Corporate Briefing

Corporate Briefing
Issue 17 | October – December 2015 | towerswatson.com
Integrating funding,
investment and covenant
How can this be achieved,
and what are the benefits
to an employer?
Pensions flexibility
Financial advisers’
experience of advising
DB members so far
Withdrawal strategies
for DC retirees
Year-end UK pensions
accounting issues
Deciding how much to
withdraw each year
The potential impact of
market conditions on
2015 year-end accounting
Editorial
This quarter’s publication focuses on the key articles made available on the web
(towerswatson.com) in the last three months. As we come to the end of another year
filled with a myriad of pensions developments, it is clear from our online readership statistics
that our readers’ eyes are still drawn to articles on the (now not so) new defined contribution
(DC) pensions flexibilities. Accordingly, in the last three months alone, we have two such articles.
Lisa Wright and Simon Pariser reflect on our survey of IFAs in this field and assess what defined
benefit (DB) members have been choosing to do at retirement since April, what financial advisers’
advice models look like and how much they cost (page 04). On the DC side, Jonathan Gardner
considers appropriate withdrawal strategies for retirees on page 07.
Moving from 2015 to 2016 legislation, Ann Flynn looks at the implications of the reduced lifetime
and annual allowances for plan design, together with recent Towers Watson survey information on
clients’ proposals for replacement benefits for those who opt out (page 15).
Turning to funding for DB schemes, we reflect on the interactions between funding, investment and
employer covenant and how an integrated approach goes much further than meeting regulatory
requirements in giving the company the most effective strategy for the management of its scheme
obligations (page 10).
Of course, many finance departments will currently be in final preparations for year-end accounting.
On page 13, Andrew Mandley considers the impact of market-conditions, the cessation of
contracting-out and developments in the various accounting standards.
We have continued to see competitive pricing on recent buy-ins, highlighting again the need to be
‘buy-in ready’ to capture the moment. Settlement Watch, on page 20, gives further details, whilst
Settlement in Focus, on page 18, covers the potential impact of Solvency II in 2016.
We wish all our readers a very good (and hopefully pensions-free!) break over the holiday season.
Nick Kenny
Senior Consultant
+44 20 7170 2724
[email protected]
Ben Knight
Senior Consultant
+44 20 7170 2185
[email protected]
Nicola MacKay
Senior Consultant
+44 131 221 7849
[email protected]
Contents
Corporate Briefing
04
Pensions flexibility
Simon Pariser and
Lisa Wright take a look
at financial advisers’
experience of advising
DB members so far
07
10
Withdrawal
strategies for
DC retirees
Integrating funding,
investment and
covenant
Jonathan Gardner assesses
some rules of thumb on
withdrawal from DC funds
in retirement
Bina Mistry, Helena Mules
and Laun Middleton explore
how this can be achieved
and what the benefits are
to an employer
13
15
Pension allowances
are changing
Year-end
UK pensions
accounting issues
Ann Flynn has a look at
the immediate impact
of the proposed annual
allowance and lifetime
allowance changes on
employees and members
Andrew Mandley assesses
the potential impact of
market conditions on
2015 year-end accounting
18
20
22
Ian Aley considers the
potential impact of
Solvency II in 2016
Ian Aley and Shelly Beard
examine the bulk annuity
and longevity hedging
markets
Summary of forthcoming
Towers Watson events
and legislative timeline
Settlement in Focus
Settlement Watch
Events and
timeline
Pensions flexibility
Financial advisers’ experience of advising DB members so far
Towers Watson surveyed 15 of the market’s leading firms
of financial advisers in August 2015 to find out what defined
benefit (DB) members have been choosing to do at retirement
since April, what financial advisers’ advice models look like
and how much they cost. Simon Pariser and Lisa Wright
examine the results.
What does advice look like now?
Simon Pariser
Senior Consultant
In our experience, many of the reasons why
members wish to transfer relate to lifestyle
factors rather than which option is likely to
end up paying out the most. It is therefore
helpful from both the pension scheme’s and
the member’s perspective that all the financial
advisers we spoke to sensibly combine analysis
of the numbers (the ‘hard facts’) with consideration
of the ‘softer factors’ that will affect a member’s
decision, as illustrated in Figure 01.
Their recommendations will take into account
criteria such as health and marital status, as
well as considering inheritance, wealth and other
dependants. They all stressed the importance
of taking into account the whole picture for the
member, with near universal agreement that
precedence is given to soft factors over hard
factors for those members who are looking to
draw their income straightaway.
That said, the Financial Conduct Authority
currently requires financial advisers to carry
out a prescribed transfer value analysis (TVA)
calculation, which forms part of the numerical
analysis the members receive.
At a glance
Lisa Wright
Senior Consultant
4 towerswatson.com
•• Financial advisers take into account lifestyle factors as well
as the numbers in forming their advice.
•• Our survey showed that around half of members sent a
communication about their retirement options engaged with
the financial adviser.
•• Almost 40% of members who took advice transferred their
benefits out of their DB scheme.
Pensions flexibility
D
AR
RS
TO
C
FA
SO
FT
FA
C
Tax
RS
TO
H
Figure 01. Factors financial advisers take into account
Risk appetite
Cross-over and
break-even points
Cash flow modelling
Spouse
?
Dependants
x%
per year
TVA critical yield
analysis
What is TVA?
The TVA works out whether the transfer value
is a good deal in value terms by estimating the
return required (‘critical yield’) on the transfer
value to replicate the scheme benefits that are
being given up in the DB scheme. The higher
the critical yield, the worse value the transfer
value looks.
Most of the financial advisers we spoke to were
fairly critical of the relevance of TVA to transfers
at retirement, as it is seen as overly rigid. Most
advisers therefore use some other form of analysis
to supplement it, for example:
•• Cash flow modelling – to reflect the individual’s
financial needs in retirement.
•• Calculating ‘break-even’ points and ‘cross-over’
points – particularly when considering annuity
purchase. These help to inform at what point
in the future the member becomes ‘worse off’
by transferring and taking an annuity of
a different shape.
How much does advice cost?
It is fair to say that the cost of advice has
increased since the flexibilities were brought in;
more options mean more advice is needed.
