Encouraging a sense of security

This month's Off The Record asks readers to consider the issue of pension protection schemes and whether they increase the risks of ‘moral hazard'.

The danger of any form of insurance is that it may encourage people to take risks they would not otherwise take. This is known as ‘moral hazard' and it is one of the risks of providing solvency insurance and pension fund protection. There is an argument that, to avoid this risk, it is better to have less protection and more regulation. In other words, take away the safety blanket and encourage people to behave sensibly.

Over the past 45 years, a number of European countries have set up pension protection schemes of one sort or another :

Sweden established its Pensionsgaranti (FPG), a mutual insurance operation owned by members which guarantees pension liabilities, in 1961; Germany set up the PSVaG, a PAYG scheme that is now switching to a funded system, in 1974; Switzerland created its LOB Guarantee Fund, which provides insolvency benefits, in 1986; and the UK launched its Pension Protection Fund (PPF) in 2005.

The principal argument against such schemes is that they may encourage pension plan sponsors and their investment managers to act irresponsibly - either by risky asset allocation or by under-funding - if they know that their pension promises are insured. This is an example of ‘moral hazard' - the risk that someone will behave recklessly if they know there is a safety net to soften their fall.

Another type of moral hazard is when the existence of a pension protection fund encourages unscrupulous employers to dump their pension scheme's liabilities on the fund. This has the effect of forcing the sponsors of well-managed pension schemes to subsidise poorly-managed schemes.

A recent report by the Organisation for Economic Co-operation and Development (OECD) concluded that, although pension protection schemes can be run successfully, regulators must take steps to avoid moral hazard.

It suggests that countries should consider other types of pension protection policies, such as effective funding rules. Some European countries, notably the Netherlands, have already chosen to provide pension protection through strict control of funding rules rather than pension protection schemes.

The OECD also suggests that only book reserve systems should be fully covered by pension protection schemes, and that funded schemes should use a combination of protection mechanisms, including effective funding rules.

So, do the risks of ‘moral hazard' outweigh the benefits of pension protection schemes? Or are pension protection schemes the way forward? We wanted your views.

The message from the pension fund managers, administrators and trustees who responded to our questions suggest that there is no right way of protecting pensions. Respondents in countries that have chosen to operate without such schemes feel they are right to do so. Similarly, respondents based in countries with protection schemes feel they are on the right track.

Only a minority (44%) think that countries that have not already introduced pension protection funds or schemes should do so. Some point out that whether a country decides to adopt a pension protection scheme will depend on the pension system it has.

Not surprisingly, most of the support for a greater use of pension protection schemes comes from respondents based in countries that already operate such schemes - half (51%) from UK, with smaller proportions from Germany, France, Portugal and Latvia.

Worries about reckless asset allocation are unfounded, a UK pension fund manager says: "A pension protection fund should enable funds to invest sensibly in assets that are likely to achieve higher long-term total returns and hence reduce costs."

Only a minority (44%) agree with the OECD that only book reserve pension schemes should be fully covered by pension protection schemes.

Opinion is evenly divided on whether pension protection schemes are needed at all. Half (50%) believe that effective pension funding rules can achieve almost everything that pension protection funds try to achieve.

Predictably, the largest percentage (56%) in favour of tougher funding rules are from the Netherlands, although there is support from pension fund managers in Austria, Belgium, Denmark and France. As one Dutch pension fund manager puts it: "I think the set up in the Netherlands is the way to go."

However, there are fears that funding rules are too crude and do not catch special cases. One UK pension fund manager warns: "There is a significant risk that funds will fall into trouble for scheme-specific reasons that aren't covered by the funding rules and regulations."

Managers based in countries other than the UK also feel that funding rules are not enough. A Portuguese pension fund manager comments: "I don't think that funding rules can be the solution. It has much more to do with the legal framework regarding accounting and financial rules.

"It all depends on what you oblige a company to do in a situation of bankruptcy. If there was a rule stating that the first liability to be settled has to be the pension fund's, that would help."

Pension protection schemes have their drawbacks, and most (72%) agree that the existence of a pensions protection fund increases the chance of ‘moral hazard' - that is, the opportunity for pension fund boards and employers to act irresponsibly.

Feeling about this has grown stronger over the past four years. In a similar survey on solvency insurance schemes for Off The Record in December 2003 only 30% of respondents said they thought that solvency insurance encouraged moral hazard.

The risk is nothing new. As one manager points out, all insurance increases the chance of moral hazard. One manager feels that the degree of moral hazard will depend on the degree of management turpitude, and that moral hazard is a risk "only where the directors and trustees are not acting in best faith."

Yet managers take a tough line what pension protection funds should and should not do. A large majority (82%) says they should not provide a soft landing for bankrupt funds. A much smaller majority (55%) think that they should not provide protection against all possible catastrophes.

In their attempt to reduce the risk of pension fund insolvency, pension protection funds have arguably introduced a new series of risks for pension regulators.

There is the risk that employers may manipulate scheme benefits before joining a pension to maximize the level of compensation and this will increase the cost of claims.

There is also the risk that employers will organise matters in such a way that the pension scheme has a reduced claim on them in the event of insolvency.

The UK government has sought to protect the PPF from these kinds of risk with a series of ‘moral hazard clauses' in the Pensions Act 2004.

Two out of three managers (66%) who responded to our survey agree that the introduction of pension protection schemes has introduced a new series of ‘moral hazard' risks for regulators.

A persistent grumble about pension protection schemes is that they ultimately lead to higher premiums for everyone, and an overwhelming majority of our respondents (89%) agree that this is a likely consequence.

Keeping politicians at arms' length is important, as Vincent Snowbarger, deputy director of the US guarantee scheme, the Pension Benefit Guaranty Corporation (PBGC) recently warned.

There is almost unanimous (94%) support for the idea that pension protection funds should have complete political independence if they are to be effective.

Political interference can limit the effectiveness of a pension protection scheme, as one UK manager points out: "The UK scheme has much more conservative funding rules than the schemes it insures. Given that its guarantor is more secure, this is mistaken.

"It should, for example, invest in equities. This political requirement for ultra-conservative funding makes no sense and greatly increases the cost of the scheme."

Although a large majority (81%) do not think it is the business of central government to bail out corporate pension schemes, a small majority (53%) think they have some limited responsibility, especially if they have actively promoted the virtues of corporate pension schemes.

One UK pension fund manager comments: "Governments should be prepared, jointly with the employers, to contribute to the funding of any protection scheme as in the long term this will reduce the benefits central government will have to pay out to pensioners whose schemes have failed." In other words, if you don't pay for pension fund protection in the short term, you will in the long term.