Reducing risk in corporate pensions Myles Pink, Paternoster Faculty of Actuaries 6 December 2006 P A T E R N O S T E R

Drivers of change in the defined benefit pension buy-out market Securing pension promises “safe haven” Pensions Regulator Increasing disclosure obligations Pension Protection Fund Employee / union pressures Pension fund trustees Company directors Defined benefit pension plan Concerns about “unsecured creditor” status Improving longevity Deficit volatility

How did we get here? 2005: The Pensions Regulator replaces OPRA 1997: Gordon Brown removes tax relief on dividends OPB is replaced by OPRA MFR introduced 8000 6000 1988: Nigel Lawson taxes surpluses under SSAP24 4000 2006: SSF and PPF introduced 2001: FRS 17 disclosures introduced 2000 1990s: Contribution holidays 1985 1989 1993 1997 2001 2005 2006

Mortality rate for men aged 65-74 in England & Wales The life expectancy revolution 1841 1981 140 years 1999 18 2007 8 7.00% Mortality rate for men aged 65-74 in England & Wales 6.00% 5.00% 4.00% 3.00% 2.00% In 1841 the mortality rate for men in England & Wales aged 65-74 was 6.6% In 1981 - 140 years later - this mortality rate was 30% lower The next 30% fall was achieved in just 18 years (by 1999) We now expect a further 30% fall will be achieved by 2007 – a period of just 8 years 1.00% 0.00% 1800 2050

The pace of change has accelerated dramatically 4.0% 3.5% Average annual reduction in mortality rates for men in England & Wales aged 65-74 (smoothed) 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 1855 1885 1915 1945 1975 2005

This is partly due to the emergence of the “cohort effect” In the UK men and women born in the period 1925-45 have experienced more rapid reductions in mortality rates than generations born either before, or after, this period

Deaths from heart disease have reduced dramatically 1.8% 1.6% 1.4% Mortality rate from heart disease for men aged 65-74 in England & Wales 1.2% 1.0% 0.8% 0.6% “Premature deaths from heart disease could be eliminated with 10 years” Professor Roger Boyle, 2004 0.4% 0.2% 0.0% 1950 1960 1970 1980 1990 2000

We are now seeing mortality improvements in cancers not linked to smoking -40% -30% -20% -10% 0% 10% 20% 30% Age 40-49 Age 50-59 Age 60-69 Age 70-79 Change in incidence mortality Change in breast cancer incidence and mortality over the period 1992-2003 for females in England & Wales

Projected future improvements for the 1930-34 generation… 6.0% 5.0% 4.0% 3.0% 2.0% Medium cohort projection Published in 2002 by the Continuous Mortality Investigation Became an almost universal standard for annuity pricing Generally speaking, actuaries advising pension schemes have been somewhat slower to adopt “It’s been very difficult to persuade clients to move all the way to medium cohort” Perhaps 50% of pension schemes use medium cohort. Most of the remainder assume less rapid future improvements A Lane Clark Peacock survey showed the average life expectancy assumption for FTSE100 companies was 2 years less than implied by the PXA92 standard mortality tables with the medium cohort projection Implications Most pension schemes are using assumptions that understate likely future mortality improvements There is considerable uncertainty as to the exact magnitude of future changes Pension schemes should consider the impact of different scenarios on liabilities 1.0% 0.0% 1972 1982 1992 2002 2012 2022

Deficit for final salary pension plans Increased disclosure requirements Watson Wyatt Deloitte Willetts £-42bn FTSE 100 FRS17 £-100bn All UK companies FRS17 £-180bn All UK companies Buyout cost Deficit for final salary pension plans

Increased disclosure requirements Pension liabilities Insurance companies must operate in surplus True economic cost Pension funds can be managed in deficit Pension regulation Insurance regulation

Scheme specific funding Changes in pensions regulation PPF Pensions regulator SPV Scheme specific funding Section 75

Bulk annuity market volumes (£bn) Past performance – a growing market 3 2 Bulk annuity market volumes (£bn) 1 2000 2001 2003 2005 2002 2004

Bulk Annuity Market Volumes (£bn) Future outlook – an exploding market 100 200 300 400 500 600 700 800 900 LIABILITIES £900 billion FRS17 deficit £100 billion Buy-out deficit £300 billion No. OF SCHEMES 10,000 No OF MEMBERS 15 million Bulk Annuity Market Volumes (£bn) 2000 2001 2003 2005 2002 2004 2007+

Paternoster’s proposition Traditional buyout Low risk Risk transfer with profit share Partial/ progressive risk transfer ALM Asset return optimisation Managing deficits High risk No action Increased contributions Low funding High funding

A pension scheme buy-out Cash payment (net of tax relief) Assets Paternoster Scheme Sponsoring Company 100% of benefits Members become annuitants of Paternoster Annuitants

Partial/ progressive risk transfer A scheme can be naturally split into the liability cash flows payable to its pensioners and those to its deferred members…

Partial/ progressive risk transfer It is also possible to completely remove the liability cash flows of a scheme for a period of time…

Risk transfer with profit share £ Y m Increased benefits for former Scheme members £ Z m £ X m Paternoster Escrow account Sponsoring Company Annuitants Payment of benefits + cash commutations £ X m + £ Y m + £ Z m = Total available cash for commuted pensions

P A T E R N O S T E R

The DB scheme risk transfer process Buy-out price and structure agreed Employees informed Trustees and Pensions Regulator approval Scheme closed “On risk” events Group policy issued Employer triggers termination Liabilities assumed by Paternoster Assets plus premium paid to Paternoster Escrow established Derivatives overlay “Exchange for physicals” Data transfer Contracts novated “clean up” Escrow release Trustees wind up scheme Trustees sign deed of termination