Health
others use an online or telephone-based filter
system to root out members who perhaps have
a few questions about their options, but are
highly unlikely to transfer out.
The cost of advice usually depends on what the
member will ultimately end up doing, for example,
advice around choosing an annuity is more
expensive than a recommendation to stay in the
scheme and do nothing, whilst drawdown requires
further work still.
What choices have members made
so far?
Our survey showed that members are interested
in exploring their options. Engagement with
financial advisers was around 50%. That is, of all
the members sent a communication about their
retirement options, half called the appointed
financial adviser to find out more. However, the
advisers we spoke to told us that engagement
levels vary considerably – typically between
40% and 65% – and that clear, eye-catching
communications are key to achieving good
engagement. Face-to-face workshops further
improved the engagement rate.
The survey captured the choices of around 6,000
members who have taken advice since 6 April 2015,
when the DC flexibilities came into force. Figure 02
shows a breakdown of these members’ choices.
Pricing models vary; some advisers charge
a larger fixed up-front cost followed by lower
per-member charges and vice versa. Several
Corporate Briefing 5
Pensions flexibility
“Almost
“
40% of
members who took
advice transferred
their benefits out of
their DB scheme.”
Figure 02. Breakdown of member choices for members who took advice since 6 April 2015
Transferred, took annuity purchase
17%
Transferred, took drawdown
10%
Transferred, took cash
6%
Transferred, took combination
6%
Deferred taking benefits
53%
Retired, stayed in scheme
8%
Around half the members captured by the survey
took no immediate action after receiving advice,
instead leaving their benefits in the DB scheme.
These members will of course be able to revisit
the decision to transfer or retire early at a future
date. Anecdotal evidence suggests that this is
becoming increasingly common; although it was
not the right choice at that time, the member has
a better awareness of their options and will be
more inclined to do something sooner.
Of those members who did take action, around
20% took a pension immediately from the scheme
– this is usually a benefit to the scheme as the
payments become more certain.
Almost 40% of members who took advice
transferred their benefits out of their DB scheme.
So depending on the level of engagement, this
would suggest an expected take-up rate of the
transfer option of around 20% to 30%. For a
business-as-usual option, we would expect a
higher take-up rate as members are retiring and
so will not take the ‘defer taking benefits’ option.
Of those who transferred, almost half took an
annuity while the other half took advantage of the
new DC flexibilities. This shows that a Retirement
Transfer Option (RTO) can appeal to members
seeking a wide range of retirement outcomes,
including alternative forms of annuities, not just
those who want complete flexibility. Although the
proportion transferring out is fairly consistent
across the firms of financial advisers, some
appear to be recommending annuities over
drawdown, and others not.
It is clear from these results that members are
interested in exploring their retirement options,
but to do so financial advice is essential.
Further information
For further information please contact
your Towers Watson consultant, or:
Simon Pariser
+44 1737 274113
[email protected]
Lisa Wright
+44 161 833 6253
[email protected]
6 towerswatson.com
Withdrawal strategies for DC retirees
Under the new defined contribution (DC) flexibilities, retirees
have to decide how and when to use their retirement savings.
As annuity purchase declines in popularity, retirees will be
exposed to the risk of outliving their savings and have the difficult
decision on how much to withdraw from their funds each year.
Jonathan Gardner assesses the merits of the ‘4% a year’ guideline.
Jonathan Gardner
Senior Economist
The new pension landscape in the UK has opened
up new possibilities for retirees, who now have
to decide how and when to use their retirement
savings. If the UK follows other countries and
annuity purchase declines in popularity, retirees
will be exposed to the risk of outliving their savings
and the need to make complex decisions on how
much to withdraw from their funds each year. In
the US and elsewhere, the ‘4% a year’ rule has
emerged as the dominant rule used by financial
planners, not necessarily because it is optimal
but due to its relative simplicity and clarity. It
first emerged some 20 years ago and has since
become entrenched, despite its flaws. Such simple
rules of thumb could well find favour in guiding
behaviour amongst retirees in the UK.
How to spend it? Withdrawal
strategies in retirement
With the advent of the new flexibilities
introduced by the 2014 Budget, retirees from
DC arrangements have much greater freedom and
flexibility in how they draw their retirement savings.
But with choice comes complexity. When annuities
were universal, retirement planning was relatively
simple: to spend or save the income produced by
the state pension, defined benefit (DB) pensions
and any annuities.
Today, retirees have much greater choice on
whether to buy an annuity or not. Some 87% of
employers feel there will be demand from their
employees to take advantage of the new flexibility
At a glance
•• The new DC flexibilities present retirees with the difficult decision
as to how quickly to withdraw monies in a drawdown approach.
•• ‘Perceived wisdom’ is that withdrawing 4% of the fund per year
is a good rule of thumb.
•• However, this may be overly simplistic and alternative approaches
should be considered.
Corporate Briefing 7
Withdrawal strategies for DC retirees
“Annuities
“
are not
in high demand
in most markets
around the world.”
and use drawdown in some way (including taking
it all as cash immediately). Just under a third
(31%) of schemes are planning to offer some
form of ‘in plan’ drawdown by 2016 and a further
13% are considering its introduction in 2017
(Towers Watson, ‘Fit for Retirement Survey 2015’).
The US studies assumed a 30-year retirement
period and simulated outcomes based analysis
of historic US investment returns. Given these
assumptions, the 4% rule reduced the chance of
financial ‘ruin’ to below 10% for a typical ‘balanced’
portfolio of equity and bond investments.
If retirees do opt for drawdown, they have to decide
how the money is invested and how to draw on
their pension savings to sustain their lifestyle.
Spend too quickly and they risk running out of
money in their retirement. Spend too little and
they risk missing the point of saving for retirement
in the first place: to enjoy a satisfying retirement.
As a result there is a need for schemes to
communicate around retirement, particularly
if they plan to offer drawdown options.
