Lloyds derisks to stabilise scheme funding

Changes to accounting standards and stricter capital adequacy requirements introduced since the financial crisis have led banks to take steps to reduce the volatility in their pension schemes.

Lloyds Bank Pension Scheme No. 1 increased its bond allocation to 61.3 per cent in 2013, up from 49.8 per cent in 2012. Its equity allocation decreased to 14.3 per cent in 2013 from 22.7 per cent in 2012.

“We have been working with the trustees of the pension schemes over the last three years to increase investment in bonds to provide greater stability of the schemes’ financial positions,” said a Lloyds Banking Group spokesperson. The scheme's funding level deteriorated to 77 per cent in 2012 from 82 per cent in 2011 according to its most recent statement.

Property and hedge funds made up 24.4 per cent of the portfolio in 2013. In 2012, 25.8 per cent was alternatives and 1.7 per cent was cash.

Managing regulation

The Basel III capital adequacy requirements demand banks to increase their use of ‘tier one’ assets, such as shareholders’ equity, retained profits, and preference shares, to back the risk from their pension schemes.

Mike Smedley, pensions partner at consultancy KPMG, said the main effect of this on banks is that the accounting deficit will feed through into its total capital.

“Banks care about their accounting deficit, but their trustees don’t,” said Smedley. The capital requirements have more effect on banks as sponsoring employers than other types of companies, as changes in the deficit have less impact.

Banks and their schemes may be more likely to invest in lower-risk assets to decrease the volatility the pension poses.

“We could see it filter through to investment strategy,” said Simon Taylor, associate at consultancy Barnett Waddingham.

“Some banks have made moves in that direction. A safer investment strategy generally means more contributions. It’s a balance between contributions and risk.”

Banks can also use management actions such as introducing salary caps or closing accrual to mitigate against risk, he said. Lloyds proposed a reduction in annual pensionable pay increases last year.

Managing costs

Another alternative is transitioning into defined contribution schemes, which have no effect on the funding position. “We’re generally seeing banks cutting back on DB benefits,” said Smedley. “Ultimately you can get rid of all risk by going to an insurer [for a buyout], but the big banks are too big.”

Prior to the regulatory shift companies could smooth out large changes in funding positions over a period of time or offset them by subtracting capital from future contributions.

“Historically [banks] didn’t have to worry so much about the volatility of the funding position because they could replace it with future contributions,” said John O’Brien, a partner in the financial strategy group at consultancy Mercer.

“[Now] there will be a focus on minimising the volatility of the balance sheet position,” he said.

The use of derivatives to hedge against risks such as equity downside may provide a unique opportunity for banks looking to decrease volatility.

Basel III will change the mindset of banks regarding their pensions and may produce long-term benefits for members, said O’Brien, adding: “Banks will be very mindful of trying to keep their funding stable.

“You could argue capital rules are in members’ best interests as a derisked scheme is less reliant on the employer. From a risk perspective most of the initiative would align with members interests.”