Internal controls, TKU requirements and "de-risking" of liabilities – managing risk?

In this pre-Christmas issue, we have chosen to focus on risk-avoidance and consider the Regulator's new guidance on internal controls, the introduction of the new Trustee Knowledge and Understanding (TKU) requirements and a growing trend amongst certain trustee bodies to look at steps designed to try to "de-risk" their liabilities.

Regulator's guidance on Internal Controls
The Regulator has renewed the focus on risks faced by pension schemes with the publication of revised draft guidance on internal controls - this guidance is currently out to consultation. In tandem with the revised guidance, new "bite-sized" e-learning modules have been released to provide an overview of the issues surrounding internal controls. The aim of this new guidance is to ensure that trustees (especially in smaller schemes) are equipped to perform their role in protecting pensions, particularly given the current economic difficulties being faced across the country. Although the Regulator states the guidance is aimed at "smaller schemes" it has not clarified precisely which schemes fall within this category. The Regulator does seem, in any event, to have focussed on smaller schemes since it considers that the majority of larger schemes already have adequate internal control mechanisms in place. 

The key message in the guidance is that trustees must have processes in place to identify and manage their scheme's most critical areas of risk. Schemes must put appropriate controls in place in seven key risk areas:- lack of knowledge and understanding; conflicts of interest, ineffective relations with advisers, poor record-keeping, deterioration in the employer covenant, investment risk and ineffective retirement processes. In addition to tackling the seven key areas of risk, the Regulator suggests that trustees should carry out an annual risk assessment and put in place a risk register – both of these tools should help ensure internal controls are satisfactory.

Although many of the key risks identified by the Regulator are already covered in existing guidance, the draft guidance on internal controls is different in that it examines the inherent risks that trustees should try to mitigate.   The Regulator makes it clear that those schemes that do not have appropriate internal controls in place must act promptly to put in place appropriate measures or risk being pursued for a breach of the law. There will inevitably be cost implications for some schemes which are not currently as focussed on internal controls as the Regulator's new guidance recommends, particularly as risk management is described as an ongoing process whereby trustees should continually review their exposure to new and emerging risks. 

The draft guidance includes a long (but not exhaustive) list of scenarios within each of the seven risk categories and describes the type of control procedures that trustees should have in place to deal with these situations. The closing date for the consultation is 1 March 2010. Once the guidance has been finalised we will provide further advice for schemes on ensuring compliance.

New TKU requirements in force
As you may recall, in our September 2009 E-Bulletin we focussed on the new draft code of practice on TKU that was laid before Parliament earlier this year. This code of practice is now in force and amongst other things, "raises the bar" in relation to a trustee's required level of knowledge of the trust deed and rules for his/her own particular scheme. Ensuring adequate standards of TKU is, of course, key to any scheme risk management strategy. Trustees requiring assistance on compliance with the new regime (or Scheme Managers concerned as to current TKU standards) should contact us directly for tailored advice or training.

Trying to "de-risk" liabilities – longevity swaps*
Various types of liability driven investment have been attracting attention recently as sponsoring employers focus on risk management. Aside from the well known insurance-based options such as buy-outs and buy-ins, a relatively new option has appeared in the market – longevity swaps. 

Longevity swaps may be considered by a scheme as an isolated option or perhaps as part of a package of other types of swaps. Any scheme considering a longevity swap is essentially trying to protect against the risk of members living longer than expected. In practice, the swap provider pays defined annual pension amounts to the scheme and in return the scheme must pay fixed premiums to the swap provider. Those schemes that are attracted to such swaps are doing so primarily because they are drawn by the ability to "fix" their future risk as far as longevity of members is concerned - the scheme will always make the same fixed payments, regardless of what happens in terms of longevity. The motivation for swap providers is that, although they must cover the cost if longevity increases above current expectations, there is a potential financial benefit to them if longevity decreases.

Although at present the high costs involved mean that generally only large schemes are considering longevity swaps as an option, this is something that may change. There are, however, considerable risks that can arise from embarking on longevity swaps and any scheme considering such a move will require to take very detailed and careful expert investment, actuarial and legal advice. The most significant risk for schemes considering longevity swaps would seem to be the strength of the swap provider's covenant and it is likely that it will always be extremely difficult for trustees to be confident that the swap provider is still going to be around (and have a strong covenant) for the next 50 years. There are also numerous other issues including what will happen in the event that the scheme enters a winding-up process. This interesting new area is undoubtedly, however, one to monitor for the future to see how the product develops.

*Please note that the material in this E-Bulletin does not constitute investment advice and you should not rely on any material in it to make (or refrain from making) any decision or take (or refrain from taking) any action. Any scheme seeking to make investment decisions in relation to its scheme must first take expert advice.

18 December 2009