the scheme. Consequently FINAL THOUGHTS any increases in the funding deficit at future triennial valuations, such as from CONTINGENT ASSETS The Risk of Ruin provides the lens adverse investment experience over through which to view almost all pension Contingent assets are a very effective issues. The Risk of Ruin framework can time, are assumed to be met through way of reducing the Risk of Ruin if they help trustees and sponsor improve higher contributions from the sponsoring are robust and properly constructed. employer. So long as the sponsor remains their decision making. It is the best solvent therefore, it is the sponsor, rather Contingent assets increase the scheme’s way of considering pension scheme than the scheme and the members, which recovery on insolvency and therefore reduce risk and a true example of integrated bears all the investment risk. As such, the number of scenarios in which insolvency risk management. changes in the investment strategy have would lead to a reduction in full benefits The conclusions in this report apply only little impact on our example scheme. for members. In order for the impact on to our example scheme. Each individual Risk of Ruin to be material, the value of the The real impact of investment strategy pension scheme has its own set of contingent asset needs to be significant in on the Risk of Ruin will be sensitive to the circumstances. The modelling techniques relation to the size of the scheme. individual circumstances of the scheme in described in this paper can be applied to question. The implications of changes in Contingent assets are, in many cases, any UK defined benefit pension scheme investment strategy are also highly sensitive far more valuable than cash contributions and reveal the true risks to which any to the assumptions used about the assets in terms of benefit security. scheme is exposed.
Risk of Ruin | 5 Contents
1. Introduction 7
2. What is ‘ruin’? 8
3. Insolvency of the sponsoring employer 11
4. The long term nature of pension schemes 15
5. Calculating the Risk of Ruin 20
6. Actual member outcomes 24
7. Affordability issues 28
8. Funding and prudence 31
9. Investment strategy 35
10. Contingent assets 39
11. Cash for deals? 41
12. The Risk of Ruin in overview 44 1. INTRODUCTION
This report introduces the Risk of Ruin, a complete Integrated Risk Management solution for defined benefit pension schemes, allowing trustees and sponsors to understand and manage the real risks to their pension schemes.
We explain from first principles what success is for a The Risk of Ruin model allows trustees and sponsors of pension scheme and the situations in which failure can arise. defined benefit pension schemes to: The focus of the report is on failure brought about by the insolvency of the sponsor but we also encapsulate in the `` Understand how likely it is that their scheme will be able Risk of Ruin situations where the cost of the scheme becomes to pay full benefits to all members; unaffordable to the sponsor. We show that failure is a real risk `` Assess the impact of different funding, investment and for most schemes in the UK and that a significant proportion liability management strategies in enhancing the security of schemes are more likely to fail than to succeed. of members’ benefits;
With this framework in place we construct a notional `` Consider how changes in the covenant and funding ‘average’ UK pension scheme and assess the Risk of Ruin position will impact on members’ benefit security. for this scheme across a range of assumptions for the level of sponsor covenant support. The Risk of Ruin model presented in this paper is a simplified The key to proper Integrated Risk Management is to be able example applied to a notional ‘average’ pension scheme in to consider all of the risks that a scheme is exposed to in the UK. A scheme wishing to implement Integrated Risk a holistic fashion: the Risk of Ruin allows this analysis to be Management would need to calibrate the Risk of Ruin model undertaken. to their particular circumstances.
Taking our ‘average’ UK pension scheme we then test various changes to the funding, investment and liability management strategies that are adopted, to see what is and what is not effective in reducing the Risk of Ruin. From this we determine which areas are most important in determining success or failure for a pension scheme. We find that some surprising conclusions emerge when funding, investment and covenant are analysed in one Integrated Risk Management model.
Risk of Ruin | 7 2. WHAT IS ‘RUIN’?
A defined benefit pension scheme is exposed to a huge number of risks and uncertainties, given that the last member’s benefits will not be paid out for fifty years or more.
Members might live longer than expected, investment returns considering holistically, the risks they are exposed to using might disappoint, inflation could spiral out of control, the ‘Integrated Risk Management’ (or ‘IRM’) techniques. The employer might suffer financial difficulties: an almost endless aim of IRM is to consider covenant, investment and funding stream of potential woes could befall a pension scheme over together, so as to identify the real factors that affect the its lifetime. scheme achieving its objective. Those factors can then to be managed so as to increase the chance of a successful In December 2015 the Pensions Regulator published guidance outcome for the scheme. for pension schemes aimed at providing practical help with
Integrated risk management (IRM)
Covenant There are three pillars of IRM – covenant, investment
and funding, as described by the Pensions Regulator:
IR M M ‘If the three fundamental risks to defined benefit R I
schemes are illustrated as a triangle with employer
Overall
covenant, investment and funding risks at each corner,
risk in
and each edge of the triangle examines the relationship
scheme
between two risks bilaterally (for example, the right
edge examines the relationship between covenant and
Investment Funding
scheme funding), IRM is the surrounding circle that
encompasses all these risks together. IRM investigates
I R M
the relationships between these risks (the triangle edges) altogether, examines their interrelationship and seeks to understand how risk at one corner of the triangle might affect the other two.’
8 | Risk of Ruin The first question to answer in defining and modelling the The starting point for implementing IRM Risk of Ruin is to understand the circumstances when the scheme will fail to deliver the benefits in full. When do is therefore to ask ‘What is the real risk pension schemes fail to provide benefits in full? for a pension scheme?’ As benefits cannot be unilaterally reduced in an ongoing situation, the only time when a scheme can pay reduced benefits to all members without obtaining their agreement Under the IRM approach therefore, the starting point for is in the event of a scheme wind-up. In a wind-up situation, successfully running and managing a pension scheme is not members’ benefits would be reduced if the combined what is typically the focus of trustee, employer and advisor’s resources of the scheme and the sponsor were insufficient considerations. It isn’t, for example, the risk of investments to cover the cost of a buyout with an insurance company performing poorly on a year-on-year basis (commonly (purchasing annuities in members’ names to meet their expressed as Value at Risk or ‘VaR’). As we will see, this is benefit promises in full). There are only two situations mainly because schemes have a very long time period to where such a wind-up occurs: insolvency of the sponsor, make up investment losses and a sponsoring employer to fall or unaffordability of the scheme for the sponsor. back upon. Nor is it the risk that the funding assumptions are incorrect. For example, if the trustees underestimate future If the scheme remains affordable for the sponsor and the longevity improvements, then this can be corrected at the sponsor remains solvent, then members’ benefits will be paid next triennial valuation and additional contributions sought in full as they fall due. This will happen either because the from the employer. scheme is able to continue to run until the last payment is made to the last surviving member or, at some earlier date, The starting point for considering risk under the IRM framework the scheme has sufficient resources available to it to purchase is instead to ask, “What is the objective of a pension scheme?” annuities from an insurance company, safeguarding that as without an objective, risk cannot be measured. members’ benefits will be paid in full. The purpose of the pension scheme is simple: to pay to Situations where a scheme is genuinely unaffordable to members as they fall due the benefits specified in the the sponsor are somewhat rare and therefore we begin by scheme’s trust deed and rules. The real risk for a pension considering insolvency events alone. We return to the issue of scheme and its members therefore is that, for whatever affordability later in the report. reason, the benefits promised will not be paid in full. This simple statement encompasses the framework within which all the risks that trustees need consider should be framed. The trustees are aiming to deliver the promised benefits: the risks WHAT HAPPENS ON INSOLVENCY that count are those that imperil this aim. OF THE SPONSOR?
A successful outcome for a scheme is therefore members When a sponsor becomes insolvent, the scheme receiving their promised benefits in full. If members’ benefits calculates the cost of securing full benefits with an are not paid in full for some reason, that would be classed as a insurance company (a ‘Section 75 debt’, named after failure of the pension scheme to deliver on its objective. the relevant provisions of the Pensions Act 1995). The purpose of IRM is to identify the factors that affect the The Section 75 debt becomes payable by the sponsor risk of meeting this aim to develop an appropriate overall and ranks in the insolvency as an unsecured creditor strategy for managing the scheme. In this report we study the (unless the scheme has acquired additional security circumstances in which pension schemes fail to deliver their provisions prior to insolvency, which applies to less members’ benefits in full, using modelling to consider the than 10% of schemes). likelihood of failure in different circumstances. We then move Full benefits can only be paid to members on an on to consider how trustees might adapt their management insolvency of the sponsor if the Section 75 debt is strategy for the pension scheme to reduce this likelihood. recovered in full. Otherwise, a reduced level of benefits We start by defining our key measure of pension scheme risk: will be paid, based on whatever assets are available. the Risk of Ruin. This is subject to the scheme being able to secure annuities that cover at least the level of benefits that would be provided by the Pension Protection Fund (PPF). If the scheme is unable to afford this level of The Risk of Ruin is the likelihood that the benefits, it is likely to fall into the PPF following a pension scheme will fail to deliver members’ period of assessment, with members (again) receiving benefits in full as promised. lower benefits than originally promised by the scheme.
Risk of Ruin | 9 Unfortunately for scheme members, data from Moody’s illustrates very clearly that unsecured creditors (such as pension schemes, unless they acquired additional security provisions prior to insolvency) rarely if ever achieve full recovery on their claims and even secured creditors suffer in an insolvency situation: `` Moody’s corporate debt recovery rates, 1987–2015
100% 90% This chart shows that the average 80% recovery for debt on insolvency 70% depends on the security applying 60% to that debt. Secured debt achieved 50% a better recovery than unsecured 40% debt, which in turn achieved a 30% better recovery than subordinated 20% debt. None have anywhere near 100% recovery. 10% 0% Loans Senior Secured Senior Unsecured Subordinated Bonds Bonds Bonds
`` Moody’s unsecured recovery rates, 2015
This chart shows the variation in the level of recovery on unsecured debts in 2015: none were recovered in full and more than half of
Frequency insolvencies in 2015 resulted in a recovery rate of 30% or less on unsecured debt.
< 10% 10–20% 30–40% 40–50% 50–60% 60–70% 70–80% 80–90% 20%–30% 90–100% Recovery on unsecured debt
Statistics from the Pensions Regulator show that the average pension scheme currently has around 60% of the assets required to secure scheme benefits in full with an insurance company. Combined with an assumed recovery on insolvency of around 50% for unsecured creditors, based on Moody’s data, the typical pension scheme might only be able to cover around 80% of members’ full benefits on an insolvency of the sponsor.
10 | Risk of Ruin 3. INSOLVENCY OF THE SPONSORING EMPLOYER
Unfortunately for pension schemes, insolvency is a fact of life: for every scheme sponsor; however strong they might be today, there is always a chance of encountering financial difficulties in the future and ultimately, becoming insolvent.
The Pension Protection Fund (PPF) came into operation from 6 April 2005 and has taken on any schemes that following the insolvency of their sponsor, had insufficient resources to secure at least the PPF level of benefits with an insurance company (see box). After twelve years of operation the PPF has completed assessment of over 1,000 schemes, taking on around 870 of those (with yet more currently in assessment).
THE PENSION PROTECTION FUND (PPF)
The PPF is the statutory compensation scheme that The PPF does not provide full benefits as promised aims to protect eligible scheme members from the worst under a pension scheme because it is a compensation consequences of their sponsoring employer becoming arrangement, not a guarantee. Indeed, despite the benefits insolvent whilst the scheme has insufficient funds to of the PPF being designed to avoid hardship by protecting deliver full benefits. It operates as a mutual insurance the immediate incomes of those scheme members who company by taking premiums from all eligible defined have already retired, on average across all members, for a benefit pension schemes, providing compensation to typical scheme the PPF only provides around 75% of the members of those schemes that cannot survive outside value of the scheme’s full benefits. The reduced value of of the PPF. In essence, the PPF takes on the responsibility the benefits provided by the PPF arises primarily from the of paying the PPF compensation levels of benefit to lower levels of indexation applied to pensions in the future members of ‘failed’ schemes. Alongside the premiums when in the PPF compared to that previously promised collected, the assets of schemes that fall into the PPF and by the failed scheme and the 10% immediate haircut on any recoveries from their employers are used to fund the benefits for those yet to retire. High earners’ are subject to PPF’s obligations. a more significant cap through a maximum annual level of compensation that the PPF permits.
Risk of Ruin | 11 Entry to the PPF, with the consequent reduction in receive a reasonable proportion of their original benefit benefits, is therefore a failure of the scheme to deliver promises. Prior to the introduction of the PPF, it was not members’ scheme benefits in full. In essence the PPF only uncommon for members in some insolvencies to see mitigates the consequences of a sponsoring employer’s their pension savings over a whole working life effectively insolvency, ensuring that even the extremely poorly wiped out where their employer became insolvent. funded schemes with weak employers (who cannot Workers could therefore lose both their employment provide any material additional resources on insolvency) and their pension from one single event.