Why not annuities? The annuity puzzle
It has been shown that the 4% rule is built on the
particularly favourable post-World War II investment
experience of the US. Some academics have
suggested that it does not generalise outside the
US – with 4% providing a ‘safe’ withdrawal strategy
in only 4 of 17 countries studied in the post-war
period. Recent research using updated investment
return assumptions to reflect the current more
sombre economic environment shows in over half
of cases that 4% is too high to represent a safe level
of withdrawal. For those with longer expected life
spans, the rule is even more susceptible to failure.
Annuities provide a stable income stream for
life, offering full protection against longevity risk
and allowing retirees to easily budget for their
expenses. There is no ongoing investment risk and
annuitants will benefit from what is known as the
‘mortality premium’, the extra financial return that
stems from mortality risk pooling (those who die
young subsidise those with a long life).
Based on this evidence, critics have argued for
a lower safe withdrawal rate. Such rates are, in
many cases, worse than available annuity rates.
This should not be surprising; the academic
literature has extensively documented the benefits
of annuitisation. A safe withdrawal rate may then
be near an annuity rate (more like 2.5% to 3%) but
without the loss of flexibility.
Despite these advantages, annuities are not in
high demand in most markets around the world,
with individuals reluctant to follow the textbook
arguments that annuities are the best strategy.
For many, the flexibility and ability to pass assets
on as an inheritance make drawdown a preferred
option. Others are prepared to wait and see what
happens to annuity rates and draw on their assets
in the short term. Whilst those with a DB pension
may not want or need to supplement their pension
with the additional security of an annuity.
Running out of money
So how much can retirees safely withdraw?
“Can
“
a rule devised
based on US data
over 20 years ago
be suitable for the
UK today?”
8 towerswatson.com
The 4% rule
The most widely quoted rule of thumb for
withdrawals is the 4% rule. This means that around
4% of the invested fund would be withdrawn each
year (adjusted for inflation). This is believed to be
the maximum ‘safe’ rate to withdraw – the amount
which minimises the probability of depletion of
the fund during the retiree’s lifetime. This rule
has gained increasing prominence with the new
pension freedoms, but can a rule devised based
on US data over 20 years ago be suitable for the
UK today?
Running out of money is a possibility with the
4% rule, as it does not allow for adjustments
based on poor investment performance or
life expectancy. This may be an overly strict
interpretation of how people would follow such
rules, but if adjustments occur only late in
retirement, it could by then be too late.
Imagine an investment market crash shortly after
retirement. In this scenario, a fixed withdrawal rule
can withdraw a larger portion of assets than is wise.
This highlights that the sequence of investment
returns matter with fixed withdrawals and can be
significantly detrimental if negative returns occur
at the beginning of retirement. While simulation
models do account for this (that is, you are likely
to be safe on average), for the unlucky few this is
scant consolation. Especially as such market falls
could also impact other (non-pension) investments,
heightening the risk to retirement security.
Withdrawal strategies for DC retirees
For these reasons, an alternative approach is to
instead withdraw a fixed fraction of the remaining
portfolio each year. With this strategy there is no
possibility of running out of money, but it can lead
to a volatile income stream and make planning and
budgeting difficult.
For example, with a notional £100,000 fund the
4% rule would set the withdrawal initially at £4,000.
If investment markets crashed shortly afterwards,
this would not alter. A fixed fraction rule would
instead amend the amount withdrawn downwards.
For example, setting the fraction of wealth to be
withdrawn at 4%, the initial withdrawal amount would
be the same, but if the fund fell to £75,000, the
withdrawal amount would fall to £3,000 per annum.
Other strategies
Whilst fixed withdrawal strategies are appealing
in their simplicity, this very simplicity can pose
a risk to the retiree’s financial security, given
their inflexibility in the face of changes in
circumstances. Variable withdrawal rules are more
complex but potentially more robust. They have
a two-fold objective: to minimise the probability
of ruin whilst also minimising income volatility
in retirement. A variety of approaches have
been suggested:
Floor and ceiling withdrawals. Here the withdrawal
rate is set as a fixed fraction of the remaining fund,
but within limits according to ceilings (maximum
amounts) and floors (minimum amounts).
Decision rules. Withdrawals are set initially and
adjusted subject to a series of rules on asset
returns, withdrawal rates, capital preservation
and portfolio growth.
Spending objectives. Here essential spending
is funded through a conservative portfolio, with
discretionary spending funded with a portfolio
invested in more volatile investments.
Time segmentation. Funds needed for short-term
spending are invested in safe assets and funds
with longer horizons are invested in riskier
investments.
An advantage of these approaches is that they
may help retirees stay calm during periods of
market downturn. This may help prevent excessive
caution. However, these rules are more complex to
administer and require a more engaged investor to
monitor. In some cases they may also lead to lower
returns and have a higher chance of failure.
Further information
For further information please contact your
Towers Watson consultant, or:
Jonathan Gardner
+44 1737 274097
[email protected]
Corporate Briefing 9
Integrating funding,
investment and covenant
How can this be achieved and what are the
benefits to an employer?
Bina Mistry, Helena Mules and Laun Middleton look at how
developing a corporate framework for integrating funding,
investment and covenant can be achieved and how the employer
will benefit from this.
Bina Mistry
Senior Corporate
Consultant
Employers who take control of the pension funding
agenda achieve more effective outcomes and drive
solutions which better align with their business
needs. An important requirement to achieve
these outcomes however, is for employers to be
empathetic to the needs, approach and language
of trustees when they consider pension funding
requirements. Driven by the Pensions Regulator’s
2014 Code of Practice on Funding, and subsequent
statements and guidance, trustees will more than
ever be seeking to adopt an integrated approach
to funding, investment and covenant.
The Code emphasises that the risks around
funding, investment and covenant should be
understood and managed. At the same time one
of the key principles of the Code is to consider
an appropriate funding outcome that reflects a
reasonable balance between the need to pay
promised benefits and minimising any adverse
impact on the sustainable growth of an employer.
Helena Mules
Senior Covenant
Consultant
Laun Middleton
Senior Investment
Consultant
10 towerswatson.com
What does an integrated approach look like?
Precisely what an integrated approach means is
not defined, but the main objective will be for the
employer and trustees to build a robust funding
framework that considers a range of scenarios.
