Providing pensions flexibility to manage defined benefit pensions risk in a volatile world
25 August 2016
By Roslyn Williams
Gilt yield lows following the EU referendum result and subsequent rate cut have led to increasing Defined Benefit (DB) pension scheme deficits, clearly demonstrating the risk and volatility that schemes and sponsors are currently exposed to. Given this market uncertainty, the critical question for companies and trustees is how they can address this risk and ensure stability for the scheme – and ultimately its members - over the longer term.
One way of reducing risk is member option exercises, also known as member incentive or liability management exercises. These exercises offer members a raft of options to reshape their retirement benefits. An exercise of this kind not only reduces the deficit, but also removes liabilities, shrinking the overall size of a scheme. What’s more is that they are cost effective – spending £1 on a member options exercise typically results in a deficit reduction of more than £1.
Is now the right time to launch a member options exercise?
In this post referendum low gilt yield environment, transfer values have increased and, as a result, look relatively more attractive to members when making Flexible Retirement Option (FRO*) offers. Whilst some corporates may be concerned about settling liability in current conditions, recent events have emphasised the need to take action to address pension risk now. With an expectation that yields will stay lower for longer, the real question is whether there is any benefit in waiting? For many schemes, the choice is clear; if no action is taken, the members currently approaching retirement will retire within the scheme, meaning the only option to remove risk in the future will be to insure their benefits at a significantly higher cost than the corresponding transfer value.
The same story holds for Enhanced Transfer Values (ETVs**). ETVs currently look attractive to members and may be beneficial to sponsors on a journey towards buying out their scheme.
If the expected upward pressure on inflation materialises, this will lead to a reduction in the savings that can be made from running a Pension Increase Exchange (PIE***) exercise. Schemes and sponsors may therefore want to implement a PIE sooner rather than later, although uncertainty about future inflation could lead to lower numbers accepting the option than in the past.
Member options have become a tried and tested option for significantly reducing risk and giving members more choice in how they take their benefits. With pension schemes facing more uncertainty than ever following the EU referendum, these exercises will form an important tool for schemes to mitigate risk.
*FRO – gives members over their minimum pension age the ability to transfer their DB pension into an alternative arrangement where they can either retire immediately and change the form of their benefit or invest and subsequently draw their benefits to suit their circumstances.
**ETV – gives members below their minimum pension age the opportunity to transfer their defined benefits, along with a top-up from the sponsor, into an alternative arrangement so that when they reach retirement they will have more flexibility in how they take their benefits.
***PIE – gives pensioners the option to receive a higher pension in exchange for giving up all future non-statutory pension increases.