`` Cumulative number of schemes transferred to the PPF
1,000
900 Total schemes transferred to the PPF (all time) The growth in the number of 800 Schemes in assessment now schemes absorbed by the PPF is 700 shown in the following chart. The
600 lack of claims in the early years of the PPF’s life is explained by 500 the need for schemes to have 400 completed an assessment period 300 before they are confirmed as 200 transferring, a process which can
100 take two years or more to resolve.
0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Since July 2007 the PPF has published an index for the latest estimated funding position of all defined benefit schemes in The PPF has already taken on more than 10% its eligible universe. The PPF 7800 Index was so called because at the time it was constructed it was believed there were of all schemes in the UK due to employer approximately 7,800 schemes in the country eligible for entry insolvency. More than 1% of all schemes fail to the PPF. Almost ten years after the PPF 7800 Index was each year and it is estimated that around a established, it now covers some 5,800 eligible schemes. third of schemes will fail in the future. Roughly 60% of the total reduction in the number of eligible schemes remaining in the PPF 7800 Index, some 5,800 today versus 7,800 schemes thought to be eligible at outset, is due Despite extensive data showing pension schemes are at to a mix of: significant risk of insolvency of their sponsoring employers, `` A better understanding of the number of schemes that there is a tendency to think that such an event could not actually exist to be eligible for PPF compensation; befall large, well established companies that have been successfully trading for long time. Unfortunately, whatever `` Scheme mergers; and the current characteristics and fortunes of any one employer, `` Schemes settling all members’ benefits in full prior to the future is uncertain and things can quickly change. winding-up, such as through a buyout with an insurer, or at a higher level than PPF benefits even if not full.
The other 40% of the reduction is in respect of the approaching 900 schemes which have experienced a ‘failure’ event, entered PPF assessment, and subsequently transferred to the PPF. This equates to around 1% of all eligible schemes transferring to the PPF each year, resulting in reductions in their members’ benefits to the levels of compensation provided by the PPF.
12 | Risk of Ruin A number of well-known, large, longstanding companies have become insolvent and seen their scheme enter the PPF.
The SAAB scheme transferred to the The Woolworths scheme transferred The Polaroid scheme was transferred PPF in 2016 following the insolvency to the PPF in 2012 resulting in to the PPF in 2011 following the of the SAAB group in 2012, after it 10,000 members entering the PPF. administration of the famous instant had been sold by General Motors. Woolworths had 800 stores in the camera maker. At its peak Polaroid UK when it became insolvent and employed 21,000 people and had had been trading since 1909. a turnover of $3 billion.
The Golden Wonder scheme was The Jessops scheme was transferred Despite having survived nearly transferred to the PPF in 2006 after to the PPF in 2011 following the 200 years, Royal Doulton became being owned by a number of large camera retailer’s insolvency in 2009. insolvent and the scheme transferred UK listed companies and having been At the time the company was listed to the PPF in 2013 after the failure of established in 1947. on the UK stock market and had its parent Waterford Wedgewood. 315 stores.
Pension schemes, of course, are long-term obligations and are not exposed to the risk of employer insolvency over days or months, but years and decades (we discuss the relevance of the long-term nature of pension schemes in more detail in chapter 4). When considering the long lifetimes of pension schemes, it becomes increasingly apparent that however strong the sponsoring employer is currently, the risk of sponsor insolvency in the future cannot be ignored.
One simple way of considering this point is to look at the data for insolvencies of companies that have a formal credit rating from one of the credit rating agencies. These have extensive data on the insolvency rates and recovery outcomes for rated companies over many years, with Moody’s data going back to 1920.
`` Cumulative likelihood of insolvency by credit rating
60%
Caa_C Ba A Aaa This graph shows the cumulative 50% B Baa Aa likelihood of default for a rated company over twenty years 40% according to Moody’s data, for each of the rating bands (which express 30% the relative creditworthiness of companies, Aaa being the 20% most highly rated and therefore Probability default of creditworthy, down to Caa and C rated, which have substantial risks 10% and/or at risk of imminent default).
0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Future period (years)
Risk of Ruin | 13 The graph shows that a company that was rated A, which Moody’s describe as being “judged to be upper-medium grade” and “subject to low credit risk”, and which would be expected to be rated as ‘Strong’ or ‘Tending to Strong’ in a covenant assessment process, has a 6% chance of failing in the next twenty years. In this instance, it is likely that members would not receive their scheme benefits in full (noting also that in general, pension schemes including those with strong or tending to strong sponsor covenants, may well have to rely on their company for more than twenty years).
The following table provides further detail on the graph, showing sample points for the likelihood of insolvency over periods of different lengths, alongside the names of some famous companies that currently have such credit ratings:
Cumulative likelihood of insolvency (%) Credit rating 1 year 3 years 5 years 10 years 20 years Example companies
Microsoft Aaa 0.0 0.0 0.1 0.4 0.8 Johnson and Johnson Lloyds Bank Aa 0.0 0.1 0.3 0.8 2.3 Apple GlaxoSmithKline A 0.1 0.4 0.8 2.3 6.1 Unilever British Airways Baa 0.2 0.8 1.7 4.0 10.7 Standard Life Tesco Ba 1.0 4.5 8.4 16.5 30.2 Debenhams Tullow Oil B 3.6 13.5 22.1 36.3 48.1 Toshiba Caa_C 10.7 25.6 35.6 47.8 51.3
As shown, insolvency is essentially a trivial issue if a pension scheme is fortunate enough to be sponsored by one of Employer insolvency is the major issue for the only two Aaa rated employers in the world (Microsoft or Johnson and Johnson), with a cumulative likelihood of all pension schemes as it is the major cause insolvency over a twenty year period of less than 1%. of a situation where benefits will not be paid in full. Employer insolvency is the key Based on the rate of PPF insolvencies, the average scheme is sponsored by something approaching a Ba rated company to calculating the Risk of Ruin. however, which is below investment grade status (so called ‘junk bonds’). These companies are described as “speculative and subject to substantial credit risk”: according to Moody’s, such a company has a 30% chance of becoming insolvent over a twenty year period.
Even A rated companies have a small likelihood of becoming insolvent in the next year (i.e. a likelihood of 0.1% based on the data above, equivalent to 1 of every 1,000 going insolvent in the next year). Lehmann Brothers was indeed A-rated by Moody’s, Standard & Poor’s and Fitch Ratings up until days before its collapse in September 2010.
14 | Risk of Ruin 4. THE LONG TERM NATURE OF PENSION SCHEMES
Pension schemes have an extremely long time horizon. This is the case even where, as has become increasingly common over the last ten years or so, there are no current employees in the scheme who are paying contributions and earning further pension benefits (that is, schemes with no ‘active’ members; so-called ‘closed’ schemes).
`` Cash flow profile of annual benefit outgo for a typical pension scheme
Deferreds Pensioners This chart illustrates the annual benefit outgo for a typical closed pension scheme over the next eighty years.
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
Risk of Ruin | 15 The peak benefit outgo for a typical closed scheme does not occur until twenty-five in the future, and benefits will still be COVENANT GRADE 1 (CG1) – ‘STRONG’ being paid in at least seventy years’ time.
The legislative environment recognises this long-term nature Very strong trading, cash generation and asset position and allows schemes to be run on a long-term basis for the relative to the size of the scheme and the scheme’s purposes of funding and investment decisions. Effectively deficits. The employer has a strong market presence schemes are run on a ‘going concern’ basis, even though there (or is a market leader) with good growth prospects for is a significant possibility that the sponsoring employer will the employer and the market. The scheme has good become insolvent at some point in the future. In practice only access to trading and value if the employer is part of a where insolvency is imminent and inevitable does the ‘going wider group. concern’ basis of operation of a pension scheme change. Overall low risk of the employer not being able to The primary funding objective for a pension scheme is to support the scheme to the extent required in the have sufficient assets available to allow it to meet its benefits short/medium-term. in full as they fall due. Schemes therefore do not target, at least as a primary aim, to have sufficient funds to secure annuities with an insurance company to provide full benefits to members. Thus, even if a scheme is fully funded on a ‘going COVENANT GRADE 2 (CG2) – concern’ basis, there would still be a significant Section 75 ‘TENDING TO STRONG’ debt due on an insolvency of the sponsoring employer (which would almost certainly not be recovered in full, leading to Good trading, cash generation and asset position benefits not being paid in full). relative to the size of the scheme and deficits. Operates in a market with a reasonably positive Most schemes do however have a deficit on a ‘going concern’ outlook and the employer has a stable market share. basis: the average scheme has agreed to reach full funding Outlook is generally positive but medium-term risk of on their going concern basis within an eight year period and employer not being able to support the scheme and therefore are expected to have a significantly greater deficit manage its risks. on a Section 75 basis in the near term.
The legislative environment does encourage schemes to take into account the strength of the sponsor backing the scheme by a process of assessing the ‘covenant’ that the sponsoring COVENANT GRADE 3 (CG3) – employer provides, through an analysis of its financial position ‘TENDING TO WEAK’ and prospects. The strength of the covenant is then used to determine how much risk the scheme can reasonably take Concerns over employer strength relative to the size in determining its ‘going concern’ funding and investment of the scheme and deficits and/or signs of significant strategy. decline, weak profitability or balance sheet concerns and/or high vulnerability to economic cycle. No Essentially the covenant assessment is similar in many ways immediate concerns over insolvency but potential risk to the assignment of credit ratings discussed in the previous of further decline. chapter, but is designed to reflect the specific characteristics and position of the pension scheme, including its long-term nature and status as an unsecured creditor. A variety of different approaches and definitions are used across the COVENANT GRADE 4 (CG4) – ‘WEAK’ pensions industry, but for the purposes of our report we adopt the definitions used by the Pensions Regulator as summarised Employers is weak, to the degree that there are on the right hand side of this page. concerns over potential insolvency, or where the scheme is so large that, without fundamental change to the strength of the employer, it is unlikely ever to be in a position to adequately support the scheme.
16 | Risk of Ruin `` How employer covenant is incorporated into the technical provisions
Cost of securing benefits with an insurer
More prudent Employer This diagram summarises the covenant expected impact of covenant Technical provisions on the ‘going concern’ funding (adopted funding target) position of a pension scheme (where ‘technical provisions’ is Prudence Less equivalent to the ‘going concern’ prudent funding target adopted).
Expected cost of benefits ‘Best Estimate’ of liabilities
Essentially the scheme assesses the ‘going concern’ funding The typical scheme, according to data from the Pensions position with no allowance for any prudence or margins for Regulator, considers that it would be fully funded as a adverse deviation (the ‘expected cost of benefits’ or ‘best ‘going concern’ if it had around 70% of the money required estimate’), assuming that the scheme will be run onwards to meet the cost of securing annuities in full with an investing its assets over the long term. The scheme also insurance company. calculates what funds it would need to have today to secure the benefits in full with an insurance company. It then sets The data from the Pensions Regulator shows that there is the funding target at some point between those two points, some evidence that trustees are making an allowance for introducing margins for prudence, depending on the strength their covenant rating in setting discount rates. Schemes in of the covenant. the stronger covenant categories should, in theory, be adopting higher discount rate assumptions on average The extreme points of the range are only used in exceptional than those in weaker categories and this does appear to be circumstances. A scheme can only fund to the best estimate happening. The association is, however, weak as shown in level if it has an impeachable covenant such as a Government the chart below. guarantee. At the other end of the spectrum, a scheme is only required to fund to the full cost of funding annuities if insolvency is inevitable and imminent.
`` Discount rate outperformance by covenant category
2.0%
1.5%
1.0% Pensions Regulator data, tranche 8 valuations received
0.5% up to 31 January 2015.
0.0% Discount rate outperfomance rate Discount
-0.5% CG1 CG2 CG3 CG4 Strong Tending to strong Tending to weak Weak
Risk of Ruin | 17 Pension schemes also set their investment strategies with regard to their ‘going concern’ funding approach, reflecting the long- term nature of their benefit outgo. Schemes tend to invest materially in long-term assets with significant allocations to equities and other high risk, high return asset classes. This is based on the theory that in the long-term this reduces the cash cost of providing members’ benefits and if investments perform poorly in the short term, many years remain to make good any losses.
