Swaps and other derivatives which contributed to the credit crunch may be coming to the rescue of final salary pension schemes.

While some companies who still operate final salary schemes such as Fujitsu are planning to close their scheme to future accrual, Babcock International has found an alternative way to keeping this gold plated benefit for employees by sharing risk with the investment banks and insurance companies.

Caoimhe O’Neill, an Associate of Charles Russell LLP says in these financially challenging times, “every silver lining must have a cloud.” “Whereas we should be rejoicing in life expectancy rates increasing - for a 45 year old man expected age at death is now 87.6 - this has meant that annuity rates have become prohibitive for many pensions funds. The engineering firm has hedged £500 million of longevity liabilities with many other large schemes set to follow suit.”

This is all very well for the larger schemes, but the smaller schemes cannot necessarily benefit from these progressive and innovative forms of hedging. So there have been calls (primarily from the insurance industry who, as the annuity providers, are on the front line of pricing the mortality risk) on the Government to step in and issue a particular type of bond designed to be attractive to pensions schemes.

Taking the long view
These bonds known as “longevity bonds” or “survivor bonds” consist of future payments that are linked to rate of survival of a specified age group, for example those aged 55 in 2009, or those aged 60 in 2009. The idea is that the Government would share the risk with the private sector of the long term financial effects of increasing life expectancy.

“The argument that as the Government has considerable influence over the factors and public policy decisions that can determine an increase (or otherwise) in life expectancy and should not devolve all risk to the private sector, makes this option all the more interesting,” says O’Neill. Until the Government issues such bonds, hedging against longevity may remain the preserve of the larger schemes. Employers with smaller schemes may still have other creative options available which could limit the cost of providing final salary benefits without actually closing the schemes to future accrual.

Taking drastic action
The majority of employers with final salary schemes, while worried about the cost and exposure to risk, still appreciate keeping this valuable benefit as an incentive and a reward for valued employees. The most drastic step, but which produces the most instantaneous results on the bottom line involves reducing the kinds of benefits provided by the scheme.

These types of changes, unlike the investment decisions, require consultation with the members. The typical changes being considered by employers are:

• changing the benefits from a pure final salary scheme to one with an element of money purchase or introducing what is known as a “CARE” scheme;
• changing the accrual rate, moving from the traditional “1/60th” final salary scheme to one that provides benefits of “1/80th” of salary for each year of service;
• changing the definition of “pensionable salary” i.e. removing bonuses/allowances from the pension calculation;
• limiting pensionable salary to a fixed percentage rather than tracking the actual salary increases.

“Finally, there is always the option of asking the employees to share the risk of their increased life expectancy and asking them to contribute more towards their final salary pension scheme. With increased awareness now amongst members of the value of these guarantees in an otherwise freefall financial world this way not be as difficult a concept to sell as it once was,” says O’Neill.