David Prosser: How to park the pension liabilities
Tuesday 02 February 2010
Outlook Closing the company pension scheme is not the only option for employers worried about the cost of final salary plans, despite what you may have heard in recent months about the end of defined contribution provision being nigh.
Look closely at the explanations given by employers for closing final salary schemes and you'll discover that uncertainty about future costs, rather than concern about today's bill, is their most common motivation. And the good news is that there are ways to reduce that uncertainty.
BMW is the latest in the small but growing number of firms hedging against longevity risk by offloading some of its potential liabilities in the UK to a third party. The detail of the deal has yet to be announced, but BMW may be able to offload as much as £2.5bn worth of risk.
These deals could be crucial for employers with large final salary funds: even the difference between having to close only to new members or to shut up shop altogether.
What's really hit employers for six over the past couple of decades has been the rapid increase in life expectancy of Britons. Companies provided final salary pension benefits on the basis they would have to pay out for a set period, only to discover their assumptions about the duration of this period fell significantly short of reality. Cue a much larger than expected pension bill.
With deals like the one BMW is currently exploring, the risk of making this mistake again in the future is offloaded to a specialist insurer. The employer pays a premium for this protection, safe in the knowledge that if staff live longer than expected, the extra costs falling on the pension scheme as a result will be absorbed by the insurer.
In the short term, longevity risk deals may increase the cost of final salary pension benefits because insurers price some room for error – and some profit – into the premiums they charge. Crucially though this sort of deal reduces the risk of a scheme facing an unexpected bill 10 or 20 years into the future. You might see the contract as a pension industry version of a fixed-rate mortgage. The cost of such loans may be higher for the cheapest variable rate mortgages, but you have certainty about future payments.
Longevity risk is not the only unknown in a pension scheme's finances. Funding requirements will also fluctuate as investment returns rise and fall, and in line with other market movements. However, a deal such as this will substantially reduce volatility in pension scheme finances.
As such, it is to be hoped more companies follow BMW's lead. For employees that value their membership of a final salary scheme (even if it is closed to new joiners) longevity insurance could make all the difference to them keeping it.
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