`` Average asset allocation across UK defined benefit pension schemes
4.0% 3.0% 6.6% The average allocation of the 4.8% 30.3% Equities whole pension industry can be Bonds Property seen in this chart based on data Hedge Funds from the Pensions Regulator. Cash Pensions Regulator data Other Purple Book 2016 51.3%
In 2016, 30% of pension scheme assets were invested in Alongside the going concern approach, the assessed strength equities with a further circa 15% in other return-seeking of the covenant should also be a driver of investment assets including property and hedge funds. The remaining strategy. The theory is that schemes with more support from 55% of assets were invested in more ‘conservative’ assets their sponsoring employer have greater freedom to take such as bonds and cash. investment risk, safe in the knowledge that the employer can make good any losses that arise if this higher risk investment There has been a long term trend, however, for schemes to strategy does not pay off. reduce investment risk by increasing the amount invested in bonds and cash and in return reducing exposures to equities and other return-seeking assets. In 2006 the position was reversed, with schemes investing over 60% of their assets in equities and less than 30% in bonds.
`` Allocation to return-seeking assets by covenant category
100% This chart shows data from the Pensions Regulator regarding the 75% correlation between covenant rating and the allocation made by the scheme to return-seeking 50% assets (such as equities, property and hedge funds).
25% Pensions Regulator data, tranche 8 valuations received
Allocation to return-seeking assets return-seeking to Allocation up to 31 January 2015
0% CG1 CG2 CG3 CG4 Strong Tending to strong Tending to weak Weak
18 | Risk of Ruin Looking at the data from the Pensions Regulator (as shown in the graph on the previous page), there appears to be very little correlation between covenant strength and the amount of risk taken in the investment strategy of a typical scheme at the current time.
Pension schemes are extremely long term obligations with benefit outgo for more than seventy years. There is very limited evidence that, Pension schemes operate on a long term basis assuming that they are a ‘going concern’. in practice, substantial variation arises in funding and investment solely This means that insolvency of the sponsoring due to covenant ratings. employer nearly always occurs at a point where the scheme has insufficient funds to meet the benefits in full with an insurance company; this is a deliberate design feature of the legislative environment.
Trustees are required to assess the strength of the covenant provided by their sponsoring employer and use this information to inform their decisions on investment and funding.
Risk of Ruin | 19 5. CALCULATING THE RISK OF RUIN
To determine the Risk of Ruin we first have to be able to project the pension scheme, to assess its status at any future point in time.
For this we will use a stochastic model that projects the future of the scheme over a large number of different possible future scenarios to calculate the range of possible outcomes for the pension scheme (see box for further details on stochastic models).
STOCHASTIC MODELLING
A stochastic model of a scheme projects the scheme’s The main driver of uncertainty in a stochastic model of assets and liabilities in each future year, based on the a pension scheme is investment returns on the scheme expected benefit payments to members, modelling the assets and the correlation of these assets with the uncertainty of future investment performance of the scheme’s liabilities. In order to generate these variables, assets using a ‘Monte Carlo’ simulation approach. A a scenario generator needs to be used to model the Monte Carlo simulation is a technique used to understand investment markets and a huge range of different scenario the impact of risk and uncertainty in financial, project generators are available. management, cost, and other forecasting models. For the purposes of this report we will use the simplest A stochastic model repeatedly projects the scheme available scenario generator but Risk of Ruin can be across its whole future using a different draw of possible calculated using any available scenario generator. future outcomes for the investment performance in each future year, thus generating a picture of uncertainty. Each projection represents just one potential evolution of the scheme over its lifetime. The results of these simulations can then be analysed to estimate the likelihood of different events occurring.
20 | Risk of Ruin We then need to take account of the presence of the sponsoring employer. Initially we will ignore affordability issues (as previously discussed we will return to affordability later) and assume that the sponsor can always afford the ‘going concern’ contributions required by the scheme. We allow for insolvency by overlaying the default rates from Moody’s data over the results of the stochastic model to show the range of outcomes, allowing for both the position of the scheme and the sponsoring employer.
Whilst we will consider the results of the Risk of Ruin calculation for different strengths of sponsoring employer, we will assume that whatever the strength of the sponsor, the same approach will be taken on investment strategy and funding. This is considered a reasonable assumption given the data discussed in the previous chapter is supportive of it.
Continuing our approach of looking at all available data to ensure our initial results have the widest application, we will assume that the starting point for our pension scheme is in line with a typical UK scheme as detailed further in the box below.
OUR TYPICAL UK SCHEME
Each year, the PPF and the Pensions Regulator analyse `` Interest rate and inflation hedging is in place such the data from pension scheme returns required to be that changes in liability values due to interest rate submitted to the Pensions Regulator and produce ‘The and inflation movements are 100% immunised at Purple Book’ which virtually covers all pension schemes all times. in the universe of PPF-eligible schemes. The Purple Book provides a comprehensive view of the pension landscape `` Funding is on a ‘going concern’ basis with a discount in the UK. The Pensions Regulator also publishes scheme rate based on the long-dated gilt yield plus 1.2% funding analysis based on this data. per annum, with an explicit reserve held for scheme expenses. Using this information as guidance (and erring on the side `` The outperformance in the discount rate will be of simplicity), we can set up a theoretical ‘typical’ pension reduced in line with the reduction in the allocation to scheme as follows: return-seeking assets over time. `` The scheme is closed to new members and closed `` We will assume the following opening position for the to future accrual of benefits for existing members. pension scheme at the start of the modelling process: `` Current liabilities are split 40% in respect of ‘Going Section 75 members currently receiving pensions in payment £ million Concern’ basis basis and 60% in respect of deferred pensioners yet to Assets 80 80 draw their pension. Liabilities (100) (150) `` All liabilities are index-linked in nature. Surplus / (20) (70) (Deficit) `` Assets are invested on the basis that bonds will be held for current pensioners and return-seeking assets Funding level 80% 53% for longer duration deferred pensioners, resulting in an initial investment strategy of 40% in long-dated bonds `` Any deficit on a ‘going concern’ basis, be that at the and 60% in a diversified portfolio of return-seeking outset or future triennial valuations, will be settled assets. over an eight-year recovery plan.
`` The investment strategy will be de-risked naturally, resulting in the scheme being 100% invested in bonds once all the deferred pensioners have retired.
Risk of Ruin | 21 Whilst the scheme is being run on a ‘going concern’ basis, pension scheme is still a going concern, as is expected based should it ever be able to afford to secure all benefits with an on our analysis of the Moody’s insolvency data. insurance company at some future point, due to the inherent volatility in the investment strategy, then it is assumed the The scenario generator for the purposes of our stochastic scheme will do so and that the benefits will be paid in full. model will be a lognormal mean variance model with no We also assume that the sponsoring employer will make reversion to mean but positive risk premiums. We expect a special immediate contribution to allow the scheme to return-seeking assets on average to achieve excess returns secure all benefits with an insurance company after fifty in line with historic averages, but do not allow for a period years (assuming it has not done so already). At this point, of bad performance to be followed by a period of good the remaining scheme will be around 20% of its initial performance. We allow for risk in the returns in line with size and thus the cost of the insurance premium would be historic averages and thus have numerous projections in expected to be affordable for the employer. our model where return-seeking assets underperform bonds for long time periods, as has been observed in We will assume that the Section 75 debt is never recovered in history. The correlation between assets classes is set in full on the insolvency of the sponsoring employer whilst the line with historic averages.
`` Scheme deficit (as a proportion of remaining liabilities) on each basis
50%
Company funds the purchase Section 75 of annuities for the scheme The long term funding strategy 40% De-risked after 50 years when the of our typical UK scheme can Going concern scheme is only 20% of its current size and expected to be illustrated graphically by this 30% be reasonably well funded on chart, which shows the expected a Section 75 basis (compared to the current position) evolution of the average deficit in the scheme on three key 20% measures of funding (noting that Scheme deficit deficit Scheme the purpose of the stochastic 10% model is to consider the variation around this average).
0% 0 10 20 30 40 50 60 70 80 Year
The average ‘going concern’ position improves quickly due to fully funded on a Section 75 basis close to the end of the life the deficit contributions from the employer, with the scheme of the scheme. becoming fully funded in eight years. Thereafter, until such time as the fully de-risked position is reached when the last However, the scheme does not need to wait until the Section deferred member retires, on average surplus is expected to be 75 deficit is eliminated to secure annuities for its members: in generated, building a buffer against future adverse experience our model we assume that the sponsoring employer will pay such as mortality risk. off the remaining deficit in 50 years’ time.
The position on a ‘de-risked’ basis (often referred to as a fully Of course this is only the implied average strategy; the matched position or a self-sufficiency position) improves scheme is taking considerable investment risk to generate quickly at first through contributions and excess investment the returns that are driving a lot of the improvements. These returns and then more slowly once it becomes reliant on the investments could turn out well, or badly, and that may excess returns alone. However, due to the excess investment happen over the short-term or the long-term. If they turn out returns, the scheme is on average expected to be in surplus on well then the scheme is not going to have to wait fifty years, this basis before the last deferred member retires. but can buyout all members’ benefits in full much sooner: under some extreme scenarios the scheme could reach full The position on a ‘Section 75’ basis improves even faster than funding on a Section 75 basis in less than 15 years. If things on a de-risked basis because it also benefits from the removal turn out badly then the sponsoring employer will be required of the insurer margins for risk and profits through time. As to put more money into the scheme at future valuations to contributions cease and the investment strategy de-risks, the effectively push the scheme back on track. The combination improvement eventually becomes solely dependent on the of these factors means that there is a considerable chance gradual erosion of insurance company margins, only becoming that the scheme will secure annuities well within 50 years.
22 | Risk of Ruin In essence therefore the Risk of Ruin is going to measure the By applying a little judgement, we can map the credit rating likelihood of the sponsoring employer becoming insolvent before based Risk of Ruin as follows: the earliest point at which the pension scheme can afford to secure annuities for its members with an insurance company. Covenant Proportion Equivalent Risk of group of schemes credit rating Ruin Running our model and looking at the likelihoods of Risk of Ruin for employers with different credit ratings gives the Strong 20% Aaa – Aa 1% – 7% following results. Tending to 35% A – Baa 14% – 22% Strong Credit rating Likelihood of scheme benefit promises Tending to of sponsor not being paid in full, Risk of Ruin 25% Ba 51% Weak Aaa 1% Weak 20% B 66% Aa 7% A 14% Around one fifth of PPF eligible pension schemes can Baa 22% therefore be relatively relaxed, with a low likelihood that they will fail to deliver full benefits to all members. A further Ba 51% one-third of such schemes have a reasonably high likelihood B 66% of delivering full benefits to all members, but run a moderate risk that they will fail in this objective. One quarter of PPF As you might expect, pension schemes with the strongest eligible pension schemes only have a fifty-fifty chance of sponsoring employers have an extremely good chance of providing full benefits to all members, with the remaining one paying all benefits in full. Were the typical scheme sponsored fifth of schemes that have a ‘Weak’ sponsor covenant more by one of the only two Aaa rated companies (Microsoft likely than not to fail to deliver full benefits to all members. and Johnson and Johnson) it would be expected to pay full benefits to all members in 99% of all possible future scenarios These are very long term-projections and, as such, the and have a Risk of Ruin of only 1%. number of schemes having to reduce benefits each year is relatively modest but, as seen by the experience of the PPF, a The typical scheme is in reality not so fortunate, with the modest number of cases each year soon accumulate to a very average sponsor in the UK being around the Ba rating level. large number in aggregate. Across the universe of 5,800 PPF Here, things are not so attractive, with the scheme only eligible pension schemes remaining therefore, we expect in having a 50/50 chance of paying all members’ benefits in full! aggregate around one-third of these to fail to pay full benefits The majority of employers sponsoring a pension scheme will to all of their members. not have a credit rating, nor necessarily will any available credit rating accurately reflect the pension scheme’s position In essence, the aggregate Risk of Ruin is somewhat as a creditor of the sponsor. We can however attempt to unsurprising given the regulatory environment does not broadly map credit ratings across to the Pensions Regulator’s require all schemes to fund, on a going concern basis, to the covenant ratings and consider what this might show for the level required to immediately secure all benefits with an PPF universe of eligible defined benefit schemes as a whole. insurance company. The PPF was established and designed entirely to deal with the risk of sponsor insolvency whilst The Pensions Regulator has only recently started monitoring underfunded and ensure that if and when schemes do covenant ratings across the industry and so there is only data experience a failure event, a compensation underpin is available for three years of triennial valuations. This data set provided for the level of benefits members would otherwise should however include most schemes, simply due to the have expected to receive. triennial valuation cycle (all schemes have to complete a formal funding valuation every three years, with very broadly Schemes cannot alter the ultimate strength of their sponsor one-third of schemes falling in each year, such that three and thus any strategy designed to reduce the Risk of Ruin years of data should cover nearly all, bar those who have yet has to focus on pulling the levers that can be controlled: to complete their valuation before the data was compiled). this is the key to Integrated Risk Management (IRM). Having This data is summarised below: identified the framework within which all risks to a pension scheme should be considered, the Risk of Ruin, the first step Covenant First year Second year Third year for a scheme is to consider its drivers and whether there are rating of data of data of data any ways to mitigate the Risk of Ruin by a change of strategy. Strong 21.8% 18.2% 17.0% Having done so, we can move on to consider what future actions might be taken where risks arise. Tending 37.3% 33.0% 37.5% to Strong However, before considering what different strategies there Tending 22.1% 24.9% 22.0% are for reducing the Risk of Ruin, in the next chapter we give to Weak some brief consideration to the member’s perspective. Weak 18.8% 23.9% 23.6%
Risk of Ruin | 23 6. ACTUAL MEMBER OUTCOMES
From a ‘whole’ scheme perspective, using the Risk of Ruin as a measure of risk within it makes sense. For individual members, the first thing they should be aware of is that for most schemes, there is a not insubstantial and often quite high likelihood that schemes will not be able to pay their benefit promises in full: although their pension benefits might be defined, they are not guaranteed to be paid.
