Pension schemes risk further volatility

Many schemes still face significant pension deficit volatility as a result of mis-matches between assets and liabilities, according to Mercer Human Resource Consulting.

Although the de-risking of defined benefit pension schemes continues, Mercer's FTSE 350 Pension Scheme Survey shows that for the most exposed 5% of the FTSE 350, the median impact of a 1-in-20 year adverse event (e.g. a major collapse in equity markets combined with low interest rates) could reduce their market cap by at least 12%.

John Hawkins, a principal in Mercer's Financial Strategy Group, commented: "Increasingly, scheme sponsors are using risk assessment tools such as Value-at-Risk to estimate the impact of adverse developments on pension deficits and how these translate into changes in key financial metrics for employers. This analysis is driving the growth in liability-driven investment. However, there is still a long way to go."

Solvency deficits

There has been a strengthening of IAS19 (International Accounting Standards) assumptions, relating, for example, to longevity. This, and the increased competitiveness of the annuity market, has reduced the estimated liability buy-out premium above IAS19 levels from an historical 40% to around 25%. Alongside other market innovations, such as online auctions, this has driven the total FTSE 350 buy-out deficit as at 30 June down to around £120 billion – little more than half its previous level.

Mr Hawkins commented: "This is music to the ears of the new annuity providers. Unfortunately it still represents an average buy-out deficit of over £300 million per employer. It is far from clear that shareholders would consider money spent on annuities a good investment. For the time being activity will remain focused on smaller schemes."

Mortality

Although the median scheme is still well below the PMA92 medium cohort level, companies reporting later in 2007 have continued to disclose stronger longevity assumptions. Even the schemes with the weakest initial assumptions are assuming significant rates of future longevity improvement.

According to Mr Hawkins: "Longevity calculations are complex and the right measure is the subject of much debate. You can spend hours debating the right interest rate and inflation assumptions for a scheme but weeks debating longevity. However, evidence does show that schemes with weak assumptions feel under pressure to move closer to their peers. Excellent work is being done across the market in to develop longevity hedging products. However, take-up is likely to be low until realistic assumptions are commonly adopted."