Banks unveil products to address mounting deficits as cost of providing pensions rises, writes Dominic Coyle.

It's been a good few years for pensions - or so the headline figures would have you believe.

Returns for group-managed pension funds over the 12 months to the end of April have topped 26 per cent on average, with the top performers managing a 28.5 per cent increase. Over the last three years, returns have averaged more than 16.5 per cent.

At a time when inflation has been averaging somewhere between 2 and 3 per cent, it sounds as though members of occupational pension schemes have little to worry about.

However, the figures are deceptive. While buoyant, they measure only the performance of pension fund assets. What they don't take account of are fund liabilities - and these have been rising consistently in recent years.

In 2004, for instance, Irish pension funds managed to fall further into the red despite a 10.4 per cent return on assets, as liabilities climbed by 15 per cent.

The first quarter of 2006 has seen a startling turnaround. Having fallen by more than one percentage point in three years to the end of 2005, bond yields rose 3.2 per cent at that point to 4 per cent by the end of March.

"The improvement in the first quarter of 2006 represents by far the most significant rise we have witnessed over any single quarter since 1999 and sees the ratio at its best level since mid-2002," said Mercer senior investment consultant Michael Curtin.

However, gains of this magnitude are rare and bond yields remain at the heart of the problems with pension liabilities.

The difficulty is twofold. First, people are living significantly longer. For those in defined contribution schemes, this means their accrued pension fund will have to be spread more thinly over a greater number of years. In the case of defined benefit schemes, the actuarial assumptions on which funding plans are based are having to be rewritten - imposing increased costs on either employer or the scheme member.

Second, bond yields have been in the doldrums. That has effectively pushed up the cost of providing pensions. "This problem has become increasingly worrying for many companies as the pension plan deficit is now shown on corporate balance sheets," says Thomas Farrell, actuarial product manager at Bank of Ireland Global Markets.

"In extreme cases, the deficit can be so large that it impacts on the company's ability to pay out dividends. There is also evidence that rating agencies may include the level of pension fund deficit when assigning a credit rating. This, in turn, may impinge on a company's cost of borrowing."

In an effort to more closely align assets with liabilities, pension schemes are now beginning to look at liability-driven investments (LDI) - which first examines pension fund liabilities before deciding on an investment of assets that will meet them.

The first LDI scheme embarked on by a pension scheme was UK company Boots which, in 2001, decided to switch all its fund assets into bonds. It was a remarkably unsophisticated LDI and the market has moved on considerably since then.

Bank of Ireland is now unveiling the first domestic LDI product as pension schemes here struggle with strict funding standards and new accountancy rules.

LDI uses a series of derivative contracts - interest rate and inflation swaps - to align asset inflows with benefit pouts. The liability profile of the particular pension scheme will determine the mix of each type of swap and the range of terms over which they run.

"We are creating a synthetic bond effectively, creating an asset that will make the required payout in X years' time," said Farrell. "The whole process is about managing risk. We want to introduce as little risk as possible and yet be certain that we are going to generate cash."

John Conway, head of institutional business development at Bank of Ireland Asset Management (BIAM), says a key selling point of the bank's LDI offering will be its price transparency in what is a "murky" area. "We will be getting paid out of the management fee and will not be taking the usual margin on money market trades."

That, he says, will give customers confidence that the price at which the bank strikes a deal is the best price available - an important consideration in a world where a five basis points (five cent) difference in the pricing of a contract can ultimately amount to a difference of €1 million or more.

"It is important to note that LDI strategies do not remove all the risk associated with a pension fund," says Farrell. "In particular, there may be a mismatch between the euro-zone inflation targeted and the Irish inflation that is affecting the liabilities. Other risks, such as the longevity risk also remain.

"Despite these drawbacks, it is fair to say an LDI strategy does remove a large proportion of the risk associated with pension fund investment and therefore deserves serious consideration by pension fund trustees and sponsors."