From a member perspective the fact that their scheme as a From a member perspective, the timing of Risk of Ruin whole might have for example, a 10% chance of not paying is crucial, as different members’ benefits are paid at all benefit promises in full is just a starting point: a particular different times: member wants to know not about the averages for the whole scheme, but rather about the implications for their `` Current pensioners are already in receipt of their benefits entitlements. They are not interested so much in whether and older pensioners may only be expected to live for their benefits might not be paid in full, although clearly this another ten years or so. If scheme failure happens in will be of some interest, but rather what level of benefits twenty years’ time, there is a good chance the majority they would be expected to receive if and when they were of current pensioners will have received all of their to be reduced. benefits in full.
The Risk of Ruin is calculated for the entire life of a scheme (or `` Deferred pensioners are in the opposite position, with the in our model of a typical UK scheme, over the next 50 years). youngest members not expected to even begin receiving Viewed on a year-by-year basis, the Risk of Ruin their benefits for perhaps thirty years or more. Any failure is not uniform however, reflecting variations in the risks of the scheme before they retire puts the whole of their the scheme is exposed to over time, including the risk of benefits at risk of reduction. sponsor insolvency.
24 | Risk of Ruin This issue of the different risk profile different members are exposed to is illustrated and explained further in the box below:
`` Risk profile of different members
80,000
70,000 The purple bars represent the benefits each member expects 60,000 to receive from the scheme on normal retirement at age 50,000 Deferred Pensioner 65: a one-off, tax-free lump member member 40,000 sum payable immediately on Income (£) retirement and thereafter a 30,000 monthly pension payable for life (increasing each year in line 20,000 with inflation).
10,000 55 60 65 70 75 80 Age
A current pensioner aged 77 has Our deferred pensioner is currently assumed already received their tax-free lump sum, to be 58 years old and is not expected to together with twelve years’ worth of receive any benefits from the scheme until pension payments. normal retirement in seven years.
Each year that the Risk of Ruin does not materialise During this seven-year period, all of the member’s means they receive a further annual pension payment benefits are at risk of reduction should the a ruin event in full. They are very unlikely to still be drawing benefits occur. Once the member reaches normal retirement from the scheme in twenty-five years’ time; therefore, age, a significant chunk of benefits are paid out as a even if the scheme does fail eventually, its impact on the lump sum, substantially reducing the exposure to Risk member will be more limited and if it did not occur until of Ruin. However, someone currently aged 58 might be the long-term, there would be no impact. expected to still be receiving their pension in thirty years (when they would be in their late 80s) and they and their dependants could still be entitled to receipt of a pension in even forty years’ time.
This concept of different risks applying to different groups (or scheme fails they will at worst see their benefits reduced to the rather, generations) of members is commonly referred to as PPF levels of compensation. Whilst the compensation levels ‘intergenerational risk’ sharing. It is a very important concept vary in particular, for those above and below normal retirement for trustees to take account of when making decisions about age, such that intergenerational differences still exist in the their scheme. They cannot, for example, justifiably run their PPF, these are much less significant than could theoretically scheme on an approach that gives a very high likelihood of at least, potentially arise in the scheme. The existence of the having to reduce benefits in thirty years’ time at the expense PPF therefore materially mitigates members against the worst of having a very low likelihood before then. To do so would excesses of intergenerational risk. In contrast however, trustees favour the current pensioner members, whose benefits would are required to ignore the presence of the PPF in making their be likely to be paid in full as a result, at the expense of the funding and investment decisions for a scheme. deferred members, whose benefits would be at significantly greater risk. As set out, even if the trustees of a scheme were to decide to run a strategy of meeting the pensioner benefits at the In practice, due to the existence of the PPF, intergenerational expense of the deferred pensioners, the PPF effectively applies risk is actually a much more significant issue for the trustees a cap of to the losses that deferred members would otherwise than the members of eligible schemes. For members, if their experience. If the scheme was only able to afford to pay 5%
Risk of Ruin | 25 of a deferred member’s benefits, the member would still In the following example we set out, a recovery rate of 0% of receive over their lifetime at least 75% of the value of their full the Section 75 deficit is assumed and therefore represents a benefits in the scheme via the compensation paid by the PPF. worst-case downside scenario. All scheme benefits would be paid in full up to the point of an insolvency; thereafter, since Trustees and members will therefore be interested in not only the scheme is assumed to recovery none of the Section 75 the Risk of Ruin itself and reducing the Risk of Ruin as far as deficit, benefits have to be secured at a reduced level with the possible, but also in monitoring the range of outcomes for the scheme assets that are available at that time. scheme as a whole and the different member categories when altering their strategy to reduce the Risk of Ruin. We can then work out what proportion of the total scheme benefits are on average expected to be paid in full. Thus the Alongside the Risk of Ruin, which assesses the likelihood of a Risk of Ruin might be 15%, such that there is a 15% chance of scheme failing to deliver full benefits to all members, another having to reduce scheme benefits at some point in the future. aspect we can consider is the proportion of benefits that are However we might find that due to timing and the level of expected to be paid in full. This would provide insight into not scheme funding where an insolvency occurs, that benefits are only the chance of the scheme experiencing a failure event, not cut (if at all) for many years in the future. We might have but the consequences for members’ benefits. a scenario therefore where although there is a 15% chance of In calculating the Risk of Ruin, we have projected the financial scheme failure, 95% or more of full scheme benefits are paid position of the pension scheme on a year-on-year basis over out to its members, suggesting a good outcome. This scenario its lifetime. We know therefore what the Section 75 deficit is can arise both from a large proportion of a scheme’s benefits at any point in time when an insolvency event might befall having been paid out prior to an insolvency and as a result of the sponsoring employer. To determine what proportion of the expectation that over time, the funding level on a Section scheme benefits will be paid where sponsor failure occurs, 75 basis will improve significantly, reducing the impact of we need to know how much of the Section 75 deficit will be insolvency for the benefits that have yet to be paid (whatever recovered in the insolvency process. If 100% is recovered, recovery rate is assumed). then all of the benefits will be paid in full: the scheme will Of course trustees would have to be extremely careful in have paid directly the member benefits falling due up to the dismissing a high Risk of Ruin as irrelevant simply because point of insolvency. All scheme benefits falling due thereafter a particular strategy leads to a higher expected proportion would be met from the annuities secured for members from of benefits being paid, since ‘intergenerational risks’ may the proceeds of the insolvency process together with the still remain. Indeed it is highly likely that a high Risk of Ruin existing scheme assets. coupled with a high proportion of full scheme benefits being Unfortunately, as we have seen in chapter 2, Moody’s historical paid would indicate a strategy focussing on the short-term recovery rate data indicates that pension schemes are very at the expense of the long-term, favouring the current unlikely to recover anything like the full Section 75 deficit on pensioners and concentrating any losses that may arise on an insolvency of their sponsoring employer (the Section 75 sponsor insolvency on the younger members. debt ranking as an unsecured creditor, unless the scheme has In our illustrative example, from a member perspective it is acquired additional security provisions prior to insolvency, comforting to know that the average outcome (that 95% of which applies to less than 10% of schemes). Schemes might scheme benefits will be paid in full) where Risk of Ruin occurs expect on average to recover only 40% of their Section 75 (assessed to happen 15% of the time) is not a drastic one. They ‘debt’ claim but could realistically recover anywhere from 0% do however need to be made aware of and understand the to 90% depending on the particular circumstances applying to variability in outcomes that are possible. Trustees also have to the scheme and the sponsoring employer. consider whether their attempts to reduce the Risk of Ruin for We do not believe there are any credible models for the scheme’s membership in aggregate are having any ‘second determining the expected variability of the recovery rate of a order’ impacts they might need to consider in more detail. scheme’s Section 75 deficit through time. Whilst a reasonable To illustrate this point, consider a board of trustees looking at starting point might be to consider the level of recovery of some potential changes to their current investment strategy the current Section 75 deficit assuming an immediate fire-sale for the scheme. Having calculated the Risk of Ruin both before of the sponsoring employer’s assets (a commonly estimated and after the proposed changes, they are surprised to see that position in most covenant reviews), this is unlikely to be they are having an immaterial impact on the Risk of Ruin, even representative of the potential outcome for the scheme on a though the risk profile of the two investment strategies are future insolvency of the sponsor. Our preferred approach is quite different. What is happening is that whilst when viewed to illustrate the sensitivity of the member benefit outcomes overall, the average outcome of the two strategies is similar, to variations in the assumed recovery rate on insolvency, the distribution of the investment outcomes under the two using a central scenario of recovery at the average rate from strategies is markedly different, which changes the resulting Moody’s historical data of 40%, a downside ‘worst-case’ of profile of potential benefit losses for members where an a 0% recovery and an upside case of an 80% recovery of the insolvency occurs. Section 75 deficit.
26 | Risk of Ruin `` Loss of benefits – frequency
Investment strategy 1 We can see the variation in the Investment strategy 2 profile losses under the two investment strategies in this chart. It shows the how often (the frequency) with which each level of reduction in members’ Frequency benefits (as a percentage of full scheme benefits) is expected to occur under each of the two different investment strategies.
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Loss of benefits
The first investment strategy most commonly has smaller losses (of around 5%) than the second (for which the most common outcome is a loss of around 10% of members’ full scheme benefits). However the first investment strategy also gives rise to a significantly greater chance of members’ benefits having to be reduced by 20% (or more) when compared to the second, where a scheme failure event occurs.
From a member perspective, the ‘safety net’ of the PPF means they might well prefer the first investment strategy to the second. As trustees are not allowed to factor the PPF underpin into their planning, they may consider the second investment strategy to provide a better outcome. This strategy mitigates the risk that there would be a very significant reduction in benefits at the expense of a slightly worse reduction in benefits on average.
Such choices are not straightforward. It is useful to understand however that there are second order impacts and more complex issues in managing your Risk of Ruin than just the raw headline result alone might suggest. We make reference occasionally to these more complex issues as we consider the impact on the Risk of Ruin on different strategies and situations, particularly around the impact of alternative investment strategies.
Risk of Ruin | 27 7. AFFORDABILITY ISSUES
In our basic model we deliberately ignored the possibility that the sponsoring employer could not afford the contributions required from it in calculating the Risk of Ruin: the basic model simply assumed that the sponsoring employer would always be able to make good any funding deficit that could possibly arise (based on paying the deficit off through equal instalments over an eight-year period).
Unfortunately, most sponsoring employers cannot afford Let us consider this further by assuming our illustrative to increase their contributions without limit and a large pension scheme is in such a position: we consider a scenario number are already at the limit of what they can afford where the sponsor has just agreed to fund the deficit in the to pay. Historically schemes were required to attempt to scheme through equal instalments paid over an eight year remove their funding deficits as quickly as their sponsoring period (as in the basic model) but we introduce an additional employer could reasonably afford, taking appropriate account constraint that there is no ability for the sponsor to increase of their business plans. Following the introduction of a the level of cash contributions above that in the future. further statutory objective for the Pensions Regulator “to Where the level of any future funding deficit demands higher minimise any adverse impact on the sustainable growth of deficit contributions than this would support, any additional an employer”, whilst there may be some greater flexibility in deficit could only be met through contributions of the same the funding system in terms of the contributions demanded amount continuing for a longer period than eight years. The from employers, a significant number of schemes still face period cannot be extended limitlessly however and depends the possibility that if their deficit gets materially worse in part on how mature the scheme is, the level of covenant they cannot expect to get higher contributions from the support available to it, and the funding position. Practically, sponsoring employer to help them out (as the employer the longest period over which a funding deficit can reasonably simply cannot afford them). be paid off is around 25 years for the typical pension scheme.
