Annual survey of pension financial risk – special contributions continue to rise

Special contributions to pension schemes have risen for the third year in a row as companies continue to address pension risk, according to the Annual Survey of Pension Financial Risk carried out by Mercer and the Association of Corporate Treasurers.
According to the report, the number of FTSE 350 companies making special contributions (i.e. over and above normal contributions) to their UK or overseas schemes increased from 58 percent in 2007 to 66 percent in 2008. 

This group was driven by general pressure from trustees (19 percent), general risk mitigation (27 percent), PPF Levy (8 percent), strengthened mortality assumptions (16 percent) tax (13.5 percent) and Pension Regulator triggers (5.6 percent).

The number of respondents undertaking specific financings in connection with special contributions has fallen from 20 percent to around 11 percent – the same level as 2006.
According to Dave Robertson, Worldwide Partner in Mercer’s Financial Strategy Group:

“This suggests that some sponsors believe discretionary risk mitigation and improved funding levels add value to the firm.” Another reason offered by respondents is the utilisation of strong cash flow from operations.  In one case, a special contribution related to a deal between sponsor and trustees on discretionary benefit increases.
The report also highlighted that 37 percent of schemes had strengthened their mortality assumptions but noted that even these revised levels fell short of the benchmark which the Pension Regulator recently focused on.

Just over half the respondents felt that there had been a change in perception of the sponsor’s credit risk as a result of the upheaval in the market place. Perhaps more surprisingly, more than a third thought that there had not.  
“This may be because, for these schemes, the deficit is small in absolute terms, or in relation to the size of the sponsor,” commented Dave Robertson.

“Equally, it may simply be that the ‘stickiness’ of credit ratings has led many trustees to believe that there has been no material adverse change in sponsor creditworthiness, despite the evidence presented by bond spreads, credit default swap prices and other market indicators.

“We would expect all trustee groups to at least consider this, since they are expected to focus on employer covenant throughout the valuation cycle”.
After a significant increase in 2007, the proportion of schemes using interest and inflation hedging derivatives has remained almost unchanged. Both stand at close to 20 percent.

The proportion using derivatives for currency protection (approximately 25 percent ) has also changed little since 2007, while there was negligible use of credit protection derivatives and no use at all of longevity derivatives.

Three-quarters of those undertaking interest rate and inflation hedges had used derivatives directly while the remainder had used indirect methods such as investing in ‘bucket funds’.

In these cases, trustees took the initiative in negotiating derivatives documentation in over half of cases, despite the potential greater existing familiarity of sponsors.

Notwithstanding the turmoil in credit markets, only one-third of schemes had reviewed the underlying collateral arrangements.
The use of contingent assets by schemes has fallen back, from 16 percent to 11 percent. Of these, 60 percent were using parent/other group company guarantees.

52 percent of respondents said that they were likely to consider further de-risking of their schemes in the event that the PPF modified the risk-based levy formula to take into account investment risk.
A large proportion of respondents (31 percent) believed that there was an adverse general impact of recent pension legislation on corporate activity, almost unchanged from last year.

The proportion that thought there was an adverse impact on their company specifically was also little changed, at 53 percent.

In the event that proposed changes to pension accounting standards (such as the introduction of a risk-free discount rate) are adopted, 60 percent of respondents said that they were likely to modify the funding or investment strategy of their schemes, or modify benefits.

Just under half (40 percent) stated that these changes would make them consider buy-out more seriously.
“There is no single right or wrong level of risk that should be acceptable to a pension scheme and its sponsor,” commented Dave Robertson.

“However, the contention that scheme trustees and sponsors should understand the level of risk that they are running is now broadly accepted. Once this has been done, they can make informed decisions about whether to modify that level of risk and, if so, how they should do so.”
Richard Raeburn, ACT Chief Executive, commented:

“Risk and the management of pension schemes are inextricably linked; the results of our survey underline the contribution treasurers make to the risk mitigation process as volatile market conditions continue to change overall risk profiles.”

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