Market uncertainty presents challenges for SA corporates

Many South African companies that still have defined benefit obligations towards their active and retired staff face the risk that the cost of this obligation cannot be projected with certainty. Examples of such obligations include defined benefit pension funds and post retirement medical aid subsidy obligations. The associated cost uncertainty can have a significant impact on the company’s financial accounts.

This is according to Louis Theron, Actuarial Specialist at Liberty Corporate, who spoke at the Actuarial Society of South Africa (ASSA) Actuarial Convention, held at the Sandton Convention Centre on Thursday. He said that companies that still have defined benefit obligations to former and existing staff must decide on the appropriate funding and investment strategies that will deal with this uncertainty and the impact on the expected costs of these benefits.

An important consideration in this regard is the discount rate assumption used to calculate the expected costs. The framework to consider in choosing an appropriate discount rate assumption are discussed in the research paper by Ishara Sukhraj and Theron titled "Swapping your funding basis”.

The aim of the convention was to promote dialogue and debate within the profession, so as to encourage modern ideas and fresh solutions that apply to a new and increasingly complex retirement world.

Theron says that while defined benefit pension funds have not been subject to such huge swings in deficits locally, given the nature of these schemes, the sponsor (usually an employer) and trustees do still face a number of significant risks.

"One of these is the issue of longevity; a scheme needs to ensure that it has sufficient investments should members live longer than expected. In addition, it also needs to find investment solutions that will grow in line with the liability.”

For companies that do have defined benefit obligations, there are two important questions to ask. Firstly, how to determine the expected cost of the defined benefit obligations i.e. the funding strategy; and secondly, in what assets should the employer invest to fund its defined benefit obligations i.e. the investment strategy.

Theron continues to say that risks associated with defined benefit schemes can be difficult to determine and that any misjudgements can also be very costly to the fund and the employer. "As a result, there is often a preference to transfer these risks to insurance companies that specialise in managing these kinds of liabilities.”

It is important for any employer that considers transferring such a risk to understand what de-risking solutions are available, such as a cash flow hedge, a buy-in or buy-out policy, as the choice of product they opt for would depend on the amount of risk and assets the company or trustees are willing to transfer.

"A cash flow hedge is where the fund purchases a series of future cash flows from an insurer. These cash flows are specified in advance and are usually based on the fund’s expectation of its future benefit payments. If the fund’s projections are correct, the purchased cash flows will exactly match its outflows. However, the fund bears the risk if the expected cash flows are incorrect.”

Theron says a buy-in policy is where the insurer issues a grouped annuity policy based on the actual lives of pensioners in the pension fund. "This policy acts as an asset of the fund, guaranteeing to pay benefits for as long as the pensioners are alive. Although the fund retains the ultimate liability, the policy acts as a hedge to its longevity and investment risks.”

"A buy-out policy is when the pensioners are the owners of the policy and not the fund. If this policy is accepted by the pensioners (the pensioners have a right to decline), the pension fund will be released from its responsibility towards them. Instead, the relationship will be directly between the pensioners and the insurer.”

"Trustees that are considering transferring the liability of a defined benefit pension fund also need to understand the level of financial support the employer is willing to give, should there be a shortfall.

"The cost of such solutions depends heavily on prevailing market conditions, which can change rapidly. For any company or trustees that are considering transferring such a liability, it is critical that they carefully consider what options are available and employ the services of consulting and actuarial specialists who can guide them through the process,” concludes Theron.