All is not lost for such schemes however, given that the We present the Risk of Ruin of the model under two different Pensions Regulator’s data shows an average recovery plan approaches in the table below; first assuming there is no limit length of currently around eight years, whilst schemes (and to the contributions that can be paid (the basic model) and hopefully their sponsoring employers) have around fifty years secondly assuming the current contribution level applies as a or more of operation ahead of them. Extending the term maximum across the life of the scheme (the variant model): over which contributions are paid is an obvious alternative to increasing the amount of contributions paid each year.
28 | Risk of Ruin Variant model: period) and that this resulting lower level of contribution is Basic model: affordability constrained: the maximum that is affordable by the sponsor each year over no affordability contributions limited to the whole lifetime of the scheme. The results for this are set Credit rating constraint initial level out in the right-hand column of the table below alongside Aaa 1% 1% those for the original two approaches:
Aa 7% 7% Affordability Affordability A 14% 14% Basic issue: issue: model: no contributions contributions Baa 22% 23% Credit affordability constrained to constrained to 12 rating constraint initial level year initial level Ba 51% 51% B 66% 67% Aaa 1% 1% 3% Aa 7% 7% 10% As can be seen, whilst the Risk of Ruin increases fractionally A 14% 14% 17% for Baa and B rated sponsoring employers, there is no significant increase in the risk across any of the credit ratings. Baa 22% 23% 26% At first this might seem surprising but we should remember Ba 51% 51% 55% that our starting point is an 80% funded position with an B 66% 67% 70% 8-year recovery plan. Each additional year of contributions is effectively adding 2.5% to the opening 80% funding level, As can be seen, starting with a 12-year recovery plan on such that our assumed maximum recovery plan length of affordability grounds has a noticeable impact on the Risk of 25 years could theoretically return a scheme to full funding Ruin compared to the original approach under the basic model assuming an initial funding level of less than 40% (half the where there was no constraint (and the recovery plan was level we assume in the model). eight years in length). The very slight increase in risk we observe is driven by The Risk of Ruin is now becoming a material consideration the scheme having on average slightly lower assets where for even the highest rated credit ratings with the Risk of Ruin affordability is constrained and a longer than eight year for a Aaa rated sponsor tripling to 3% (not insignificant) and recovery plan is required in any future scenario. This reduces, for an Aa rated sponsor increasing by almost half to 10% marginally, the likelihood that the scheme will acquire enough (significant). Fortunately for stronger sponsors, they are much assets to be able to afford to secure annuities for full benefits less likely to have a pension scheme of such scale that they with an insurance company before the sponsoring employer face a genuine affordability constraint on their contributions. becomes insolvent (if it does so) and so accordingly, increases the Risk of Ruin. The absolute change in the Risk of Ruin for the weaker credit ratings are larger. Whilst not changing the broader picture, there Of course this situation is somewhat unrealistic in that very is roughly an additional 5% chance that benefits will have to be few sponsoring employers have agreed an eight year recovery reduced over the lifetime of the scheme where the sponsor has plan which is genuinely the maximum they can afford. Given a 12-year affordability constraint at outset, compared to the the long-term nature of pension schemes, they are run on a position where there is no affordability constraint at all. ‘going concern’ basis that reflects the inherent uncertainty as to what contributions are truly required from the sponsor. The driving force here from a Risk of Ruin perspective is that Accordingly, where affordability is not an immediate issue, a the initial longer recovery plan means that all future scenarios reasonable period of time (typically of at least two further now have lower amounts of cash contributions to the scheme, triennial valuation cycles) is afforded to sponsoring employers reducing the likelihood that the scheme will acquire enough who do not choose to put in place a shorter recovery plan. assets to secure annuities for full benefits before any potential Indeed employers who are genuinely suffering from an sponsor insolvency. Furthermore the capacity of the sponsor affordability issue will already be running a longer recovery to make good the ‘worst case’ funding deficit that could arise plan than that typically thought of as reasonable (of around in the future is now reduced by a third as we move from an 8-10 years). 8-year to a 12-year recovery period.
A more realistic scenario for a scheme facing an affordability Of course some schemes face an even greater affordability issue at the outset of our model is that the sponsoring issue than the scenarios illustrated. Data from the Pensions employer would not be able to agree to an eight year recovery Regulator shows that 5% of schemes have been forced by plan in respect of the existing funding deficit and require a a genuine affordability issue to agree a recovery plan of 19 longer period to return the scheme to full funding. years or more. We therefore consider some more extreme levels of affordability constraint and its impact on the Risk We therefore re-run the Risk of Ruin to model a third of Ruin by modelling scenarios starting with a 16-year and a approach, assuming a 12-year recovery plan (based on paying 20-year recovery plan (based on paying the deficit off through the deficit off through equal instalments over a twelve-year
Risk of Ruin | 29 equal instalments over a 16 and 20 year period respectively) to extend beyond the theoretical limit. In such cases where and assuming that the resulting (lower) level of contribution affordability limits give rise to impractically long recovery in each case is the maximum that the sponsor could afford plans, a pension scheme would have to reduce members’ each year over the whole lifetime of the scheme. The results benefits through a compromise of the nature of that was are shown in the table below relative to the basic model undertaken by Uniq plc in 2011¹. where no affordability constraint was assumed (and an eight year recovery plan was adopted with equal contributions). Of course some of the examples above are unrealistic: an Aaa rated sponsoring employer or even an Aa rated sponsoring employer would not simultaneously be able to have such an affordability issue with respect to its pension scheme whilst Basic Affordability issue: Affordability issue: retaining such a high credit rating. model: no contributions contributions Credit affordability constrained to 16 constrained to 20 It is not unusual however for sub-investment grade companies rating constraint year initial level year initial level (or those rated ‘Tending to Weak’ or ‘Weak’ on the Pension Aaa 1% 16% 30% Regulator scale) to have a long recovery plan: 25% of schemes Aa 7% 22% 35% have a recovery plan of 10 years or more and 5% have 19 years or more (and the majority of these cases will be A 14% 28% 40% expected to be where the employer is rated ‘Tending to Weak’ Baa 22% 36% 47% or ‘Weak’).
Ba 51% 62% 68% The issue is most severe for sponsoring employers in the B 66% 74% 79% mid-range of credit ratings: the Risk of Ruin for a Baa credit increases from 20% where there is no affordability constraint The key issue identified here is that with a theoretical under the basic model, to 36% where the affordability maximum of a 25-year recovery plan length, the additional constraint is defined by a 16-year recovery plan at outset, funding deficit that the sponsoring employer can address to a 47% level if the affordability constraint is defined by a over and above the level at outset is materially constrained: 20-year recovery plan at outset. In essence the sponsoring beginning with a 20-year recovery plan on a funding level at employer has limited capacity to deal with the potential outset of 80% only provides a 5% downside to the funding downsides and the required recovery plan length can easily level before the constraint on the level of contributions pass beyond the theoretical maximum of 25 years. would lead to the length of the recovery plan being required
We can conclude from our consideration of affordability that the fact that contributions are Affordability constraints can have a currently at the maximum level (or that there exists some higher maximum level that the company significant impact on the Risk of Ruin could not afford) is not particularly concerning as for all sponsoring employers but it is long as the starting point for cash contributions is a much more likely to be an issue for reasonable proportion of the liabilities as a whole and weaker sponsors. the recovery plan is currently short (again in relative terms). In such cases, there is a lot of scope for an extension of the recovery plan in the future to absorb downside risk.
However, if the starting point is already a long recovery plan then there is limited scope for the recovery plan to be extended and thus less scope for adverse deviation in the future to be met by extending the recovery plan. Such situations are extremely risky and likely to lead to a very high Risk of Ruin.
¹ For further details on the Uniq plc case please see our Briefing Note available from our website at the following link: http://www.pstransactions.co.uk/knowledgecentre/pages/2011-02-NewsAlert-Uniq.aspx
30 | Risk of Ruin 8. FUNDING AND PRUDENCE
The ‘going concern’ triennial actuarial valuations of schemes are required to be prudent with the degree of prudence theoretically reflecting the strength of the employer covenant, albeit that only a weak correlation can currently be observed in the industry between prudence and covenant strength.
Prudence is effectively a margin held against adverse For example, a scheme may have rated its employer as experience (against the best estimate). The theory goes that ‘Tending to Strong’ at the previous valuation with the the more prudence, the greater this margin and therefore the discount rate set at a level just above average for the industry more secure the benefits. If the ‘going concern’ valuation is as a whole. When it comes to the current valuation and the set more prudently, the deficit will be greater and therefore rating is now ‘Tending to Weak’, the scheme will introduce higher deficit contributions will be required from the more prudence by reducing its discount rate to just below sponsoring employer. A greater degree of prudence in the the average for the industry as a whole. Of course the ‘going concern’ valuation therefore results in higher cash converse could be applied in situations where the covenant contributions from the sponsoring employer in the future. is improving, leading to lower levels of prudence and a higher discount rate. Assuming such behaviour continues in the Of course this idea relies on the fact that any additional cash long-term, as covenant ratings do fluctuate from valuation contributions from the employer will not have any impact to valuation, the prudence in the ‘going concern’ valuations on its long term viability (or at least that the extra cash so of schemes should increasingly correlate with the covenant paid offsets the additional insolvency risk and long-term rating of their sponsors’ over time. affordability issues that these contributions might create). As we have already covered, there is limited evidence of schemes The majority of the risk in our discount rate comes from the reflecting their sponsors covenant strength in their chosen return-seeking assets and thus this is where the majority of funding strategies. The degree of prudence is often more a the required level of prudence will be generated. We expect reflection of the accumulated history of the scheme and its our return-seeking assets to generate outperformance relationship with its sponsoring employer. of 2.4% per annum on a best-estimate basis and in our basic model, we introduce prudence by only allowing for In our experience however, the relationship between covenant outperformance of 1.5% per annum. Reducing the allowance strength and funding strategy is almost always ‘corrected’ for outperformance introduces further prudence into the when there is a significant change in the covenant of the ‘going concern’ valuation and increases the resulting funding sponsoring employer. In situations where the trustees are deficit at the outset of the model projection: advised that their covenant has worsened over a triennial cycle, it is incumbent upon them to increase the prudence from its current level, where previously this did not accord with the covenant prior to its deterioration.
Risk of Ruin | 31 Basic model: More prudence: More prudence: More prudence: Consider, for example, a scheme whose sponsor was, at the £ 1.5% per annum 1.2% per annum 0.9% per annum 0.6% per annum previous valuation, Aa rated at which time it was assessed millions outperformance outperformance outperformance outperformance there was a Risk of Ruin of 7%. At the following valuation the Assets 80 80 80 80 employer has been downgrade one notch to A rated and now Liabilities (100) (106) (112) (119) the scheme has a Risk of Ruin of 14%. The trustees decide to add prudence to the valuation to bring this back down: by Surplus / (20) (26) (32) (39) adding 20% more prudence to the liabilities they reduce the (Deficit) Risk of Ruin down to 9%, close to where they started. This Funding 80% 75% 71% 67% however requires the funding deficit to double. No employer level is going to react well to a set of trustees telling them that because of a one notch credit downgrade, they have doubled We see that when the prudence is increased such that the the funding deficit. allowance for outperformance on the return-seeking assets is reduced to only 0.6% per annum (compared to our best An alternative approach to increasing the prudence in the estimate allowance of 2.4% per annum), the ‘going concern’ funding strategy of the scheme is to shorten the length of funding deficit effectively doubles compared to that under the the recovery plan, meaning that deficits are recovered more basic model (£39 million versus £20 million). quickly and the average funding level of the scheme will be higher in all future scenarios. We can illustrate this by running Whilst the changes to the ‘going concern’ deficit calculation the Risk of Ruin with a six-year recovery plan rather than the do not immediately impact on the Section 75 deficit, it does eight years used in our basic model as follows: result in a doubling of the cash coming into the scheme every year and results in the assets being expected to be broadly Basic model: Higher contributions: Credit rating 8 year recovery plan 6 year recovery plan 20% higher on average at the end of the initial eight year recovery period. Aaa 1% 1%
We will now calculate the Risk of Ruin across the credit ratings Aa 7% 6% for this increasing level of prudence in the ‘going concern’ A 14% 12% valuation: Baa 22% 20% Basic model: More prudence: More prudence: More prudence: Ba 51% 47% 1.5% per 1.2% per 0.9% per 0.6% per £ annum out- annum out- annum out- annum out- B 66% 63% millions performance performance performance performance
Aaa 1% 1% 1% 1% A shorter recovery period results in a modest improvement Aa 7% 6% 5% 4% in the Risk of Ruin. Reducing the recovery plan much further (than 6 years in length) would be unusual in that A 14% 12% 11% 9% it would effectively eliminate the inherent allowance for Baa 22% 20% 18% 16% the uncertainty in the true funding position of the scheme Ba 51% 47% 44% 39% permitted through use of a recovery plan longer than one or two valuation cycles. B 66% 63% 60% 56% In reality, the length of the recovery plan that is agreed is Adding more prudence obviously has some impact for an Aaa considerably less important for the Risk of Ruin than rated sponsoring employer but as the Risk of Ruin is already whether it translates into a fixed recovery plan length trivial it is too small to change the overall conclusion. For whatever the deficit, or instead is reflecting an affordability other credits, good and bad, the impact is significant. constraint and is therefore being driven by a fixed cash contribution amount. Consider the table below, which shows A solid investment grade company with an A credit rating sees the Risk of Ruin under our basic model (which has an eight its Risk of Ruin fall from 14% to only 9% when the prudence in year recovery plan and no affordability constraint) against the ‘going concern’ valuation is increased significantly enough a situation with a 16-year recovery plan with no affordability to double the deficit. Sub-investment grade sponsoring constraint (any deficit can and will be met over 16 years) employers rated Ba move from a 50/50 position to a together with the results from our previous analysis where significantly better 60/40 position due to the doubling of the the affordability constraint is fixed at the level implied by deficit contributions from the sponsoring employer. Additional a 16-year recovery plan at outset. prudence does therefore work to reduce the Risk of Ruin, but it is very costly for the sponsoring employer in terms of the cash contributions required. We also observe that smaller increases in prudence have a limited impact.