One simple way of doing this is to use a framework
that focuses on:
•• Understanding the facts, so capturing the key
information on each of the funding, investment
and covenant aspects.
•• Assessing the risks, thereby understanding what
happens to funding levels if things go to plan, as
well as the options in a number of ‘what if’ upside
and downside scenarios.
•• Utilising the levers that exist in the current
funding regime to manage deficits, for example
scope for changing the prudence in assumptions,
allowing for investment outperformance and
flexing recovery plan lengths.
At a glance
•• Employers who take control of the pension funding agenda achieve
more effective outcomes and drive solutions which better align
with their business needs.
•• Precisely what an integrated approach means is not defined, but
a suitable framework can help reduce contributions and help
make effective investment decisions.
•• Undertaken in the right way and at the right time, it provides
the tools and helps employers decide upon the most effective
strategy for the management of its scheme obligations.
Integrating funding, investment and covenant
An integrated approach should not aim to set in
stone a monitoring approach or action plan, as
genuinely few employers will want to sign up to such
prescription. However, undertaken in the right way
and at the right time, it provides the tools and
ammunition to feed into discussions and help
employers decide upon the most effective strategy
for the valuation and ongoing management of its
scheme obligations. In particular, an integrated
assessment can be used to answer questions
such as:
•• How much flexibility is there in the funding
regime to allow the company to maintain
(or reduce) current contributions in different
scenarios? Or
•• Should the company consider lower risk
investment strategies that reduce the impact
of downside scenarios?
What are the key components of
the framework?
For many employers, a key focus is the
management of its cash resources – seeking
the optimal balance between minimising expected
cash costs and making them as predictable as
possible to support future business planning.
Conversely, for trustees, the ability to pay
contributions into their scheme is a key component
of the assessment of the employer covenant,
having knock on implications for the setting of
funding and investment strategies.
As such, the key initial component to the process
is understanding which entities provide support to
the scheme, their ability to generate cash and the
demands on this cash such as capital expenditure,
dividends and debt repayment. From this, based
on forward-looking plans, it is possible to determine
some boundaries of stretched and maximum
contribution levels. Additionally, an understanding
of the corporate’s key milestones such as
refinancing dates, key contract renewals and capital
expenditure programmes are also important.
The next key component is to consider the current
approach to funding and investment strategy.
Starting with the funding deficit, an assessment
can then be made of the appropriate time horizon
to meet the deficit based on current and future
investment strategy. In addition, highlighting the
prudence inherent between the funding target and
the investment strategy gives key information on
the scope to reduce prudence and/or risk in the
investment portfolio. However, such an assessment
should not be made in isolation and it is also
important to understand how funding demands and
projected journey plans may change over time as a
result of changes in asset and liability values, and in
particular the risks that the scheme could face over
the next three years – at which point the scheme’s
position will be reassessed. Three-year value at
risk assessments on upside best estimate and
downside 1-in-20 scenarios therefore give useful
book-ends to build a suitable integrated framework.
The resultant contribution profiles in each scenario
can then be considered in the context of the
capacity of the employer to flex their cash payments
and the employer’s ability to underpin the current
investment strategy.
How can the information be combined
to give meaningful results?
“By
“ the Pensions
Regulator’s 2014
Code of Practice
on Funding, and
subsequent statements
and guidance,
trustees will more
than ever be seeking
to adopt an integrated
approach to funding,
investment and
covenant.”
How the outcome from any integrated analysis
can be used will of course vary on a case by case
basis. In some scenarios, we expect employers
can use this approach to demonstrate that they
can maintain or reduce current contributions at the
current valuation, as the risk assessment indicates
there is sufficient headroom to increase recovery
plan length, use a greater allowance for investment
out-performance, or reduce the prudence in the
technical provisions.
In more extreme downside scenarios, an integrated
approach may demonstrate that if required there
would be scope to increase contributions, potentially
in conjunction with other flexibilities, allowing the
current funding strategy to be maintained and
highlighting that such scenarios, if they arise,
can be addressed at future valuations.
In other situations, the outcomes may show the
only meaningful way to manage the deficits is
to rely on the recovery plan levers, as cash is
already exhausted. Even reducing investment risk
to manage downside scenarios may not provide
meaningful. An integrated assessment would
therefore also help employers initiate a debate
on whether changing the investment strategy
can materially reduce the contribution variability
to levels which better sit within the employer’s
business plans.
“Undertaken
“
in the
right way and at
the right time, it
provides the tools
and ammunition to
feed into discussions
and help employers
decide upon the most
effective strategy.”
Figure 01 shows an example of how outcomes
from such a framework can be pieced together and
used to develop a strategy to be presented to the
trustees, arming the employer with the appropriate
responses to the types of questions they may
face from the trustees, especially if the proposals
are aimed to reduce contributions or push for
favourable employer outcomes.
Corporate Briefing 11
Integrating funding, investment and covenant
“By
“ leading the
Figure 01. Analysis of recovery plans
discussions,
£m
30
we expect that
employers should
Maximum contribution
£27.2m
achieve more
25
robust funding and
investment plans
Current recovery plan assumed
2018 deficit
£86m
5 years
10 years
15 years
13.8
5.4
2.8
20
that provide better
overall risk and
cost management.”
1-in-2 ‘best estimate’
2018 deficit
£44m
1-in-4 worst 2018 deficit
£94m
4.5
0.0
0.0
16.1
6.3
2.8
15
Stretched contribution
£10.3m
1-in-20 worst 2018 deficit £154m
29.7
14.1
8.7
10
Current contribution
£6.5m
5
0
Proactively engaging on integrated funding should
give employers a genuine understanding of the
pension risks and knowledge of how effective
each of the various mitigations are. By leading
the discussions, we expect that employers should
achieve more robust funding and investment
plans that provide better overall risk and cost
management, enabling the employer to maintain
costs at levels which better support business
planning even under significant market stresses.
12 towerswatson.com
Year-end UK pension accounting issues
UK companies with 31 December year-ends should already
be turning their attention to their pensions disclosures, and
the impact these could have on the company’s overall financial
position. Andrew Mandley assesses the potential impact of
market conditions on 2015 year-end accounting, together
with developments in the various accounting standards plus
potential plan changes.
