The ongoing bout of equity market chaos and resultant slump in sovereign bond yields appears to have thwarted the long-awaited kick-starting of the UK pension fund buy-out market.

However, corporate sponsors keen to see the back of their closed defined benefit pension schemes are being offered a wide range of options as financial innovation finally appears to be catching up with the problem.

This may prove galling to the rash of specialist insurers that have entered the pension buy-out market in the past year and, until July, looked set to finally start to receive some serious business.

Rising equity markets and bond yields pushed the aggregate surplus of the UK's 7,783 DB schemes to Pounds 99bn, according to the Pension Protection Fund, as of June, making the buy-out option - historically priced at around 130 per cent of scheme liabilities, as calculated by the FRS17 measure - affordable for a growing number of schemes.

But market movements have since eroded this surplus and, according to June Mulroy, executive director of business delivery at the Pensions Regulator, extinguished this burst of enthusiasm, temporarily at least.

"I think there were a number of people out there who were considering the buy-out route who pulled out, organisations that were pretty well funded," Ms Mulroy says.

Interestingly, the market turbulence does not yet appear to have damped down merger and acquisition activity, with swathes of companies still lining up to seek clearance from the regulator before completing transactions that affect employer covenants.

"This has been the hottest M&A season we have seen in some time and (the market turbulence) has not stopped M&A," says Ms Mulroy.

"Seven of the FTSE 100 companies came through our doors in the same week."

Rank Group, the casino and bingo group operator, does still appear to be persevering with the buy-out option, having engaged Mercer to explore options for its Pounds 700m pension scheme - potentially making it the first large company to voluntarily enter buy-out.

But the marketplace is rapidly evolving, with a range of alternative, and potentially cheaper, options opening up for decently funded pension schemes, which the regulator has been happy to clear.

Last month, Citigroup carried off an innovative deal when it took on the Pounds 200m closed pension scheme of Thomson Regional Newspapers. Crucially, Citi plans to continue operating the scheme, rather than winding it up and replacing it with a series of annuity contracts as in the buy-out model.

This regulatory arbitrage, keeping the scheme in the pension regulatory space, rather than the realm of insurance regulation, potentially allows Citi - and the banks and insurance companies rumoured to be keen to follow its lead - to undercut the buy-out operators. The Pension Corporation, a consortium headed by Edmund Truell, the founder of private equity group Duke Street Capital, had already blazed a similar trail.

In May it completed the UK's largest ever corporate pension deal, snapping up the Pounds 1.2bn Thorn scheme, as well as the smaller Thresher fund, with the intention of keeping the schemes alive, for the the time being at least. The Pension Corp deal differed from Citi's transaction in one crucial respect. The consortium bought the relevant operating companies as well as the pension schemes, only to sell the bulk of the trading companies soon after.

However, Mr Truell is keen to extend this model to sponsors that merely want to offload their pension scheme, and is in talks with several companies over such deals, including Age Foodservice, in which the Pension Corp has bought a 10 per cent stake in the hope of participating in a "re-rating" of the operating business if the pension scheme, at Pounds 792m significantly larger than Aga's Pounds 490m market capitalisation, is removed from the balance sheet.

Like Citi, Mr Truell, who is backed by the likes of HBOS, Royal Bank of Scotland, ABN Amro and Swiss Re, is reluctant to discuss prices. However, such deals are believed to be comfortably cheaper than the traditional buy-out route.

"We have come up with a much more affordable way to totally sever the sponsor's obligations to the pension scheme," says Mr Truell, who claims to have the capacity to write Pounds 25bn of business.

This innovation, and the increased competition it is sparking, is providing unheralded opportunities for closed DB schemes. Graham Mitchell, senior consultant at Watson Wyatt, estimates the cost of a Citi-style transaction is likely to be in the region of just 115-120 per cent of FRS17 liabilities, undercutting the traditional buy-out model.

"We would expect there to be considerable interest in this from a considerable number of pension schemes," he says.

However, the buy-out merchants are fighting back with John Hawkins, principal at Mercer, noting that some are quoting premiums of as little as 20 per cent over FRS17, as well as offering profit-sharing schemes.

In common with most of the new entrants to the buy-out market, Mr Hawkins argues that a number of buy-out deals are in train, and he fully expects some of them to reach fruition.

Mr Truell, whose initial foray into the pension sector was via an insurance company he established last year, also believes the buy-out route still has some validity, remaining the preferred option of some trustees.

However, he does fear a cull, warning: "Whether all these new entrants are going to be around in due course I doubt, because some of their backers are going to be disappointed with their slow progress."

Ms Mulroy, from her vantage point at the heart of industry, offers her own words of caution for the new entrants that flocked to the sector in anticipation of great riches.