32 | Risk of Ruin Affordability issue: that the whole of deficit is paid off on day one (the remainder Basic 16 year recovery contributions paid off as originally agreed without change): model: no plan: no constrained to level Credit affordability affordability implied by initial 16- Credit Basic model: Lump sum: Lump sum: rating constraint constraint year recovery plan rating no lump sum half the deficit whole deficit Aaa 1% 1% 16% Aaa 1% 1% 1% Aa 7% 8% 22% Aa 7% 6% 6% A 14% 16% 28% A 14% 13% 12% Baa 22% 26% 36% Baa 22% 21% 20% Ba 51% 58% 62% Ba 51% 49% 47% B 66% 72% 74% B 66% 65% 62%
As covered in the previous chapter, an affordability constraint We see that, despite the funding deficit being substantially driven by a 16-year recovery plan leads to a huge increase reduced or immediately eliminated under these two scenarios, in the Risk of Ruin. There are two distinct factors which the Risk of Ruin is barely affected by these large one-off cash contribute to this: contributions. The exception is at the lower credit ratings and `` Firstly, the fact that the recovery plan is being extended out even there, the movement is somewhat disappointing given (from 8) to 16 years and it therefore takes materially longer the size of the contribution involved. to get cash into the scheme increases the Risk of Ruin. The extent of this impact can be seen by the movement The reason this occurs is as follows. The lump sum is a pre- from the first set of results to the second set of results. payment of contributions that will be received in any event under the original eight year recovery period, not additional `` Secondly, the fact that contributions are capped at the cash. The benefit to the scheme is therefore that where paid level of the affordability constraint means there is no as a lump sum, these monies are guaranteed to be received, scope to increase the contributions in the event of adverse whereas under the original recovery plan they remain at risk experience and this will also increase the Risk of Ruin. This of the sponsor’s insolvency. Coupled to this is that there is a impact is shown by the movement from the second set of modest benefit that receiving the cash up front enables those results to the third set of results. monies to be invested to generate a return sooner.
The central result of the above table shows us that, at the Of course what is actually happening is that we are raising higher credit ratings, the affordability cap itself is the driving the opening funding position of the scheme from the initial force behind the increase in the Risk of Ruin, whereas at lower 80% funding level: it goes to 90% when we pay off half the credits it is the simple fact that the recovery plan has been deficit and to 100% when we pay off the entire funding extended that is more important in driving the increase in the deficit. Whilst a better opening funding position has a modest Risk of Ruin. This is a function of the shape of the insolvency impact on the Risk of Ruin this shows that the current funding likelihoods for the different credit ratings in that sponsors position of a scheme is significantly less important than the with lower credit ratings have a significant likelihood of strength of the sponsor covenant supporting it. Covenant is insolvency in the first few years of the projection. Thus, any key to the likely success of a scheme. reduction in the level of cash paid to scheme in the early years where the recovery plan is extended will increase the Risk of Often situations arise, particularly in mitigation situations, Ruin. The actual affordability constraint itself is an issue more where the schemes are combining all the above approaches relevant to those employers with better credit ratings, as it into one change: a large one-off contribution (say, £15 can impair the ability of the sponsor to make up for periods million), a shortened recovery plan and extra prudence in the of adverse experience over the longer term. technical provisions. We can run the Risk of Ruin once again to see the combined impact of these changes in strategy: A relatively common occurrence within schemes (over their long lifetimes) is for there to be occasions whereby the More prudence, lump sum sponsoring employer wishes to make an immediate one-off Credit rating Basic model and shorter recovery plan contribution into the scheme. This may be just to reduce Aaa 1% 1% future cash contributions by using the free cash that is available today or alternatively may arise as ‘mitigation’ for Aa 7% 4% a change in the covenant that the sponsoring employer A 14% 9% wishes to implement. Trustees in general are very keen on Baa 22% 15% significant immediate lump sum contributions that improve their deficit position immediately. To investigate the impact Ba 51% 38% of such actions, we re-run the Risk of Ruin on the assumption B 66% 55% that half the deficit is paid off on day one and then assuming
Risk of Ruin | 33 By making this set of radical changes we do see a significant The resulting impact of this scenario for the Risk of Ruin is reduction in the Risk of Ruin. However on the table above all then as follows: these changes only compensate in full for some one-notch reductions (A to Ba, Ba to B) whereas with others, even these Credit rating Basic model Less prudence radical changes do not make sufficient difference (Aaa to Aa Aaa 1% 1% especially but also going from investment grade to ‘junk’ by moving from Baa to Ba). Aa 7% 7% A 14% 15% No sponsoring employer is likely to agree to such a radical set of changes in approach to compensate for a one notch Baa 22% 24% reduction in credit rating. Nor does this approach work very Ba 51% 53% well for mitigation purposes. Such packages of measures B 66% 68% have been used in large leveraged buyouts where the acquired company may be taken from an A rating down to a Ba rating as a result of additional leverage. Even with this A modest change such as this has very little impact on the series of changes as mitigation the Risk of Ruin still increases Risk of Ruin, particularly if we consider that this situation substantially from 14% to 38%. often arises when the covenant has improved from one valuation to the next. We mentioned briefly previously that in theory at least, when the covenant improves the amount of prudence Consider for example a scheme whose sponsor was, at the could be reduced in future funding valuations. In practice previous valuation, Baa rated and at this valuation there was experience suggests trustees are quite reluctant to do a Risk of Ruin of 22%. At the following valuation the employer so to any significant degree. We can demonstrate what has been upgraded one notch to A rated and now the scheme impact a small reduction in prudence has by changing the has a Risk of Ruin of 14%. At the request of the sponsoring outperformance assumption upwards rather than downwards employer, the trustees decide to reduce the prudence in the and re-run the Risk of Ruin accordingly: by increasing the valuation to reflect the change. A modest change such as outperformance assumption from 1.5% to 1.8% per annum increasing the outperformance only raises the Risk of Ruin to we reduce the funding deficit from £20 million to £15 million 15% compared to the 22% at the last valuation. The trustees – a fairly modest reduction in the overall context of the would have to make sweeping changes to their level of scheme (5%). prudence to leave their members worse off in security terms than they were at the previous valuation.
Some interesting conclusions for scheme funding can be `` Lump sum contributions are much poorer value for drawn from this section: trustees than currently perceived and provide limited additional security; `` Increasing the level of prudence in the funding approach reduces the Risk of Ruin albeit the changes `` Reducing prudence when the covenant improves are not transformational; should be more acceptable to trustees than it appears to be in practice because the reduction in `` Extending the recovery plan has a large negative security from taking less prudence is swamped by the impact on Risk of Ruin for schemes with weaker improvement in security from the better covenant. employers;
`` Attempting to increase prudence to compensate for a weakening of the covenant (for whatever reason) is unlikely to be successful as the changes required to the level of prudence are extremely large;
34 | Risk of Ruin 9. INVESTMENT STRATEGY
It almost goes without saying that the decision on what assets to invest in to back the liabilities of a scheme is of profound importance to the sponsoring employers, trustees and members. Investment decisions impact both the final outcome for a scheme and the path it takes to get there.
Investment strategies adopted by pension schemes vary prudence in the funding approach will be altered. The level of considerably in complexity, risk and their overall asset prudence relative to the Section 75 deficit would also change. allocation. Our basic model has a fairly simple approach with 60% invested in diversified growth assets and 40% in bonds, In our model we will therefore alter the technical provisions moving to 100% bonds by the time that the last member as the investment strategy changes to keep the same margin retires, with all interest rate and inflation risks hedged. for adverse deviation against the best estimate cost. We note that trustees may wish to take an alternative approach to We can use the Risk of Ruin to show the impact of various prudence. changes to the investment strategy in our basic model. We maintain the level of prudence relative to the best Changing the investment strategy will typically change the estimate cost in our modelling by varying the mix of asset expected return on the assets through time and therefore classes that are employed, whilst keeping the same (prudent) change the ‘best estimate’ cost of providing the liabilities. level of investment outperformance on each asset class that Whether or not a change in investment strategy will impact is assumed in the funding approach. Thus where we assume the balance of cost of a scheme to the sponsoring employer the scheme de-risks the investment strategy over time rather will depend not only on the actual investment experience than maintaining a constant allocation to riskier return- over time, but also on the extent to which the investment seeking assets, the funding deficit increases and so with strategy is reflected in the trustees’ funding measure, which it do the required contributions from the sponsoring is required to be set prudently. employer. Conversely if we increase the weighting then the deficit is reduced. The principle behind adding prudence to the ‘going concern’ valuation is to include what is intended to be spare allowance As discussed briefly earlier, the trend for schemes is to reduce in the funding approach as a margin against experience being risk in their investment strategies through time. De-risking worse than expected under a ‘best estimate’ approach. is very popular with trustees because taking less risk sounds like exactly the sort of thing that proper trustees should be If the ‘going concern’ valuation does not change when doing. It is clear that, in isolation, holding more bonds makes the level of investment risk is materially changed through the funding level more stable from one point in time to adopting a different investment strategy, then the amount of another, which could be an important area of risk reduction
Risk of Ruin | 35 for a scheme. We can however only truly know whether the The results are shown in the table below: overall risks to the scheme are being reduced by taking an IRM Basic model: De-risked: De-risked: De-risked: approach and looking at the implications of the changes in Credit 60% 40% 20% 0% relation to the detail of the whole picture for the scheme and rating diversified diversified diversified diversified its members. Aaa 1% 1% 1% 1% De-risking obviously comes at a price: lower risk, lower Aa 7% 7% 7% 7% return investment strategies mean higher funding liabilities and hence more contributions through time for the A 14% 14% 14% 13% sponsoring employer to pay. The benefit for the sponsoring Baa 22% 23% 22% 22% employer may be seen in less volatile contribution demands Ba 51% 52% 51% 50% and elimination of any major affordability issues in the B 66% 67% 66% 66% future. We should note that, whilst the employer is solvent and not suffering from any affordability constraints, the whole of the investment risk falls on the sponsoring employer. The results are rather astonishing given the extent of the de- If things go well, the contributions they are required to pay risking considered: the most extreme scenario has the initial under any recovery plan will be made accordingly until the allocation to diversified growth assets reducing from 60% scheme reaches full funding. If things go badly, then the to nil, dramatically increasing both the funding liabilities and sponsoring employer will pick up the tab through increased cash contribution demands from the sponsoring employer, deficit contributions. and yet it has practically no effect on the Risk of Ruin.