As we approach the end of 2015, many of the
companies we work with will be thinking about
financial reporting issues. Here’s a quick
summary of what to look out for in relation
to UK pensions disclosures.
Volatile markets
Andrew Mandley
Senior Consultant
Equity markets have been particularly volatile in
2015. The FTSE 100 lost nearly 20% of its value
between its yearly high in April and low in August.
At the time of writing, the UK equity market is close
to its 2015 opening position and a similar thing can
be said about global equity markets overall, albeit
with some significant variations: Japan having done
better but emerging markets not so well.
On the liability side, corporate bond yields have
risen slightly since the turn of the year, having
been depressed for the first few months of 2015.
Looking across the FTSE 350 as a whole, it is not
really surprising that the overall accounting deficit
would have been at its highest following the equity
market falls in August. However, with the recovery
in markets since then, deficits are broadly back
to the positions seen at the start of the year
(see Figure 01).
At a glance
•• Market volatility has been high in 2015, especially equities
which had a bad run in the middle of the year. The impact will
vary scheme-by-scheme.
•• If you account under IAS, be prepared for potential changes
in the impact of ‘asset ceilings’.
•• For those accounting under UK GAAP, the implications of the
replacement of FRS 17 with FRS 102 will need to be understood.
Corporate Briefing 13
Year-end UK pension accounting issues
“The
“
FTSE 100 lost
Figure 01. FSTE 350 – Pensions accounting net deficit (£m)
nearly 20% of its
value between its
yearly high in April
and low in August.”
£
-75000
-80000
-85000
-90000
-95000
-100000
-105000
-110000
-115000
-120000
-125000
-130000
-135000
Jan 2015
25 Oct 2015
Feb 2015
Mar 2015
Apr 2015
May 2015
But what this hides is the variations between
companies. Whether your current accounting
position is better or worse than the start of the
year will depend on the scheme’s investment
strategy. With positions as volatile as they have
been, the big uncertainty is how markets will
behave in the final quarter. Not only will this impact
year-end balance sheets, but a larger deficit will
generally feed into a higher interest cost in next
year’s P&L forecast.
A number of companies are now taking an
active interest in monitoring positions. Find
out more about how the accounting (Channel)
module of Towers Watson’s Asset Liability Suite
can help you monitor your company’s accounting
position, get up-to-date forecasts of future
years’ pension costs and see the potential
impact of different scenarios in the UK.
Revisiting the IAS 19 asset ceiling
“The
“
change in
National Insurance
costs typically
will not feature in
projections
of pension costs
but it should not
be forgotten.”
The limit on the balance sheet asset in IAS 19
is one of the most difficult parts of the standard
to apply. Not only can it mean that a surplus
cannot be recognised as a balance sheet asset,
it can also mean having to recognise or increase
a balance sheet liability based on the interaction
of accounting rules and funding commitments.
The way the asset ceiling has an impact will vary
from scheme to scheme and, in the UK at least,
depends upon precise wording of the scheme’s
governing documentation.
However, the way in which the asset ceiling is
applied is likely to change soon. This means going
back to examine the scheme rules, working out
which schemes are affected by the change and
deciding what steps can be taken to mitigate any
impact. Companies that are about to agree a
funding valuation with the scheme trustees should
examine the potential accounting consequences
of these changes before signing off on a new
contribution plan.
14 towerswatson.com
Jun 2015
Jul 2015
Aug 2015
Sep 2015
Oct 2015
Many of our clients started looking at this issue
some time ago but, with the consultation period
for these changes having recently closed, the
likely impact of these changes is drawing nearer.
UK accounting standard
It cannot have escaped you that UK GAAP has
changed, and 31 December 2015 will be the first
year-end where new UK GAAP is mandatory. Where
UK statutory accounts used to be prepared using
the old Financial Report Standards, including
FRS 17 for pensions, there will be significant
change. In many cases, P&L costs will rise with
the change from expected returns on assets to net
interest cost. But those using FRS 102 in future
will find that pension disclosures can be shorter
and the asset ceiling may be less restrictive.
Groups may have been able to use the exemption
under FRS 17 that allowed all employers to account
for pensions purely on a cash basis, but in future
at least one employer will need to fully recognise
pension costs and liabilities in their accounts.
UK plan changes
The end of contracting-out in the UK from April 2016
means that most companies still providing
DB benefit accrual will be facing higher employer
and employee National Insurance costs. The
change in National Insurance costs typically will
not feature in projections of pension costs but it
should not be forgotten when setting budgets. For
those making benefit changes as a result, there are
other proposed changes to IAS 19 that could have
an impact on the treatment of P&L costs in the
part-period after a plan amendment or curtailment.
In summary, the clock is ticking fast towards
year-end, and corporates should be in discussions
with their TW consultant as soon as possible if
they are not already doing so.
Pension allowances are changing
Helping your members maximise the opportunity
Ten years after they were introduced in the great ‘simplification’
of pension tax regimes, we are now seeing the most profound
change to the annual and lifetime allowances. The changes will
affect a much broader population of employees, so schemes and
employers need to consider the immediate and longer-term
impact on those affected and the actions that must be taken.
Making pension tax allowances work –
helping your members make the change
It looks like we will never have it so good again
in terms of pension tax allowances. In our
July/August article, ‘Summer Budget changes to
Ann Flynn
Senior DC Consultant
Now we have a situation where some people
with ‘threshold income’ greater than £110,000
may no longer be entitled to contribute up to
£40k tax-free to pensions from April 2016.
However, the government has offered some
arbitrage by ending pension input periods on
8 July 2015 and creating new pension input
periods that will run to 5 April 2016. Some
individuals will be able to contribute as much
as £80,000 from pre-tax income in 2015/16
(though only those who had contributed
£40,000 by 8 July will benefit in full). Individuals
have a one-off opportunity to take advantage of
the annual allowance (AA) twice this tax year and
utilise carry-forward to maximise contributions.
the taxation of pensions', we considered the
proposed Summer Budget changes and their
impact on high earners. This article looks at what
is happening in the market in light of the changes,
including results from our recent client survey.
