UK - Only a handful of pension funds linked to FTSE 100 are reviewing their Value at Risk (VarR) target and so many are increasing the risk to corporate balance sheets, according to research conducted by accounting firm Deloitte.

A study of 90 pension schemes linked to the UK's top 100 listed companies by market capitalisation - 10 Companies with defined contribution pension schemes were not included - claims such is the level of risk some schemes are taking, approximately 8% of a firm's market value is at risk as a result of the liabilities on the defined benefit pension scheme, equating to £80bn (€100bn).

A further breakdown of pension schemes into sectors reveals the risks are substantially higher in market where firms have large pension fund legacy books, as the market risk at industrials firms is 18%, and 9% for utilities and customer service operations.

That said, the situation may not be as serious as Deloitte suggests, as consultants advising pension funds on their VaR have previously indicated the optimum risk calculation to use would be to deliver a 1 in 20 confidence level about the prospect of a scheme's deficit increasing to ensure the scheme still carries some form of risk to boost returns and inflation potential - the very same 1in 20 chance Deloitte suggests pension funds are taking on average. (See earlier IPE article: Sponsors to push for increased VaR focus)

David Robbins, pensions partner at Deloitte, acknowledges the standard approach of defined benefit pension funds would be to try and achieve a 1 in 20 confidence level of the scheme increasing a deficit.

However, the line taken by the accounting and actuarial firm suggests pension funds should be seeking to achieve an even lower level of risk, and sponsors' finance directors ought to take greater notice of the risk pension funds could have on their balance sheets.

"Companies need to proactively work with pension scheme trustees to focus on the right strategy for their individual circumstances," said Robbins.

"There are a range of options available to manage pension liabilities and risk. The one thing companies must not do is ignore it," he added.

While its own evidence suggests some FTSE 100 companies have seen the VaR drop to 1% of their market value, Robbins also told IPE this was in part because the size of the company was substantially higher than the value of the pension fund and less emphasis was therefore placed on the scheme.

"In truth, achieving 1 in 20 VaR would be a standard approach, but very few businesses are taking action. And there is a wide varience within the industries. Sponsors are keen to get involved. Technically, pension schemes have been on the balance sheet for years. But what has really made a difference is the latest round of funding legislation. I doubt if more than one in a thousand companies are looking at their VaR. But where cash and borrowing is an issue, [finance directors] are taking more notice," continued Robbins.

He noted there are three keys ways pension funds could tackle the VaR:
Apply a liability-driven investment strategy, at the simplest level increasing bond allocation or use derivatives to reduce interest rate and inflation risk
Offload some of the risk of ‘deferred liability management', perhaps through partial buyout of pensioners, and
Enact a transfer programme of former employees to other schemes, as adopted by P&O.

Research published this week by F&C suggests pension funds have been adopting LDI hedging in recent months.

A study of the volume of liability hedging transactions in the UK during the first half of 2008, through derivatives trading desks most closely involved in pension liability hedging at major investment banks, found the risk traded for pension funds in the first six months totaled £47m of interest rate risk and £26m of inflation rate risk.

According to F&C, this indicates trustees are now much more aware of the risk that comes from their liabilities and the solutions available to reduce it because its own calculations indicates this would hedge approximately £18bn or 2% of the total UK defined contribution liabilities, on an FRS17 basis.

In perhaps better news for pension funds, opinions expressed by those traders suggest most banks believe retail price index (RPI) swap rates might have peaked, with 60% of respondents forecasting a fall in 30 year RPI swaps in Q3 against 20% expecting a rise.

That said, 60% of respondents also believe European Harmonised Index of Consumer Prices (HICP) inflation swaps will rise because of growing demand from pension funds, while just 20% expect a fall.

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