How DB schemes manage risk to ensure pensions will be paid for years to come Paul Darlow and Ben Gold, 18 February 2016

2 Introductions Ben Gold is the Head of our Investment Team in Leeds Paul Darlow is the Head of Proposition Development

3 Investment markets and the financial health of UK pension schemes

4 The state of investment markets Equity markets have performed poorly in recent months

5 The state of investment markets Source: Datastream Gilt yields since 1996 Gilt yields have been falling for a generation

6 The financial position of pension schemes These factors have combined to hurt UK pension schemes recently

7 The journey to fully-funded: assets Current assets Assets for full funding in 10 years Contributions Investment growth

8 The journey to fully-funded: liabilities Current liabilities Liabilities in 10 years Member options and “liability management” exercises

9 Member options and liability management exercises

10 How long will the member live? What will the member’s pension be when they retire? Pension scheme risks When will the member retire? How much pension will the member exchange for a cash lump sum at retirement? What will inflation be in the future? When the member dies will they have a spouse? What benefit will be payable to the spouse? What returns will be generated on the scheme’s assets? Will the company continue to be able to support the pension scheme in future? There is therefore significant uncertainty and risk associated with Defined Benefit pensions Pension schemes may have to make payments for 80 more years!

11 Member and liability management options Expected cost of providing benefits Money pension scheme needs to hold. Calculated “prudently” Because of the risk, pension scheme liabilities are calculated prudently Additional assets needed

12 Member and liability management options Expected cost of providing benefits Money pension scheme needs to hold calculated “prudently” Cost of member options Reduction in funding target if member exercises option Member options and liability management exercises can either reduce the amount of risk, or reduce the cost of providing benefits

13 Types of member and liability management options Trivial commutation Transfer values Embed trivial commutation option at 55 Transfer values Trivial commutation Pension increase exchange Transfer values Embed pension increase exchange at retirement Buy-in Buy-in (perhaps medically-underwritten) Transfer values Active members Deferred pensioners Current pensioners Reduce cost of accrual Close to new entrants Cease accrual Not forgetting: Data cleansing, Mortality screening, WULS and buy-out! Embed pension increase exchange, trivial commutation and transfer values

14 Member options and liability management exercises Trivial commutation

15 Trivial commutation The exchange of small pension benefits for a cash lump sum OR Pension £50 per month for life Cash lump sum of £14,400 ?

16 Trivial commutation Open to people over age 55 whether or not their pension is already in payment

17 Trivial commutation Reduces pension scheme risk (marginally) Reduces administration costs Attractive to most members Pay out (marginally) less than prudent liabilities

18 Member options and liability management exercises Transfer values

19 Transfer values Moving Defined Benefit pensions to a Defined Contribution pension scheme OR Pension £833 per month for life Transfer value of £240,000 ? Open to people with pensions that are not yet in payment

20 Transfer values If Jo has other wealth this option may be attractive If Jo had other pension income, this option may be attractive £43k + £60k £10,600 pa No increases, single life £10,600 pa No increases, single life £12,700 pa Impaired, No increases, single life £12,700 pa Impaired, No increases, single life + OR £6,450 pa LPI increases £6,450 pa LPI increases Tax-free lump sum Annual Pension Tax-free lump sum Annual Pension DB scheme benefitsTransfer, immediate annuitisationTransfer, take as cash £60k Tax-free lump sum £180k Lump sum subject to tax If Jo was unhealthy, this option may be attractive If Jo was single, this option may be attractive If Jo is married and healthy with no other pension income this option may be attractive + £240k Transfer, leave invested Jo, age 64 DB pension entitlement of £10,000 pa Transfer value of £240,000 Investment

21 Transfer values Even if transfer values are enhanced, there will still be a saving again a prudent liability

22 Transfer values Reduces pension scheme risk Reduces administration costs Attractive to certain members Pay out less than prudent liabilities

23 Member options and liability management exercises Pension increase exchange

24 Pension increase exchange Exchanging future pension increases for a higher pension now Pension of £1,000 increasing with inflation every year OR

25 Pension increase exchange Exchanging future pension increases for a higher pension now Pension of £1,300 with no increases

26 Pension increase exchange Exchanging future pension increases for a higher pension now Pension of £1,000 increasing with inflation every year Pension of £1,300 with no increases

27 Pension increase exchange Member decisions are most commonly driven by their current and future income needs as well as their views on life expectancy How long will I live? Do I want extra income now? What income will I need in the future? What will inflation be in the future? Will I be better off?

28 Pension increase exchange Reduces pension scheme risk Brings forward payments Attractive to many members Reduces the value of prudent liabilities

29 Managing investment risk through Liability Driven Investment

30 What is LDI?  Liability Driven Investment  Investing with reference to your liabilities  Managing interest rate and inflation risk

31 Our clients’ experience of LDI We and our clients are big supporters of LDI as a risk management tool All schemesSchemes with assets under £50m Average hedge ratio Source: Xafinity

32 Accessible to all Wide range of providers, many pooled solutions, minimum investments in thousands

33 Impact of LDI on funding volatility LDI is a hugely impactful tool in the toolkit for managing funding level volatility Source: Xafinity (Assets £80m, Liabilities £100m, Liability duration 20 years, Assets 50% growth/50% matching) Equities and giltsDGF and gilts Equities and LDIDGF and LDI 35%65%

34 What next for gilt yields? Yields have been falling for a generation... Over the past 15 years, index-linked gilt yields have steadily fallen by around 3% Source: Datastream

35 The market is already pricing in yield rises:  Base rates are expected to be 1.6% in 3 years  Long term yield rises of 0.5% pa are already priced in What next for gilt yields?...but yield rises are already priced in... Yield rises of 0.5% pa are already priced in and supply of gilts is limited Source: Bank of England, Debt Management Office Rising interest rates will only impact pension schemes positively if the realised yields are above the position already “priced in” Yield rises are already priced in

36 What next for gilt yields?...and the market has continuously over-anticipated Base Rate rises The market has continuously priced in rate increases... and continuously been wrong Source: Bank of England

37 What next for gilt yields? Plus, don’t forget supply and demand There aren’t enough gilts to cover pension liabilities and existing available supply is limited DB scheme liabilities £2.0tn Source: Bank of England, Debt Management Office, Pensions Regulator Total gilt market £1.45tn There aren’t enough gilts to cover liabilities There aren’t many index- linked or long gilts Perhaps 55% of gilts are “tied up” Light blue is ILGs, dark blue is nominal gilts, values in £bn

38 What next for gilt yields? Plus, don’t forget supply and demand New issuance is projected to significantly decrease and it is consistently oversubscribed Source: Debt Management Office Net gilt issuance is likely to fall Demand for new issuance in 2015 is high (especially ILGs) Blue dots are fixed gilts, grey index-linked gilts. The size of the dot reflects the amount of the issue

39 Pensions insurance – the ultimate de- risking tool

Overview of a pensioner buy-in policy Deferred liabilities Scheme assets Pensioner buy-in policy Other assets Pensioner liabilities Before buy-in After buy-in Insurance company Payments £Xm p.a. Deferred liabilities Pensioner liabilities Pensioners Pension payments £Xm p.a. Pensioners Payments £Xm p.a. Depending on price of the policy Pension scheme

Overview of a buy-out policy Deferred liabilities Scheme assets Pensioner liabilities Before buy-out After buy-out Insurance company Payments (£Xm p.a. plus all future amounts) Pensioners Pension payments £Xm p.a. Pensioners Pension scheme Assets plus “top-up” premium transferred on day one

42 Questions ?

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