Threshold income is taxable income from
all sources, not just employment income:
•• Salary
•• Bonus payments
•• Dividend payments
•• Other taxable benefits-in-kind (P11D)
•• Interest on savings
•• Taxable rental income…
Plus the value of your contributions paid by a
new salary/bonus sacrifice after 8 July 2015,
less certain reliefs such as charitable
donations through payroll giving.
For those with threshold income over
£110,000, it is necessary to add on the
value of employer pension contributions
to calculate adjusted income.
Corporate Briefing 15
Pension allowances are changing
“At
“ £1m, the LTA is
Figure 01. Tapered AA
and more people.”
AA (£)
going to affect more
50,000
40,000
30,000
20,000
10,000
0
130
140
150
160
170
180
190
200
210
220
230
Adjusted income (£000s)
“In
“ our recent
employer survey,
‘Lifetime and
Annual Allowance
– alternative
benefits’, it became
apparent that 33%
had not considered
the impact of the
change in the AA.”
Actions for employers
What should employers be doing?
As the end of the tax year fast approaches actions
must be considered. There is no doubt that this is
an individual’s tax issue, however as a sponsor of
a pension scheme, how far should you go to help
members? Employer opinions vary on a spectrum of
‘it is not my problem so I am not changing anything’
to ‘let’s make sure no one breaches the allowance
by capping scheme contributions’. In our recent
employer survey, ‘Lifetime and Annual Allowance –
alternative benefits’, it became apparent that 33%
had not considered the impact of the change in the
AA. Of those participating, 67% did not have the
lifetime allowance (LTA) change on their radar yet,
possibly because they had completed an in-depth
analysis in 2013 and felt more comfortable in
knowing who may be at risk.
Assuming your attitude is a bit beyond ‘it’s not
my problem’, then these are steps you can take
to help your members:
At £1m, the LTA is going to affect more and more
people. A DC member with a pot of £600k, no
further contributions and 20 years to go until planned
retirement, with investment growth of say 3% per
annum above CPI, may well cross over the £1m
allowance and be liable to a tax charge at retirement.
•• Providing generic communications, spelling out
who might be affected and the consequences.
•• Understanding the demographic of your scheme
members; how many are above the threshold
earnings (that you know about).
•• Issuing targeted communications to those at
risk and explaining their options, including:
•• The opportunity to maximise pension
contributions in this tax year before the
reduction hits.
•• Managing pension contributions going forward
to make sure no additional tax charge applies
– this can be facilitated by providing access
to an earnings calculator.
•• Helping employees understand how they
register for LTA protection, fixed or individual.
•• Considering benefits policy to accommodate
those who will need to opt out of pension
saving due to the reduced LTA allowance or
those who will be restricted by the AA reduction.
At a glance
•• What are the new complications for pension tax allowances?
•• Who will be affected?
•• What needs to be considered in terms of immediate actions
and longer-term pension design?
16 towerswatson.com
Pension allowances are changing
What are others doing?
Figure 05. Partial allowances being offered
For those affected by the AA reduction, 42% of
employers have decided to offer alternatives to
pension contributions, with 39% not yet decided.
Figure 02. Alternatives to pension
contributions
the right way and
at the right time,
it provides the tools
25%
and ammunition
 Yes
 No
75%
39%
42%
 Yes
 No
 Decision not
made yet
19%
Figure 03. Options being offered
3%
90%
 Cash
 Employerfinanced
retirement
benefit
scheme
(unfunded
arrangement)
 Other
Figure 04. Level of cash allowance
being offered
50%
46
40%
30%
discussions and help
employers decide
upon the most
effective strategy.”
The partial allowances consist of a maximum
pension contribution of £10k (for example,
minimum AA) with an additional cash payment
to make up the difference.
As mentioned before, this is an individual tax issue
and whilst members will appreciate support from
employers they may not wish to divulge all sources
of earnings. To help you help members work out
their potential earnings we have developed an
‘AA IncomeCalc’ app.
LTA protection registration
In recent weeks we have also had confirmation
from HMRC on the transitional registration process
for LTA protection. Further clarity is needed on
these transitional arrangements but it seems both
fixed and individual protection will be available.
There is no hard deadline, but those opting for
fixed protection of up to £1.25m need to stop
contributions by 5 April and register for protection
before crystallising benefits. Individual protection
allows contributions to continue, with the LTA
set equal to the value of the individual’s pension
savings on 5 April 2016, up to a maximum of
£1.25m. Individuals applying for this will need to
be able to demonstrate what this value was.
The clock is ticking, and members need to be
aware of the implications and options available
for them.
26
20%
to feed into
Cash is king for members who choose to opt out
of the pension scheme too, whether on an LTA or
AA basis. Of employers asked, 42% said they
would offer an alternative, and 83% said this
would be cash.
In terms of the basis of the alternatives,
the following options are being offered:
7%
“Undertaken
“
in
18
10%
0%
11
Fixed rate
Linked to
DC rate
Linked to
DC rate
(core employer (maximum matching
contribution rate) employer rate)
Other
Further information
For further information please contact your
Towers Watson consultant, or:
Ann Flynn
+44 131 221 7818
[email protected]
Corporate Briefing 17
Settlement in Focus
The impact of Solvency II for UK pension schemes
Solvency II is a new EU-wide solvency regulation for insurers
that comes into effect from 1 January 2016. While it will
clearly have a significant impact on insurance companies in
Europe, do pension schemes need to worry about it? Ian Aley
considers the changes from a pension scheme’s perspective.
Is Solvency II relevant to
pension schemes?
How do insurers currently calculate
their capital reserves?
In a word, yes.
Insurance companies currently calculate their
reserves by reference to the gilt, corporate bond
and swap markets. Over the long term, corporate
bonds are expected to yield more than gilts
and swaps. They will break down this spread of
corporate bond yields over gilts and swaps yields
into three components:
The current solvency regime for insurance
companies has been in place for many years,
and there are currently considerable differences
between countries’ regimes.
Ian Aley
Head of Transactions
Solvency II is designed to ensure consistency
of supervision and reserving across European
insurers. For bulk annuity providers, the main
impact is on the capital reserves they are required
to hold. This is explored in more detail below.
