Introductions

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

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

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 Gilt yields have been falling for a generation Gilt yields since 1996 Source: Datastream

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

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

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. Pension scheme risks Pension schemes may have to make payments for 80 more years! When will the member retire? What will the member’s pension be when they retire? How much pension will the member exchange for a cash lump sum at retirement? What will inflation be in the future? How long will the member live? 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

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

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

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

14. Member options and liability management exercises Trivial commutation

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

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

17. Trivial commutation

18. Member options and liability management exercises Transfer values

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

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

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

22. Transfer values

23. Member options and liability management exercises Pension increase exchange

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

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

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

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

28. Pension increase exchange

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 All schemes Schemes with assets under £50m Average hedge ratio Source: Xafinity We and our clients are big supporters of LDI as a risk management tool

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

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

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

35. What next for gilt yields?...but yield rises are already priced in... Yield rises are already priced in 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 Rising interest rates will only impact pension schemes positively if the realised yields are above the position already “priced in” Source: Bank of England, Debt Management Office Yield rises of 0.5% pa are already priced in and supply of gilts is limited

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

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

38. What next for gilt yields?Plus, don’t forget supply and demand 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 Source: Debt Management Office New issuance is projected to significantly decrease and it is consistently oversubscribed

39. Pensions insurance – the ultimate de-risking tool

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

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

42. Questions ?

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