UK - Trustees and scheme sponsors need to set clear objectives and conduct "thorough due diligence" on buyout firms when looking to reduce pension risk to avoid "costly errors", Mercer has warned.

The consulting firm has suggested in the continuing volatile investment markets trustees and sponsors should be wary of certain dangers relating to pension buyouts including either paying too much for risk reduction or remaining over-exposed to future risks.

Mercer has also warned as the number of providers of buyout and longevity solutions continues to change, schemes could risk "failing to vet buyout providers adequately", particularly as the credit crunch is beginning to affect the private equity companies, hedge funds, banks and insurers that are funding the buyout providers.

Andrew Ward, consultant in Mercer's financial strategy group, said: "Investment markets, especially credit spreads, continue to be volatile. Equities have fallen and it has become more expensive to hedge inflation.

"The credit crunch is also affecting providers' backers and their margins are already low because of competition. We're now seeing signs of upward movement in providers' prices and they are certainly becoming more selective in deciding whether to quote," he added.

The buyout market has expanded rapidly over the past two years, with the original duopoly of Legal & General and Prudential being overtaken by the entrance of both existing insurers such as Norwich Union, and new companies like Paternoster, Lucida, Rothesay Life and Pension Corporation.  

Ward admitted pensions risk is "on everyone's agenda right now" as a result, but warned with a growing range of options, such as bulk annuities, investment swaps and longevity solutions, "trustees and sponsors need to set clear objectives in terms of risk reduction - and the price they are willing to pay for it - in order to avoid costly errors".

Mercer has also argued increasing competition in the buyout market, together with economic uncertainties, means some providers may have to "raise their game to remain viable" with predictions of a consolidation in the market heightened by the apparent withdrawal of Synesis Life from the market.

Ward said: "Continued change in the market seems likely, with the potential for departures and new entrants in the not-too-distant future. Sponsors and trustees need to conduct thorough due diligence to satisfy themselves as best they can that any provider they rely on for future pension payments is both operationally and financially robust".

But the consultancy added "even where the price is right" it may make sense for the scheme to retain some risk, particularly to the benefit for the sponsor, as a full buyout through a bulk annuity means giving up the possibility of future investment gains - where longevity hedging tools may be used.

This desire to only offload part of the pension scheme risk can be seen in the recent spate of "buy-ins" or partial buyouts where providers only take on responsibility for one section of the pension scheme - usually the existing pension in payment - such as those seen in P&O's deal with Paternoster, Friends Provident's "buy-in" with Norwich Union, Delta's agreement with Pension Corporation and BBA's buyout with L&G.

Ward claimed the risks to the scheme are "particularly acute" in the case of 'buy-ins' where a scheme insures certain liabilities, typically pensions in payment, while retaining ultimate responsibility for paying pensions.

He said: "In such cases, provider instability - whether financial or operational - could result in delays in pension payments and unforeseen credit risk. In extreme circumstances, it would mean a shortfall in the money available for the scheme to meet its liabilities, with potentially dire consequences for sponsors, trustees and members."

In addition, Ward claimed that trustees purchasing a bulk annuity to offset the risk of existing pensioners could find themselves facing "two key challenges".

He warned: "First, they may find they have mitigated only a minority of their overall pension-related risk, with eth majority of that risk relating to active and deferred members still held within the scheme; and second they could find it difficult or prohibitively expensive to insure the remaining liabilities in the future."

"This highlights once again the dangers of failing to set clear, long-term objectives at the outset," added Ward.

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com

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