In the short term, we have observed that many
insurers are devoting considerable resources to
Solvency II preparations, and in some cases this
has meant they have had to pull out of bulk
annuity tender processes until early next year.
Looking longer term, under Solvency II, many
insurers are finding that it is inefficient to hold
longevity risk on their books and are seeking to
reinsure this risk, reducing capacity for longevity
hedging and potentially causing prices to harden.
18 towerswatson.com
1. E xpected defaults: The expected loss on the
corporate bond if the lender is unwilling or
unable to repay its debt in full or on time.
2. Unexpected defaults: The additional return
required to compensate the investor for the
risk of further losses not allowed for in 1 above.
3. Illiquidity premium: The additional return
required to compensate the investor for the fact
that the market for gilts and swaps is larger and
therefore more liquid than the corresponding
corporate bond market.
Generally, insurers price using the corporate bond
yield less an allowance for expected defaults and
a further adjustment for unexpected defaults. As
the insurer does not anticipate selling the bonds it
holds, it is able to pass the illiquidity premium on
to its bulk annuity pricing, resulting in lower prices
(all other things being equal).
Settlement in Focus
What will the impact of Solvency II
be on buy-in and buy-out pricing?
There remains some uncertainty as to the
exact impact on insurers’ capital requirements
and hence the price they will charge after the
implementation of Solvency II. This is mainly
due to two key factors:
1. T he process for agreeing the appropriate level
of capital is still ongoing with the insurers’
regulator, the Prudential Regulatory Authority
(PRA). Under Solvency II, insurers are able to
assess the capital requirements either using
a ‘standard model’ – which is set by the PRA
– or they can apply to the PRA for approval of
a bespoke ‘internal model’ that better reflects
their asset strategy. Most bulk annuity providers
are seeking approval for an internal model, and
the PRA is not expected to sign these off until
late December 2015.
2. Under Solvency II, insurers must apply for what
is known as a ‘matching adjustment’, which,
at a high level, is their ability to recognise an
illiquidity premium in assets that represent
a close match for the liabilities. For some
insurers, the requirements in order to achieve
the matching adjustment have led to changes
in their investment strategy and repackaging of
some illiquid assets in order to improve their
matching characteristics.
It is therefore unlikely that we will fully know what
the pricing implications of Solvency II are until
early 2016. Conceptually, as insurers are likely
to be required to hold more capital, particularly in
respect of deferred pensioners (who have a longer
duration and are therefore harder to match), prices
are generally expected to increase to cover at
least the cost of holding this additional capital.
What are our current expectations
for price changes, and what actions
should schemes be taking before the
end of the year?
Our current expectations are that pricing for
pensioners will not change significantly, whereas
pricing for deferreds is likely to increase. In the
relatively optimistic scenario where only the cost of
the additional capital is reflected in pricing, price
increases would be a modest percentage – perhaps
5%. However, there are a number of scenarios under
which the price increases could be much higher, and
insurers have predicted price increases for some
schemes may be as high as 10%.
Overall, this means it is likely to be a slow start
to 2016 for the bulk annuity market, as insurers
finalise their internal models and begin a period
of price discovery – where they try to understand
how their revised pricing compares to those of
their competitors, and what prices bulk annuities
are closing at. Schemes that are looking at
annuitisation should look to use the next couple
of months to prepare to approach the market,
including considering whether data cleansing or
liability management could be used to close the
pricing gap.
“There
“
remains some
uncertainty as to
the exact impact
on insurers’ capital
requirements and
hence the price they
will charge after the
implementation
of Solvency II.”
“Overall,
“
this means
it’s likely to be a slow
start to 2016 for the
bulk annuity market,
as insurers finalise
their internal models
and begin a period
of price discovery.”
Further information
For more information, please contact your
Towers Watson consultant, or:
Ian Aley
+44 20 7170 2692
[email protected]
Corporate Briefing 19
Settlement Watch
Transaction markets remain strong in 2015
December 2015
Compared to the dizzy heights of 2014, 2015 looks to have
been relatively quiet for the bulk annuity and longevity
hedging markets at first glance. But does this mean that
pension schemes’, insurers’ and reinsurers’ interest is fading?
No, not at all.
Ian Aley
Head of Transactions
By the year end, we expect deals transacted over
2015 to rival those transacted in 2013, largely falling
short of the 2014 record year by the lack of a ‘mega
deal’ such as the £16bn longevity swap completed
by the BT Pension Scheme last year. Moreover, with
Solvency II coming into effect in January 2016, life
insurers have also been focusing on implementing
strategies to manage their capital requirements over
recent months, for example through selling their
pension back books (similar to a buy-out between
insurance companies) or hedging longevity risk.
Looking at activity as a whole, 2015 continues to
demonstrate strong appetite for bulk annuity and
longevity hedging transactions.
Figure 02 summarises the key headlines in the bulk
annuity and longevity hedging markets over 2015.
Figure 01 shows a comparison between the range
of ‘typical prices’ for insuring £1 pa of inflation-linked
pension for a 60-year-old male pensioner via a bulk
annuity, and the liability in respect of the same
pension using a gilt-based discount rate. The red
shading indicates the range of typical pricing which
may be available in the market.
For example, where the red shading is below the
gilts line, this suggests that a scheme may be able
to swap a portfolio of gilt holdings covering a set
of pensioner liabilities for matching annuities at
no additional cost to the scheme or sponsor. The
closer to the bottom of the funnel a transaction
sits, the more cost effective the transaction. Market
transactions have typically traded at the lower
extremity of the shaded area, whilst first round
quotes tend to be at the upper end.
Figure 01. Approximate buy-in pricing and gilt pricing for a sample member
Cost of £1 pa of pension
Shelly Beard
Senior Consultant
Buy-in pricing versus gilt pricing
41
40
39
38
37
36
35
34
33
May 2015 Jun 2015
Jul 2015
Aug 2015 Sep 2015
Oct 2015
Nov 2015
Gilts Range of possible annuity pricing*
*Where a particular transaction sits within the range of possible pricing will depend upon the specific characteristics of a scheme or transaction.