"There are an awful lot of people out there who seem to think there is a pot of gold sitting in these pension schemes," she says.

"I'm not at all convinced that a pot of gold is as imminent as people think it is."

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Lane, Clark & Peacock’s annual survey of pension funds has confirmed the findings of other recent reports: that UK pension schemes are now back in the black. Its figure of £12bn for the aggregate surplus of FTSE 100 companies is lower than some other reports, but it reinforces the increasingly upbeat assessment of UK pension funds.

The same survey last year put the combined FTSE 100 deficit at £36bn, which would indicate a £50bn turnaround in the last twelve months. Most of the improvement has been courtesy of buoyant investment markets - notwithstanding the volatility of the past few weeks - with investment returns producing a £30bn bonus for schemes and higher bond yields contributing an additional windfall of £10bn.

Given that pension schemes have achieved this astonishing turnaround in such a short space of time, was all the recent hysteria about pensions being in crisis, overdone? Did all the companies that closed their final salary pension schemes, either to new entrants or completely, act too hastily?

The short answer is that unfortunately, these figures are merely a snapshot of funding positions at one point last month. The assets invested in large occupational pension funds are so large that the figures could vary enormously from day to day. Many of the factors underlying the pensions crisis remain in place.

LC&P calculates the combined pension assets of FTSE 100 final salary schemes as £351bn, with liabilities totalling £339m. Almost two-thirds of pension fund money remains invested in volatile equities, despite a recent trend for matching schemes’ asset mixes more closely to their liability profiles.

Given the mini-correction suffered by global stock markets since mid-July, the £12bn surplus of the survey could have been significantly lower. LC&P notes there is a one in 10 chance of the figure fluctuating upwards or downwards by as much as £80bn over the next 12 months.

So as long as equities avoid another bear run like that of 2000-2003, are pensions in the clear? Not quite. The two most major problems for pension schemes in recent years are not connected to the volatility of global investment markets (or even Gordon Browns £5bn ‘tax raid’, which may have been unhelpful but has had little impact in the context of larger issues).

Firstly, changes to the law in 2003 have, in some cases, increased the cost of pension schemes by as much as 50 per cent. The changes required schemes to increase their annual contributions to pension in payment by more generous amounts. This is one reason why finance directors are now required to authorise substantially larger pension contributions from employers – according to LC&P, they paid in almost 20 per cent more in 2006 than in 2005.

Secondly, improved life expectancy is increasing the length and therefore the cost of pension payments. And more fundamentally, scheme advisers keep underestimating their longevity assumptions. LC&P has pointed out that its figure of £12bn would be higher if the majority of schemes had not increased their longevity assumptions over the past year.

But these assumptions are still underestimating the scale of the problem. The Institute of Actuaries in England and its Scottish counterpart, the Faculty of Actuaries, recently warned pension schemes that longevity assumptions need to be revised upwards once again. Each additional year of assumed longevity adds £12bn to the combined liabilities of the large final salary schemes.

Clearly some schemes are in a much healthier position for the future. However several large companies including British Airways, HSBC and Lloyds TSB, are still in the red on pensions, and other are only in the black following significant one-off payments from sponsoring employers.

Final pension schemes are not yet out of the woods. More companies are going to close their plans to reduce liabilities. Costs are going to continue to rise. And if LC&P picks the wrong day to publish its annual snapshot in 2008, we’ll be firmly back in crisis territory.

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Reading about the pension industry is not usually an uplifting experience. But recently there has been a rare example of some good news. The aggregate funding position of the 7,783 defined benefit schemes monitored by the UK’s Pension Protection Fund swung to a surplus of £99 billion in June 2007, compared with a deficit of £8 billion a year earlier. These findings, the first since the PPF started monitoring in 2002, are reflected by reports from several other observers.

In addition the total number of schemes in the red fell from 6,002 to 4,750, with a combined deficit down from £66 billion to £30 billion. Interestingly the aggregate surplus of the 3,001 schemes in the black rose to £127 billion compared with just £58 billion a year ago.

So does that mean we can all sit back, relax and congratulate the industry on a job well done? The answer is that in reality, it’s never that simple.

The PPF has calculated its figures using s179, which is broadly what an insurer would have to be paid to take on the payment of PPF levels of compensation to scheme members (namely, for members below pension age, 90 per cent of the rights they have built up, with a cap of £26,935 a year).

Other accounting standards, such as IAS19 could give a slightly different picture. IAS19 was used by Aon Consulting, for example to show an aggregate surplus. In theory this should be enough to pay scheme members 100 per cent of their entitlements - but without a buffer to cover any increases in longevity expectations. An insurer would typically require 130 per cent of this measure to take a scheme on to its books.

