DB-DC transfer uncertainty compounds schemes' demographic challenge

Most of the focus generated by these changes has been on the corresponding deterioration in pension schemes’ funding levels and what can be done to limit this risk.

But there has also been a significant impact on the day-to-day management of pension schemes, in particular how schemes can invest to match their uncertain liabilities while still maintaining enough liquidity to meet their daily cash needs.

Clearly increasing life expectancy means pensions will on average be paid to members at a later age, but it may also affect when members choose to retire.

Uncertainty over pension scheme cash flows has been heightened further in recent weeks following the Budget. In this, George Osborne announced that individuals with defined contribution pension savings would now have complete flexibility as to how and when they used these funds, taking it all as cash on day one if they wished.

Understandably a sizeable number of members in defined benefit pension schemes who have not yet retired may be looking at these arrangements enviously and considering their own options.

These members have always had the right to transfer a lump sum in place of their accrued pensions to a DC arrangement, but such transfers have been relatively infrequent in recent years.

Transfer risk

The government is now consulting on whether to continue to allow DB members this option, as it is worried that a sudden rush of members taking a transfer could have a negative impact on the wider economy.

The concern is that a large number of members taking the option could lead to a material reduction in demand from schemes for corporate bonds and gilts, which could drive up borrowing costs for companies and the government alike.

DB pension schemes typically invest a proportion of their assets in liability-driven investment, which aims to match the asset proceeds to the benefits paid to their pensioners. For schemes that have hedged their exposure to interest rates and inflation, they will have done this on a projection of cash flows that relies heavily on how long members are expected to live.

Some schemes have different investment strategies for the assets they notionally hold for their members who have already retired, relative to non-retired members, with schemes typically investing more heavily in return-seeking assets before a member’s retirement.

Clearly then the question as to when members will retire via the scheme, assuming they do not first transfer out, will be of particular importance as it will impact the timing of movements from return-seeking assets and the level and timing of cash flows to be matched in LDI.

Until the results of the government’s consultation on DB to DC transfers is in, there is little schemes can do to manage the uncertainty around when benefit payments to a given member may start.

However, for both the investment approaches outlined above, the appeal of removing the uncertainty of life expectancy through, for example, a longevity swap is obvious. Not only will it protect a scheme’s funding position against future improvements in longevity, it will also provide a fixed set of cash flows to target with an LDI strategy.

An alternative is to use a bulk annuity, whereby an insurer agrees to pay future benefits in return for a one-off payment and in the process taking on all the associated risks from the scheme.

Sadie Hayes is a transactions consultant at Towers Watson