For example, insurer appetite, medical underwriting and the amount of risk transferred could impact the price quoted by insurance companies.
20 towerswatson.com
Settlement Watch
Figure 02. Transaction headlines for 2015
Overview of deals
December 2015:
November 2015:
27m medically underwritten buy-in
£
for the Renold Pension Scheme
New entrants to
the market
400m buy-in for the Wiggins Teape
£
Pension Scheme
Preparation for
Solvency II coming
into effect from
1 January 2016
November 2015:£600m longevity swap for the RAC
Pension Scheme
November 2015:
Bulk annuity and
longevity headlines
over 2015
2.4bn buy-out for the Philips UK
£
Pension Fund
October 2015: £5m buy-out for the Oundle School
Pension and Life Assurance Plan for
Non-Teaching Staff
Accelerated growth in
the medically
underwritten bulk
annuity market
2015 activity on
par with 2013
£ billion
Figure 03. Volumes of business by year
40
35
“2015
“
continues
30
to demonstrate
25
strong appetite for
bulk annuity and
20
longevity hedging
15
transactions.”
10
5
0
2008
2009
2010
2011
2012
2013
2014
2015
Longevity swap Synthetic buy-in Bulk annuities
Market terms are subject to considerable variability and at any one date a wide range of quotations could be
obtained from different providers. Ultimately, the actual position can only be determined by obtaining actual
quotations and completing a buy-out.
Settlement Watch uses pricing data from a range of insurance companies including Aviva, L&G, Pension
Insurance Corporation and Rothesay Life.
Further information
For more information on Settlement Watch,
or assistance in exploring the position of your
scheme, please contact your Towers Watson
consultant, or:
Ian Aley
+44 20 7170 2692
[email protected]
Shelly Beard
+44 117 989 7439
[email protected]
Corporate Briefing 21
Events
Towers Watson regularly runs
webinars, forums and other events
of interest to sponsors of pension and
benefit arrangements. Please speak
to your Towers Watson consultant
or visit events.towerswatson.com
to register.
Performance management webcast
This practical webcast will share findings from our recently
held Talent Management and Rewards Study along
with some insights into the ever-changing landscape of
performance management. This will include investigating
the impacts and frequency of organisations choosing a
‘ratingless’ approach and assessing the role technology can
play when facilitating performance management processes.
9 February 2016
2016 Job Levelling and Architecture Summit
Join us at our 10th anniversary Job Levelling and
Architecture Summit, where we will be reviewing the
evolution that has occurred over the last decade and
examining how leading-edge programmes are transforming
the present by truly supporting the employee life cycle.
11-12 February 2016
Timeline
Key forthcoming legislative events and milestones are
listed below:
2015 (tbc)
Announcement on
equalising for the effects
of unequal GMPs
16 March 2016
Budget to contain
Government decision
on future of pensions
tax relief
April 2016
Scottish Parliament
gets new income
tax powers
April 2016
Lifetime Allowance
will reduce to £1m
6 April 2016
End of contracting out
for DB schemes
2017
Update on government
plans to allow pensioners
to sell annuities
April 2016
Tapered reduction in
annual allowance for
people with earnings
over £150,000
April 2016
Ban on differential
charging and DC
commission
5 April 2016
Deadline for passing
a resolution to amend
scheme rules to permit
a refund of surplus to
the employer
31 December 2016
Proposed implementation
of revised EU Pensions
Directive
Review of DC charge cap
1 April 2017
5 April 2017
Deadline for Individual
Protection 2014
applications
6 May 2017
Deadline for review of
how State Pension Age
should change to take
account of life expectancy
April 2018
– April 2019
End of automatic
enrolment transitional
periods for DC schemes
(following postponement)
22 towerswatson.com
December 2015
NEST contribution
limit and bulk transfer
ban lifted
April 2017
Expected that law will
allow consumers to
sell annuities
30 September
2017
End of automatic
enrolment transitional
period for DB and
hybrid schemes
AA IncomeCalc
The new app from Towers Watson
Towers Watson’s AA IncomeCalc app provides your employees
and scheme members with an easy-to-use tool to assess whether
the changes to the Annual Allowance will impact on their plans
for making tax efficient pension contributions. There is no cost
to download the app.
Download now!
The IncomeCalc app should be supplemented by
wider employer sponsored support and communication
initiatives. The issues are complex and individual
employees should not take any action without first
reviewing the options offered by their employer and,
if necessary, taking specific financial advice.
The AA IncomeCalc app will let your members and employees estimate:
• Threshold income – if threshold income is £110,000 or more then adjusted income needs to be assessed.
• Adjusted income – the level of Annual Allowance will reduce if adjusted income is more than £150,000.
• Annual allowance – will reduce to £10,000 for adjusted incomes of £210,000 or more.
AA IncomeCalc app will let your employees and scheme members test different scenarios to explore their optimum contribution
rates whilst maximising tax relief.
For further information contact your
Towers Watson consultant, or email
[email protected]
towerswatson.com
Copyright © 2015 Towers Watson. All rights reserved.
TW-EU-16-WEB-1256b. November 2015.
Apple, the Apple logo, iPad, and iPhone are trademarks of Apple Inc., registered in the U.S.
and other countries. App Store is a service mark of Apple Inc. Android and Google Play are
trademarks of Google Inc.
/company/towerswatson
@towerswatson
/towerswatson
About Towers Watson
Towers Watson is a leading global professional services
company that helps organisations improve performance
through effective people, risk and financial management.
With 16,000 associates around the world, we offer
consulting, technology and solutions in the areas of
benefits, talent management, rewards, and risk and
capital management. Learn more at towerswatson.com
Towers Watson
71 High Holborn
London
WC1V 6TP
Towers Watson is represented in the UK by Towers Watson Limited.
The information in this publication is of general interest
and guidance. Action should not be taken on the basis of
any article without seeking specific advice.
To unsubscribe, email [email protected]
with the publication name as the subject and include your
name, title and company address.
Copyright © 2015 Towers Watson. All rights reserved.
TW-EU-2015-45699. December 2015.
towerswatson.com
/company/towerswatson@towerswatson /towerswatson