Aviva: Risk removal in the real world – Nick Johnson
Understanding pension exposure is crucial to corporate risk management, particularly at present when market conditions remain so uncertain. Nick Johnson, director of distribution, defined benefit risk management, at Aviva, discusses popular new products and the advantages of full risk reduction.
Defined benefit pension schemes have become harder to manage over recent years. Investment returns fell sharply during the financial crisis and asset values remain highly volatile thanks to trouble in the eurozone. Other risk types such as inflation, longevity and tighter regulation mean that ignoring liability is no longer an option for business leaders.
"Companies need to understand what their underlying risks are," says Nick Johnson, head of defined benefit risk management at Aviva. "They need to look at how they inter-relate and how their scheme's assets and liabilities are reflected in their assessment of value."
The case for controlling pension liabilities is clear, but the cost of full risk reduction seems unaffordable to many companies at a time when they are experiencing financial pressures from many directions. Determining the price of a buy-out is also a challenge given the instability of equity markets and the length of time required to reach a deal. For those unable or unwilling to purchase a full buy-out, the temptation is to use partial de-risking vehicles, which take out certain chosen liabilities. These have risen in popularity recently, but Johnson is aware of their disadvantages.
"Taking risk off the table in smaller, manageable chunks is obviously more advisable than doing nothing, but it still carries problems," he says. "By removing certain low-risk elements from the scheme and leaving it with less attractive liabilities, you may find yourself unable to find a provider - should you want to - that is willing to de-risk those sections. Partial de-risking also tends to overstate the cost a particular section has on the overall fund and, by reducing it, you may harden the assumptions on the remainder of the scheme."
Extra choice requires change
A flurry of new innovations has sprung up as demand for global de-risking expands. Trustees and employers are both keen to mitigate their risk profiles at the earliest opportunity, while insurance providers are eager to increase their market share. This rise in new products increases choice, but it's not entirely positive, according to Johnson, who recommends a change to the way the innovation process is structured.
"Innovation can introduce transaction and other legislative risk, which can only be removed if the providers and the schemes work together," he says. "I think there's a certain irony in the current set-up. Many trustee advisers spend their time thinking of new insurance products to pitch at the providers. But the insurance companies do more or less the same thing; they innovate and then try to convince a scheme that they should use the new product. It would surely be a better use of each others' skill sets and knowledge to work together in developing a new solution to a specific requirement."
Four particular products have become popular in the market over the past few years. For those prepared to take on more risk, enhanced transfer values can, in certain circumstances, provide the opportunity to better manage benefit provisions. Those who want to increase their immediate pension in the short term by removing inflation protection can use pension increase exchanges. These can be particularly helpful if the individual's lifestyle and income are right.
"They're both useful products depending on the circumstances," Johnson says. "But I think enhanced annuities, for people with health conditions, offer the easiest potential gain for scheme members. Although, of course, it's arguable that the additional value seen by the members reflects the scheme overpaying for that particular benefit."
Longevity swaps are often seen as cutting-edge risk reduction market innovations. These new, rather complex products have proved particularly attractive to several larger pension schemes.
"They're popular products, but they carry quite a few risks," Johnson says. "The level of complexity in the collateral and legal structures hasn't been tested in the event of a party failing. The cost can also appear quite high when expressed as a percentage of expected cashflow. And, finally, should the scheme wish to take the next step and buy out, it's unclear whether the full value of the swap could be realised."
For Johnson, using an insurance provider such as Aviva, which has the knowledge and experience to plan what a full end-to-end de-risking journey should look like, is key. Not only can this provide a company with greater understanding of their underlying liabilities, it removes the negative impact that certain de-risking exercises can have on the remaining schemes.