John Belgrove, a senior consultant at Hewitt Associates points out that many schemes have “[moved into surplus on an accounting measure, but that still means if the lights were turned out tomorrow there would not be enough money in the pot. They still have some distance to go”.

If asset prices reversed the favourable trend of the past 12 months, deficits could quickly increase again. As a result, an increasing number of schemes are taking steps to lock in as much of the gains as they deem prudent. John Belgrove notes that many schemes ‘have plans in place to start to take some risk off the table at terms that are beneficial to them’.

According to Roger Urwin at Watson Wyatt, more companies are talking about ‘progressive de-risking, moving towards an endgame where pension schemes can be largely sustainable without the support of the employers’ covenant’. He sees schemes switching their mix of bonds and equities from 40 / 60 to nearer 80 / 20, and has also had a ‘dramatic’ number of conversations about formal LDI approaches. Strategies could also include a swaps overlay to hedge inflation and interest rate risk, as well as increased use of hedge funds, currency and infrastructure to create silos of uncorrelated returns.

In the end the choice of an appropriate de-risking strategy should take into account a range of factors that are unique to each scheme, from the strength of the sponsor’s covenant to the duration of the scheme.

The fortunate position of being in surplus throws up some new options for trustees. If a scheme has a surplus at the IAS19 level, it is more affordable for a sponsor to consider going down the buy-out route, making one final payment to an insurance company and relieving themselves of the obligation of running a DB pension scheme. While no large, solvent scheme has yet taken this route, John Belgrove believes a number are considering it – and given that the covenant provided by a fully regulated insurer should be extremely solid, trustees should have few issues in going down this route.

With a rising number of schemes in surplus, sponsors are starting to be wary of pumping in more cash, given that it is nigh on impossible to claw this money back, should it prove excess to requirements.

Instead they are turning to ‘contingent assets’ such as escrow accounts, so that any money can be reclaimed if it is not needed by the pension scheme. Trustees may be wary of this approach, preferring to have funds directly under their control; but if their objective is to ensure the sustainability of a scheme’s covenant, using contingent assets may be more likely to achieve this than simply putting spare cash into the scheme.

So while the news of falling deficits is to be welcomed, the industry should avoid any feeling of complacency. Running a pension scheme is a complex business, and liabilities need to be skilfully managed on a day to day basis regardless of whether a scheme is in the red, or the black.

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Recent comments by Sir Nigel Rudd, Chairman of Alliance Boots have again raised the question of whether the Pension Regulator needs more teeth. He called for the Regulator to be given the power to force agreement between target company trustees and potential acquirers, so that deals can be accomplished in a more timely fashion.

David Norgrove, Chairman of the Pension Regulator responded by saying that these suggestions are both unnecessary and unworkable: ‘We would be very, very, wary about [those powers] because we would be in the position of becoming an arbiter of a large part of corporate transactions’. In effect, the Government would become involved in virtually all corporate transactions, which is both undesirable and, with over 120,000 DB schemes in the UK, unworkable.

Nonetheless, some commentators are questioning the Regulator’s might. Despite launching over two years ago, the Regulator has used its most powerful tool only once, issuing a £91 million Financial Support Direction to Sea Containers for the first time in June. Given that the Regulator was created to help shore up the UK’s pension industry, it is perhaps surprising that it has only once used its power to compel sponsors to make hefty payments into their pension schemes.

David Norgrove has said that much of its work involves the mere threat of action, and that the avoidance of legal action is regarded as a successful outcome. Whilst this is clearly laudable, it has led to widespread uncertainty about the Regulator’s willingness to exercise its powers.

The issue of pensions funding in leveraged offers is clearly contentious, and there has been some confusion about the threshold for leveraged bidders looking to acquire companies with a DB pension scheme. The Regulator has set scheme funding standards for most companies that aim to eliminate their balance sheet deficit over a somewhat generous ten-year period.

The widespread assumption has been that when ‘clearing’ a corporate transaction, the Regulator will apply these same standards. Clearance, which is not compulsory, gives bidders the reassurance that they will not be held to account for pension liabilities if the target company later becomes insolvent. For trustees this is their one opportunity to demand upfront payment into a scheme, particularly when the new owner will be highly indebted and less able to withstand a downturn.

After weeks of behind-the-scenes negotiations, the consortium bidding for Sainsbury said it would offer no more than £300-500 million in cash, a sum roughly equivalent to the company’s pension deficit as shown in its latest published accounts. Unsurprisingly eyebrows were raised when it later emerged that trustees were looking for ten times that figure, at nearer £3 billion.

Similarly trustees to the Alliance Boots scheme sought £1 billion to fill a deficit that, on paper, barely existed. According to trustees of both schemes, the Regulator worked behind the scenes to help them achieve these amounts, but nothing has been made public.