One final point we would highlight is that the conclusions This comes about because the Risk of Ruin inherently defines drawn from investment modelling can vary considerably risk in a different way to traditional investment consultants depending on how the range of future investment scenarios who only look at the asset side of the situation. Yes we that are modelled stochastically are generated (the so-called have reduced the volatility of the assets and in particular engines for which are referred to as an economic scenario have made the funding level more stable by matching our generator or ‘ESG’). There are a wide variety of potential assumptions directly with our expected asset returns i.e. ESGs that could be used for the Risk of Ruin analysis and by investing in bonds and using a bond-based discount the illustrative model we have used for the purposes of this rate. However, as long as the sponsoring employer remains report is the simplest option available to us. It can often solvent and is not facing any affordability constraints on the be useful to begin by using a simple ESG in the Risk of Ruin contributions they can pay, then all of the funding risk falls on modelling (such as that used here) and to then confirm the the sponsor and none of it on the scheme or its members. conclusions still apply when using a more complex ESG. By de-risking, we may well have set our funding target at a To consider the impact of alternative investment strategies higher level, but this funding level is still significantly below on the Risk of Ruin, we begin by simply reducing the allocation the cost of securing annuities with an insurance company. to diversified growth assets at the start of our projection Furthermore, whilst the variation in the scheme’s funding from the 60% under the original model to firstly, 40%, level over time has been very significantly reduced, in turn then to 20% and finally to 0% (with the allocation to bond it makes it much less likely that we will see investment assets increased accordingly, all figures being expressed as outperformance alone increase the funding position to a level a proportion of the total assets of the scheme). Whatever where the scheme can afford to secure annuities. level of diversified growth assets we assume at the beginning With higher levels of investment risk we set a lower funding (where this is non-zero), we assume this weighting reduces target for the scheme, but observe much greater variability of through time as the membership matures such that when the outcomes around this target over time. The gap between our last member has retired, the scheme is assumed to be 100% funding target and the Section 75 level of funding required invested in bonds. to secure all members’ benefits in full with an insurance As we reduce the weighting to diversified growth assets, company may be greater, but the additional volatility makes it so the funding level of the scheme at the beginning of our just as likely as under the de-risked approach that the scheme projection falls. This is because a lower return expectation on will reach this level at some point in the future. the assets leads to an increase in the ‘best estimate’ expected Of course investment strategy is one area where as well as cost of providing members’ benefits and as we assume considering the headline Risk of Ruin, trustees are likely to the prudence margin in the funding basis is maintained, need to analyse the position in more detail, by considering flows through to an increase in the funding liabilities and for example the range of outcomes for the benefit losses consequently the deficit (since changing the investment members may experience under alternative investment strategy does not alter the opening value of the assets). strategies. Extreme losses are likely to be reduced by de-risking, such that trustees may have a preference for
36 | Risk of Ruin de-risking to mitigate these, even if the average loss of ‘Tending to Strong’ by the Pensions Regulator) the degree benefits where Risk of Ruin occurs is increased. Unless the of risk in the investment strategy is of little consequence pattern of losses is clearly superior, such choices can be to the scheme (due to the low Risk of Ruin) but is highly difficult to make. This is more of an issue for trustees rather significant for the employer. Trustees may wish to consider than members due to the position with respect to the PPF, engaging more pro-actively with their sponsoring employer whereby it exists and will protect the members but the in this case, to discuss which party (the scheme and thus trustees cannot take it into account in their decision making. members, or the employer) is bearing the majority of the investment risk under different investment strategies. Studying the pattern of losses is likely to be more important for those situations where the employer is not For sponsoring employers with lower credit ratings (‘Weak’ bearing the majority of the investment risk i.e. weaker and almost certainly ‘Tending to Weak’) the degree of risk sponsoring employers. Such sponsors are taking significantly in the investment strategy may well be of consequence to lower amounts of investment risk and members taking the scheme and is highly significant for the sponsor. Trustees proportionally more, as explained further below. may wish to consider engaging more pro-actively with their employer but recognising that they need to further consider Consider a Ba rated sponsoring employer under the basic the range of potential outcomes for losses when making model for which the scheme has a Risk of Ruin of 51%. This investment decisions. means that in 49% of cases the scheme is able to secure all the benefits in full with annuities before any insolvency of the If de-risking is not effective in reducing the Risk of Ruin then sponsoring employer occurs. In every single one of these cases it makes one wonder whether the existing de-risking the sponsor has borne all the investment risk, either through implicitly assumed in our basic model is particularly effective. the contribution requirements of each triennial funding We have assumed that all interest rate risk has been hedged valuation or otherwise, by paying off the Section 75 deficit in in our basic model as this reduces the volatility of the position fifty years’ time. around the funding target, but might it be that this extra volatility makes it more likely that the scheme will be able to In the other 51% of cases, the sponsoring employer has only afford to secure annuities in the future? borne the investment risk that has occurred prior to the point of insolvency, through meeting the contribution requirements What happens to the Risk of Ruin if we remove our interest of each triennial funding valuation paid up to then. In these rate hedging totally and only rely on the interest rate hedging cases, who has borne the investment risk (the scheme and provided by our bond assets at any point in time? thus the members, or the sponsoring employer) depends Basic model: No interest on the incidence of the periods of poor performance of the Credit rating full hedging rate hedging investments relative to the timing of employer insolvency. Aaa 1% 1% For example, if the next ten years turn out to be terrible for investments but the sponsoring employer does not become Aa 7% 6% insolvent for another thirty years, then this investment A 14% 13% risk will have been borne by the sponsoring employer. Baa 22% 20% Alternatively, if the next ten years turn out to be benign for investments but in the eleventh year there is a major crash in Ba 51% 47% investment markets and the sponsoring employer becomes B 66% 63% insolvent immediately thereafter, then this investment risk will have been borne by the scheme and thus the members. We do see a marginal improvement in the Risk of Ruin but it is not that significant. This is because good asset returns Disentangling who is bearing the majority of investment now do not necessarily lead to improvements in the funding risk is going to be highly complex. However, given that position as the liabilities are no longer hedged against interest benefits are likely to be reduced in the majority of scenarios rate movements. Of course sometimes moderate asset for sponsors with lower credit ratings, it will be incumbent returns can result in significant funding improvements if upon trustees to consider how the shape of the expected interest rates move upwards at the same time. The funding losses changes when considering changes in the investment level is more volatile but on average is in the same place, strategy that do not significantly impact the Risk of Ruin. As leaving the gap to the cost of securing annuities unchanged. shown in chapter 6, such analyses often do not lead to any The net gain from the additional volatility is therefore muted. firm conclusions as to the superiority of one approach over another, but the trustees will have satisfied their duty by Of course the sponsoring employer is potentially exposed considering the point and making an informed decision. to significantly higher contribution demands by the removal of the hedging. Perhaps a better way of introducing more A general conclusion might be that for sponsoring employers volatility and asset performance into the scheme (in order to with higher credit ratings (those rated ‘Strong’ and probably
Risk of Ruin | 37 make it more likely the scheme will be able to afford annuities Again, the impact of re-risking in this way is not particularly in the future) would be to increase, rather than reduce, the striking, although we do see a small improvement in the Risk exposure to the diversified growth assets. We will re-run of Ruin. This is unsurprising given what we learned of the the Risk of Ruin increasing our initial allocation to diversified impact of de-risking above. The additional volatility from the growth assets from 60% to 80% and reduce this higher level extra allocation to diversified growth assets will affect the of growth assets to zero once the last member has retired, range of outcomes for the level of benefit losses experienced as before: by members, but does not have a significant impact on the absolute Risk of Ruin itself. Basic model: More risk: 60% diversified 80% diversified Credit rating growth assets growth assets
Aaa 1% 1% Aa 7% 6% A 14% 12% Baa 22% 20% Ba 51% 46% B 66% 62%
Both de-risking and re-risking have a minimal Choices around investment strategy impact on the Risk of Ruin but can have a very significant impact on the distribution of required cash have little impact on the Risk of Ruin in contributions from the sponsoring employer in the our basic model, primarily because the long-term. This is the manifestation of the sponsoring sponsoring employer bears most of the employer bearing the investment risk. investment risk in a scheme and our basic Trustees should therefore be more pro-active in model has no affordability constraint. discussing investment strategy with their sponsoring employer.
Of course the conclusions reached above are based Whilst a change in investment strategy might not on a simple scheme set-up and a particular economic change the Risk of Ruin and thus the likelihood that scenario generator with various other assumptions benefits will need to be reduced in the future, it being made in our modelling. The conclusions may may significantly affect the shape or extent of the vary considerably when the specific circumstances reductions required. Trustees need to consider such of a particular scheme and sponsoring employer issues given that they are required to ignore the are considered. presence of the PPF, but it can be extremely difficult to determine which profile of losses would be a better outcome for the members. This is especially important for lower rated covenants where the members will be bearing some proportion of the investment risk.
38 | Risk of Ruin 10. CONTINGENT ASSETS
In the absence of an affordability constraint we have shown that benefits only ever have to be reduced if the sponsoring employer becomes insolvent prior to the point where the scheme has been able to afford to secure full benefits for all members through annuities purchased from an insurance company. Events of sponsor insolvency are thus the key driver of the Risk of Ruin.
The problem of sponsor insolvency is not that the scheme for its full Section 75 deficit on future insolvency, then the does not get to claim the full amount it requires to secure security is over-collateralised to such an extent that you full benefits at the point of the insolvency – the Section 75 would expect the claim to be met in full in nearly all cases. deficit is a legal claim on insolvency – but that the sponsoring In practice, most security is not over-collateralised to employer is insolvent and the scheme’s position as an anywhere near this extent or as clean. However, the unsecured creditor in this process means that the claim is very variations are endless. unlikely to ever be paid in full. Without a full repayment of the Section 75 deficit, scheme benefits will have to be reduced. A more typical situation would be for the security package to be under-collateralised i.e. the reverse of the example One option to help manage the Risk of Ruin might be to change above. A Section 75 deficit of £50 million would be secured the status of the Section 75 claim from being an unsecured over a £10 million property. On insolvency, assuming the creditor to a secured creditor. Secured creditors are much more Section 75 deficit at that point is greater than the value of the likely to be paid out in full and receive on average a greater property, the property is sold and the proceeds passed to the share of their claims, more like 80% rather than the 40% we scheme. The remaining Section 75 deficit of £40 million would assume in the basic model. Crucially however, because on then be an unsecured claim and treated in the same way as average claims are not paid in full even for secured creditors, other unsecured claims. Assuming that the granting of the whilst this superior claim status would serve to materially security did not have a significant impact on the recovery rate reduce the level of benefit reduction that would apply, it expected on unsecured claims, then this will reduce losses by would not reduce the headline Risk of Ruin significantly, as full £10 million in all future scenarios. payment of the claim is still relatively rare (it is at least not practically non-existent as with an unsecured claim). Additionally, if the Section 75 deficit has come down significantly at the point of insolvency (as is expected on Of course the type of security provided to the Section 75 average) and in this example is below £10 million at the claim will be highly critical to the outcome and therefore point of insolvency, then full benefits can be paid. In effect needs to be considered and modelled on a case-by-case basis. therefore the scheme can meet benefits in full at a lower level of funding on employer insolvency than otherwise would For example, consider a scheme with a current Section 75 be the case. Of course the scheme cannot secure annuities deficit of £10 million on £50 million of assets. If the scheme with an insurance company whilst the sponsoring employer were given first charge over a property worth £50 million
Risk of Ruin | 39 remains solvent: the scheme’s claim over the property is Contingent assets therefore look to be extremely powerful contingent on the employer becoming insolvent. However, for reducing the Risk of Ruin, even before considering the the trustees can reach a position where they know that if the reduction in the benefit cuts that will have to be made employer becomes insolvent tomorrow, members’ benefits under an insolvency event where the assets are still will be met in full. insufficient to secure all members’ benefits in full with an insurance company. A contingent asset therefore reduces the target funding level at which point the scheme becomes safe from the The terms and structure of any contingent asset, as well consequences of employer insolvency. We would expect as its absolute size relative to the scheme, will be crucial this to have a significant impact on the Risk of Ruin but only to the impact that the contingent asset will have on the where the size of the asset over which security has been Risk of Ruin and thus conclusions can only be drawn on granted is significant in relation to the starting size of the a case-by-case basis. Section 75 deficit. Of course, sponsoring employers tend not to offer contingent We will therefore calculate the Risk of Ruin assuming a assets at a whim and are likely to want something from the contingent asset is established equal at the start of our scheme in return (lower cash contributions for example, or a projection to 25% of the Section 75 deficit and assume that change in investment strategy). These situations, where the the claim over this asset is fixed at that monetary amount trustees have to consider a variety of changes as one package, (or the actual Section 75 deficit at the point of contingency are where the Risk of Ruin comes into its own, as we can run if less). We will ignore any possibility of the secured claim the Risk of Ruin model both with and without the proposed not being paid in full (either because of over-collateralisation changes to the scheme. The results allow us to analyse the or because the asset is extremely secure, e.g. like cash held in aggregate impact of the changes as a whole on members’ an escrow account). This is of course a very good contingent benefit security, rather than attempting to consider each asset and we would expect a significant improvement in the element separately. Risk of Ruin.
