Lucida: Risky business – John Smitherman-Cairns
As finance directors look for ways of managing down the risk of their pension schemes, they must select from a complex array of solutions, both within their company and externally. John Smitherman-Cairns of Lucida explains the benefits of transacting with an insurance company and the importance of an individually tailored approach.
Over the last few years, the pensions market has followed a clear-cut trend. With companies seeking to protect against volatility, de-risking solutions are in greater demand than ever, and the market is evolving to meet this demand.
While much of the risk can be managed internally, the external market is growing fast. Increasingly, finance directors are calling upon insurance companies to take on the liability from their pension funds, thus transferring the risk and administrative burden elsewhere and freeing up resource to focus on their core business.
"We are in a period where more and more UK corporates are looking to take risk off the table," says John Smitherman-Cairns, corporate development director at Lucida. "For many it's not a case of, are they going to de-risk? It's a case of, when are they going to de-risk and what approach are they going to take?"
These are pertinent questions for finance directors, who are generally the ones tasked with writing the cheque. Of late, they have been making some very significant contributions to pension schemes. For example, in 2010, around £10 billion was paid in as deficit funding by FTSE 100 companies alone.
"They don't want that payment to just go into what they might see as the black hole of the defined benefit pension scheme," says Smitherman-Cairns. "That's what's driving a lot of the de-risking activity we're seeing in the market."
For those that transact with external providers, the product offering is extensive. In recent times, there has been much discussion of buy-outs, where the liabilities are transferred directly to the insurance company, and buy-ins, where the insurance policy fully matches the scheme liabilities. The particularly striking thing, however, is the number of ways these products can be adapted.
"Some companies want full risk transfer solutions, whereas others want, or can only afford, solutions that just address a slice of the risk," says Smitherman-Cairns. "Within defined benefit pension schemes there are obviously risks around longevity, and we're seeing a lot of reports in the market around how people are living longer and the burden they're placing on corporates. With a longevity swap, the scheme chooses to retain all the other risks of the pension scheme, but passes on the longevity risk to an external party."
Flexible, strategic solutions
As an insurance company specialising in annuity and longevity risk business, Lucida offers a full and nuanced range of solutions. Progressive buy-outs, for example, allow clients to purchase a series of insurance policies over time, each covering a different portion of the scheme and leading ultimately to a full pension de-risking solution. This fits better with some organisations' funding plans and helps them to selectively de-risk.
Day one risk transfer, meanwhile, removes risk instantaneously while also giving the insurance company responsibility for closing the pension scheme.
The difficult thing from a client's perspective is working out what will work best for them specifically. "There has been a rapid expansion in the range of products offered, and that creates opportunities for pension funds, but also some confusion," says Smitherman-Cairns. "So this is a process where clients often turn to expert support. We are very happy to sit down with trustee boards and companies, and talk them through what they are trying to achieve and how we can customise the product to deliver that."
Lucida prides itself on delivering the optimum blend of strategies to meet each company's requirements. The aim is to engage clients in open discussion at the earliest possible stage.
Its individual focus extends right through to the payment schedule. In this regard, Lucida is immensely flexible, as Smitherman-Cairns explains: "We offer deferred premiums, where a corporate can secure an insurance policy immediately with part of the premium deferred and paid to the insurer at a later date, say five years. This enables the pension scheme to retain a degree of investment freedom or fund the premium through future agreed contributions.
"Rather than crystallise recent losses, deferred premiums provide the pension scheme with the opportunity to benefit from future increases in the value of the retained assets before paying them to the insurer," he continues. "This opens up possibilities to clients that have seen deficits emerge or widen and concluded that they cannot, at present, afford to transact. Therefore, there are answers if your asset values have fallen. Solutions just need to be a bit more sophisticated to deal with the current market volatility."
Ultimately, the advisability of transacting will depend upon a corporate's investment profile and objectives. Although the last few years have not been kind to many funds, this does not apply across the board. If a company's scheme, for example, holds a portfolio of gilts, transacting may not be as expensive as the true cost of holding on to the risk.
The cost of de-risking will also depend on whether the client is coming from an accounting or a funding perspective. Most trustee boards are focused on their funding liability, but companies will also be focused on the P&L and balance sheet impact. Clear communication between the parties will be imperative.
Corporates that do not wish to transact tend to focus on modifying benefits and restructuring their schemes to dampen down some of the liability. Solutions include early retirement programmes, enhanced transfer value exercises and pension increase exchanges. However, many businesses are running what is in essence a quasi-insurance company on the side with limited control over the way the risks are managed.
"We monitor what's happening in the markets almost on an hour-by-hour basis," says Smitherman-Cairns. "We make sure that we're selectively trading our assets to take advantage of market opportunities, and that is quite an intensive approach to managing our exposure. A pension scheme has quite a different governance structure, and is not always in a position to be able to react the same way."
The crucial thing is to stay savvy in the face of a rapidly changing picture. As pension costs continue to rise, and the market remains unpredictable, defined benefit pension schemes are starting to seem untenable.
Corporates are jumping onto the de-risking bandwagon in their droves. In the UK, around £30 billion of insurance-based deals have been performed since 2006, with roughly £7 billion of those deals originating with FTSE 100 companies.
Nor do present market trends show any sign of abating.
"I think we're in a time where the product offering has become increasingly sophisticated to appeal to a wide range of client needs," says Smitherman-Cairns. "But if we look forward and take account of the growing demand for de-risking solutions, I believe capacity could become a key issue.
"Writing insurance protection for defined benefit pension schemes is a capital intensive proposition and demand has the prospect of outstripping capacity, unless significant new capital comes into the market."
For now, the onus is on trustees and sponsors to manage risk intelligently - a tricky process made simpler through harnessing all available expertise. "This is where trustees and corporate sponsors could benefit from a detailed conversation, either with their advisors or with insurance companies, just to talk through their options," says Smitherman-Cairns. "And there always will be options with so many innovations on the product front."