Clearly, as long as the Regulator is achieving its objectives, it little matters whether it takes a softly, softly approach. But surely greater communication would help the Regulator achieve its objectives, by forewarning potential bidders about likely impositions? And wouldn’t it help trustees in negotiations if there was a publicly established precedent?

David Norgrove points out that Pensions Act specifically bans the Regulator from making public pronouncements, given that it relies on confidential information that might not be forthcoming otherwise. His view is that the covenant is relevant to trustees: ‘You could reduce it to a simple equation; scheme assets plus covenant equal [the cost of] full buy-out [with an insurer]’.

But since bidders don’t need to seek clearance, trustees can be deprived of the opportunity to demand an upfront payment. And by the time the new owners are asked for increased contributions, the company could be on its way to insolvency with an under- funded plan. Since scheme members are unsecured creditors, they are last in line for reimbursement when a company goes bankrupt... so does the Regulator need to spell out its role in protecting this vulnerable group? If its greatest weapon is its ability to make threats, it remains a fearsome beast - albeit one that has merely to bare its teeth.

The issue of Increasing life expectancy recently prompted The Pensions Regulator to call on corporate pension funds to strengthen their longevity assumptions and set aside more money for longer term pension payments. Now life assurors have come under the spotlight, after the FSA has written to them to express its concern that they may not be giving sufficient weight to the possibility of policyholders living longer than expected.

The FSA has called for companies to err on the side of caution, and include an ‘appropriate’ margin for prudence. However, life assurors are already more prudent than pension funds, setting aside solvency capital to back up their pension promises. Given that the vast majority of corporate sponsors of defined benefit schemes make far less conservative longevity assumptions than life assurors, they are likely to come under renewed pressure to fall into line.

The FSA is also concerned that the medium cohort projection, devised by the Continuous Mortality Investigation Bureau in 2002 and used by life offices for forecasting future longevity improvements, may already be out of date. But worryingly, few corporate pension sponsors use even this medium projection.

Research by Lane Clark & Peacock as recently as 2006 showed that out of 33 UK companies disclosing detailed mortality assumptions, only two were using the medium cohort projection. The other 31, or a staggering 94% of the total, were still using longevity assumptions that pre-dated even the medium cohort projection. As a result, for a man aged 60 most companies were predicting five years lower life expectancy than the medium cohort projection.

In fact, assumptions vary greatly among both corporate sponsors and life assurors. In 2006 Punter Southall, the consulting actuary showed that while the average life insurer estimated that a 65-year-old would live for a further 23 years, Marks & Spencer used a longevity estimate of 18.8 years, Imperial Tobacco 18.4 years and Tesco 17.5 years.

Challenging companies to raise their longevity expectations could lead to a huge hole in some corporate balance sheets. Recent research by Pension Capital Strategies and Numis Securities showed that the reported pension deficits of FTSE 100 companies would balloon from £20bn to £80bn if blue-chip companies stopped “underestimating future life expectancy by two to four years”.

Every year difference on longevity assumptions adds around 4% to liabilities, which could equate to as much as £32bn, if UK pension scheme liabilities are believed to be around £800bn in total. These include BT (£38.1bn), Royal Dutch Shell (£30.7bn) and Royal Bank of Scotland (£20.9bn).

Any move by corporate sponsors to raise longevity forecasts could breathe life into the pension insurance market. Insurers typically charge around a 30% premium above FRS17 valuation to take a pension scheme off the hands of a sponsor. PIC estimate that a third of this premium results from differing longevity assumptions, suggesting that the true cost of buy-out is less than the headline price.

The Pension Protection Fund’s recent announcement on the new factors used to calculate its levies for the year ahead will lead to some pension schemes paying five times more than they did last year.

Levies have increased on average, two-fold from around £300m for 2006-7 to £675m for 2007-8, less risky schemes will see a smaller increase because a larger amount of this year’s levy is being raised from the risk-based element. For pension schemes that have seen changes to the likelihood of employer insolvency and the deficit, the risk based levy will increase over four times more. If the employer’s fortunes have got worse, the levy would rise even further.

The schemes with the most risk will see their levy capped at no more than 2.5 times the previous years amount. Therefore the levy system still have many cross subsidies, with the pension schemes of the stronger employers having to pay for the benefits of the pension schemes of the weaker employers.

According to a new report by the actuaries Watson Wyatt, the combined deficit of FTSE 100 pension schemes fell by £20.5 billion to £39.9 billion in 2006, the largest annual fall since 2002. This was due to a combination of rising stock markets (equities rose 16%, including investment income), a rise in bond yields and companies themselves injecting billions of pounds into their pension scheme deficits. Watson Wyatt expects that FTSE 100 companies will pay off a further £5 billion of deficit contributions in 2007, partly to reduce levies required by the PPF.