Basic model: Contingent asset: Credit rating no security 25% of Section 75 deficit
Aaa 1% 1% Aa 7% 4% A 14% 9% Baa 22% 15% Ba 51% 38% B 66% 55%
We can see that this contingent asset reduces the Risk of Ruin across the board and by a material amount.
Lower rated covenants, such as Ba, see a material reduction from 51% to 38%: in an additional 13% of future scenarios the significant contingent asset will protect the members from any consequences from the insolvency of the employer and lead to full benefits being paid to members.
Whilst the absolute movements are lower for higher rated covenants, with an A rated covenant the Risk of Ruin only reduces from 14% to 9% and thus only an additional 5% of future outcomes result in full benefits being paid. In relative terms however, the chances of members ever having their benefits reduced has been reduced substantially, by over one-third.
40 | Risk of Ruin 11. CASH FOR DEALS?
It has become increasingly common for sponsors to look to strike deals with the members of their pension schemes, whereby members convert the benefits originally promised under the scheme into something different that better suits their personal circumstances.
The offers are structured so that the alternative benefit, while more attractive to some members, is less risky or PENSIONS FREEDOMS costly for the sponsoring employer to provide. Such deals are discussed under a variety of names: incentive exercises, On 6th April 2015, changes to taxation of pensions liability management, liability reduction exercises and were implemented which removed restrictions on how so forth. much cash could be withdrawn from pension pots and There are also a variety of types of deals, limited in range by gave members flexibility on how to take their defined the legislative and regulatory environment. The easiest to contribution pension benefits. understand is a transfer value exercise where members have The pension freedoms have been used over a million a statutory right, up to the point they start drawing their times already to withdraw more than £10 billion of benefits, to take the capital value of their promised benefits pension savings. away from the scheme to another arrangement, typically a defined contribution scheme. With the recent changes to ways in which members of defined contribution schemes can draw their benefits (see ‘Pensions freedoms’) such transfers can allow the member to take their benefits in a way which is more suited to their needs.
Risk of Ruin | 41 However, not many members choose to transfer because We can use the Risk of Ruin to consider whether the the statutory transfer terms are not overly generous. Capital members who stay behind after the transfer exercise are values are calculated on a ‘best estimate’ basis and can be benefiting in security terms and indeed whether the members further reduced if there is a deficit in the scheme. Even with would be better off receiving the ‘top ups’ in the scheme to no reduction, the ‘best estimate’ calculation is typically reduce the deficit (noting this means that the transferring considerably below the (prudent) ‘going concern’ calculation members may gain from greater security but they have lost such that someone taking a transfer of this type actually an option to transfer). improves the financial position of the scheme and hence reduces the funding deficit. We will set up a scenario to ensure that the transfer value exercise is material in the context of the scheme and thus will Sponsoring employers often wish to reduce the overall size definitely show up in the Risk of Ruin if the exercise changes of the scheme to prevent any future affordability issues the security position of members. In this case, we assume arising and to make the scheme easier to manage. Thus they the transfer value exercise results in a quarter of the deferred would prefer members to transfer on risk grounds alone, pensioners transferring away, reducing the overall funding even if it does not reduce the deficit in any material way. liabilities of the scheme by 15%. The sponsoring employer may then wish to undertake a bulk exercise offering to ‘top up’ the transfer values of any The liabilities on the ‘going concern’ valuation reduce by member transferring as part of the exercise. If the ‘top up’ is 15% but the transfer values paid amount to a cash amount sufficiently generous, then a significant number of members significantly lower than the ‘going concern’ liability. This is due may choose to transfer, reducing the size of the scheme and to the fact that the transfers are ‘best estimate’ and the ‘going the risks it presents to the sponsoring employer. concern’ valuation includes margins for prudence.
When presented with such a proposal, trustees often suggest that rather than using the ‘top up’ money for this exercise, the sponsoring employer should instead just pay it directly into the scheme such that all the members can benefit from the lump sum payment, rather than just those eligible for the exercise that elect to transfer out of the scheme.
`` TV exercise
100
Assets 80 Liabilities Deficit This chart shows the 60 movement in the assets and
£ million liabilities of the scheme in
40 our basic model as a result of the transfer exercise.
20
0 Before TV exercise After TV exercise
42 | Risk of Ruin The funding deficit has reduced because the liabilities have Undertaking the transfer exercise fractionally improves the fallen by more than the assets. benefit security of the remaining members, such that they also benefit from the exercise being undertaken, as do those One important consideration is that the Section 75 deficit who decide that the offer is beneficial to them and elect to has fallen even more significantly than the ‘going concern’ transfer. The transfer value exercise is a win-win scenario. position because of the extremely large gap between the ‘best estimate’ cost and the cost of securing annuities with an Were the sponsoring employer to divert the ‘top ups’ into the insurance company. scheme as a special deficit contribution rather than undertake the transfer exercise, we see a small improvement in the Risk We also need to take account of the ‘top ups’ that the of Ruin. However, to achieve the same degree of improvement sponsoring employer had to add to the transfer values in in the Risk of Ruin, a higher contribution of £10 million order to make them attractive to members. Were they to cost is required, as illustrated above. This is greater than the the equivalent of the reduction in the ‘going concern’ deficit, potential £5 million ‘top up’ (as an alternative to the transfer with the sponsoring employer focusing on risk reduction exercise) and thus, the transfer exercise is a more efficient rather than cost reduction, then they would cost £5 million way of improving benefit security for all members than simply in total. putting cash into the scheme. We can now compare the benefit (or otherwise) to the Risk of Ruin of undertaking the transfer value exercise, versus utilising the top-up money to fund the deficit through a special contribution towards the deficit (special ‘one off’ lump sum contributions were analysed in chapter 8).
The relevant calculations of the Risk of Ruin are shown below:
Credit Basic model: Transfers: Lump sum: rating no transfers 15% of liabilities £10 million
Aaa 1% 1% 1% Aa 7% 6% 6% A 14% 13% 13% Baa 22% 21% 21% Ba 51% 49% 49% B 66% 64% 65%
Liability reduction exercises, depending on their exact structure, are likely to leave the scheme in a slightly Spending money on liability reduction better security position and therefore trustees should generally be favourable towards them as long as the exercises is likely to be more efficient at members taking the offer are fully informed. reducing the Risk of Ruin than putting the cost of undertaking these exercises into the scheme as a special lump sum.
Risk of Ruin | 43 12. THE RISK OF RUIN IN OVERVIEW
The illustrations of the uses of the Risk of Ruin and the scenarios tested using the basic model are deliberately simplified. We have been using the Risk of Ruin approach since 2006 to test the impact of complex changes to pension schemes that include several material events occurring at the same time.
Indeed the first project we utilised the Risk of Ruin approach The Risk of Ruin model is therefore established on an for required us to model two completely different scenarios open architecture approach such that it can be adjusted in terms of covenant strength, affordability, security position, to incorporate any feature of a scheme or a sponsoring investment strategy and funding strategy (both technical employer. It can accommodate any economic scenario provisions and recovery plan setting). The difference generator and can output any data from the projections that between the two positions was so vast and the changes so is considered relevant. intertwined that trying to analyse the elements as a whole without modelling the integration of funding, investment and The Risk of Ruin looks at all changes to the scheme all covenant was impossible. Hence the Risk of Ruin was born. together and integrates the risks facing the scheme, whether investment, funding or covenant, into one single metric. We will be publishing various case studies on using the Risk of Further analyses such as the proportion of benefits paid in Ruin in the coming months to illustrate the range of benefits full, or the range of outcomes for the reductions in members’ that can be derived in complex situations. full scheme benefits are available to supplement decision making. It is therefore an ideal tool for implementing We should also bear in mind that the basic model used in this Integrated Risk Management (IRM) for schemes. report is deliberately extremely simplistic. The conclusions of the basic model as shown in this report should be considered only indicative for any specific scheme and sponsoring employer situation. The exact details of the situation have a direct impact The Risk of Ruin provides a lens through which on the Risk of Ruin and can even reverse the direction in which to view the majority of pensions problems. the Risk of Ruin moves compared to the basic model. By using the Risk of Ruin as a guide, we believe Our experience with using the Risk of Ruin is such that the both trustees and employers can vastly interaction of factors is crucial and therefore the model improve decision making in regard to needs to be calibrated to the exact position of the scheme and its sponsoring employer, ensuring all special features investment, funding, covenant and the of the situation are included. We have previously discussed strategic operation of their scheme. in a number of places that the choice of economic scenario generator can be important and trustees may wish to have certain specific factors considered in their deliberations.
44 | Risk of Ruin About us
Punter Southall Transaction Services is the specialist transactions consulting division within the leading WHAT MAKES US actuarial firm Punter Southall. The team advises DIFFERENT? private equity houses, investment companies and `` We focus our advice on the other corporate entities on the acquisition and key issues rather than listing disposal of defined benefit pension schemes as well all potential risks, thus driving shareholder value. as the ongoing management of pension liabilities. `` We do different things for A dedicated pensions transaction team was established at Punter different clients, tailoring our Southall in 1998 to build on the firm’s already well established advice to the specific needs reputation in this area and in 2003 this was branded as Punter of each of our clients. Southall Transaction Services. There are currently 12 individuals `` We provide our clients with working in the team, most of whom are Fellows of the Institute direct contact to the experts of Actuaries. in the team. The team has gained valuable experience from a broad spectrum of transaction situations encompassing a wide range of pension and employee benefit arrangements from small defined contribution plans and employee share arrangements through to multi-million pound defined benefit pension schemes.
Punter Southall Transaction Services is part of the Punter Southall Group of companies providing a unique combination of actuarial, consultancy, administration and investment services specifically for pension scheme trustees, scheme sponsors, private clients and institutions.
Risk of Ruin | 45 About the authors
RICHARD JONES FIA
Richard is Managing Director of Punter Southall in dealing with the Pensions Regulator in respect of Transaction Services. clearance and other related issues, developing innovative solutions to pension issues for clients to optimise value He has been advising corporate entities on pension and in restructuring and transaction situations. Richard investment issues since 1996 and has been at Punter also provides employer covenant advice to both Southall since 1999, including a period working for trustees and sponsoring employers. Punter Southall in Boston, USA. Richard has a degree in Business Economics and Richard has been involved in a large number of became a Fellow of the Institute of Actuaries in 2002. international mergers and acquisitions particularly involving UK and US interests, for both corporate buyers DDI: +44 (0)20 3327 5290 and private equity firms. He has significant experience Email: [email protected]
MATTHEW CLAISSE FIA
Matthew is a corporate pensions advisor and is also a key pension schemes, including the valuation of share- part of Punter Southall’s expert witness services team. based remuneration and Asset-Backed Contribution arrangements. He has focused on the provision of pensions advice to corporates since starting his actuarial career at Punter Matthew graduated from University College, Oxford, Southall Transaction Services in 2001. with a degree in Mathematics in 2001 and became a Fellow of the Institute of Actuaries in 2006. Matthew currently works for a wide range of corporate clients. He specialises in the valuation of DDI: +44 (0)20 3327 5296 complex financial instruments and risk modelling of Email: [email protected]
ALEX BATES
Alex recently passed his final exam to qualify as the pensions implications of transactions to producing an actuary. accounting disclosures and advising on triennial funding negotiations. He is also a member of Punter He joined Punter Southall in 2012, initially advising Southall’s technical committee on mortality. pension scheme trustees, before moving to Punter Southall Transaction Services in 2014 where he now Alex graduated from Bristol University with a first works advising corporate clients. class degree in Chemistry in 2011. At Punter Southall Transaction Services, Alex has been DDI: +44 (0)20 3327 5372 involved in a wide range of projects from advising on Email: [email protected]
JOHN YARROW
John is a newly qualified actuary providing support Prior to joining the team, he spent three years providing to the team’s wide range of clients, including actuarial advice to pension scheme trustee clients of corporate pensions advice for sponsors of defined Punter Southall, largely focusing on individual member benefit schemes as well as employer covenant calculations and triennial scheme funding valuations. services for trustees. Since joining Punter Southall John graduated from Newcastle University in 2011 Transaction Services in the summer of 2015, John with a Master’s degree in Mathematics. has been involved in a number of buy-in and de-risking projects, advice on exit strategies and DDI: +44 (0)20 3327 5298 sale side pensions due diligence. Email: [email protected]
46 | Risk of Ruin Contact us Visit www.pstransactions.co.uk for further information
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