A rapturous welcome was given to Chancellor George Osborne’s Budget earlier this year. The pensions industry could scarcely believe its ears when the shackles were lifted from defined contribution (DC) savers allowing them to do, effectively, as they wished with their retirement pots.
Defined benefit (DB) savers, however, were not given such freedom and for the first time DC saving suddenly looked more appealing than its DB counterpart, at least in terms of giving individuals the opportunity to take control of their funds. While DB savers are still protected from investment risk since this is absorbed by the scheme’s sponsoring employer, they must receive their pension incrementally at the behest of the trust deeds. Meanwhile, the DC saver, if they have been fortunate enough to build up a healthy pot, can blow the lot in a weekend across the casinos in Las Vegas.
Essentially this new flexibility in the DC world makes it look much greener on the other side of the fence from the DB view point and commentators already predict a significant upturn in interest in transfers.
Howard Kearns, head of liability driven investment for EMEA at State Street Global Advisors (SSGA), says: “Increased DC flexibility may encourage more people to transfer out of DB schemes, with the extent of this depending on a number of factors including age, health and size of benefits. For example, younger members, those in poor health and members with significant cash equivalent transfer values (CETVs) are arguably more likely to transfer. Some DB schemes are already reporting a significant increase in CETV enquiries.”
A flurry of activity
Consequently the government is contemplating a ban on transfers from final salary to money purchase schemes, and has launched a consultation period which concluded on 11 June. The big fear is that a flood of money out of DB and into DC will be a drain on the Exchequer as pension money abandons gilts. The consultation proposes banning transfers in the public sector, both for unfunded and funded schemes, which is highly likely to come to pass. The outcome for the private sector is less clear and the government is under pressure from employers and the industry to keep the door open.
Andrew Vaughan, outgoing chairman of the Association of Consulting Actuaries, says: “When it comes to the vexed question of restricting DB transfers to DC we believe this should not be needed. The regulatory controls around the need for advice now in place will mean transfers remain limited, and there will be a very little immediate impact on investment and financial markets which we understand are a key concern of the Treasury.”
<!–nextpage–>
However, this regulatory uncertainty means there could be a short-term rush in transfer activities as members and sponsors seek to get in ahead of any possible ban. Schemes will need to ready themselves to meet any surge in demand, which could mean making significant changes to investment and funding strategies.
Ben Roe, head of the liability management practice at Aon Hewitt, says: “We could well see a very short-term flurry of activity, as some DB members are concerned that their existing ability to transfer will be curtailed or stopped altogether at the end of the consultation period. We cannot rule out immediate anti-forestalling measures by the Treasury and we have already experienced a number of DB members wanting to ensure they can access the full Budget flexibility in the future by transferring sooner rather than later.” Roe says this puts severe pressure on members, trustees and the independent financial advisers who provide advice on the transfer, adding: “Anybody wishing to consider such a transfer needs to move fast.”
Age concern
DB schemes need to start thinking about the investment impact of significant numbers of members transferring out. This includes the liquidity demands of significant cash outflows, shorter duration of liabilities, smaller overall scheme size and a reduced timeframe over which to reach full funding. The problem schemes have is pre-empting which members are likely to leave the scheme since it will be the age of leavers that determines how investment strategies must be altered.
David Brooks, a technical director in Broadstone’s corporate benefits division, says: “It isn’t yet clear what the likely profile trend will be of members taking up the DB to DC transfers and this will be the key determinant for the types of investment held. “In cases where younger members leave the scheme the scheme’s liability profile will mature which has clear implications for the assets held, but if the transfers are dominated by older scheme members the investment ramifications are more significant. Brooks says: “It could become the norm for schemes to offer a Budget-flexible transfer at or around retirement to allow members to benefit from the flexible drawdown possibilities and to re-shape their benefits to suit their own circumstances.”
Brooks argues this will have a much more fundamental impact on investment strategy as the received wisdom of holding gilts to match long-term pension liabilities will be put under more pressure. SSGA’s Kearns says the first step in managing all this is for the pension scheme to understand the liquidity profile of the assets that it is holding to back its deferred members, which are likely to be growth assets.
“For each asset class [the scheme] should determine to what extent they can sell down the underlying holdings over a short period of time and what the likely transaction costs should be. Some growth assets are likely to be relatively liquid, such as equity index funds, but others less so; hedge funds and property for example,” Stearns says.
<!–nextpage–>
Schemes with significant allocations to alternatives, property or credit may be at risk, Stearns warns, and it may be worthwhile looking to replicate current exposures using more liquid assets. “For example, this could include using advanced beta strategies to replace existing active mandates or using synthetic credit overlays rather than physically holding credit,” Stearns says.
In cases where the scheme’s growth portfolio does not hold sufficient liquidity to cope with demand for exchange traded vehicles (ETVs) then steps need to be taken now to restructure investments, getting rid of the illiquid assets. However, this needs to be done incrementally in what Stearns calls a “controlled manner over a prolonged period”.
Brooks says there is a danger schemes are pushed into selling growth assets unnecessarily or holding too much cash for fear of a rush of ETV activity.
“The important point here is to get the balance right between not being forced sellers of higher volatility risk assets, and not being too cautious by holding unnecessary assets in cash in anticipation of paying transfers, thereby dragging down the overall return,” he says. A solution, Brooks proposes, is holding diversified growth funds which give lower volatile exposure to long-term growth, which he says “reduces both of these risks”.
The effect on buyouts
While illiquidity may force some schemes to call on the employer for additional contributions to cover immediate ETV requests, it is most likely that the lion’s share of investment strategies will have sufficient liquidity to meet demand. DB portfolios are still dominated by developed market equities which are one of the more liquid growth assets. For some schemes an exodus of DB members opens the door to further de-risking activity, and in some cases affords the opportunity to buyout. This is made more likely by the virtue of the increased attractiveness of DC post- Budget which has limited the need for employers to offer large incentives to DB members.
Hugh Nolan, chief actuary at JLT Employee Benefits, says: “DB schemes that are able to settle benefits for a high proportion of members through transfers to DC arrangements may well find a buyout for the remaining members becomes affordable, especially as it will also be possible to settle more benefits on the grounds of triviality rather than securing smaller annuities.”
Schemes may also capitalise on a possible increase in competition in the buyout market as individual annuity providers with shrinking retail businesses are tempted to enter the burgeoning bulk arena. However, Brooks is sceptical there will be any real fall in price. There is a chance predictions of a DB to DC transfer surge is overblown. A DB pension is still a highly-prized asset and members will be forced to seek advice before they switch.
Further, if the government decides to ban transfers then the issue of migration from DB to DC is redundant. However, schemes would be wise to review their investment strategies and be ready to meet any transfer requests, or ensure the sponsor is able to meet the cost.
Comments