mast image

Special Report

ESG: The metrics jigsaw

Sections

Holding back until dust settles

Spain’s short but sharp experience of defined contribution (DC) style pension plans illustrates both the advantages and disadvantages of the DC system.
The 1987 Law of Pension Plans and Pension Funds introduced the idea of Qualified Pension Plans (QPPs), complementary pension plans designed to benefit from tax deductible contributions and exemption from tax on investment income.
Employer-sponsored plans (EPPs) can be either DC or defined benefit (DB). However, if employers choose the DC option, the plan must be a simple savings arrangement where the retirement benefit cover can be only the lump sum resulting from the accumulation of the contributions made and their yield. Perhaps more important, in the period before retirement benefit becomes payable, there is no guarantee of benefit at all. Nor is there a guarantee of minimum interest on investments.
When the law became effective most employer sponsored pension plans were DB schemes, usually unfunded and often operated on a pay-as-you-go basis. In spite of this, both employer and employees were, initially, content to switch arrangements from DB to DC within EPPs.
Some impetus was provided by new accounting legislation introduced in 1990. This required companies to recognise pension arrangements on a company’s balance sheet. Employers therefore saw DC plans as useful way to avoid this requirement.
An amendment to the regulation of pension plans in 1995 provided added impetus. The new law, which became effective last November, requires that companies must externalise their pension commitments, either through a pension fund or an insurance contract.
Many employers have used this requirement to justify switching to a DC scheme, according to Almudena Hernández Guillen, head of the benefits division at pension consultant Buck Heissmann in Madrid: “Most companies have used the externalisation process to look at their pension commitments not only in terms of funding but also in terms of plan design. In this sense Spain has followed the current European trend, so that most of the former DB plans have been changed into DC models.”
It is estimated that of the 1,532 EPPs in operation at the end of 2002, no more than 20 or 30 are DB schemes. In some cases, companies have introduced DC plans for new employees while retaining the DB plan for existing staff – again in line with the European trend.
The switch to DC has been made as painless as possible, particularly when trade unions have been involved in the negotiations. In addition to future contributions, some employers agreed to pay a contribution based on past service entitlement so that older employees were not penalised. This was either paid immediately, as a single lump sum, or over a period of years.
Employers have made other concessions to smooth the transition from DB to DC. The legislation allows employers them to design “mixed” EPPs where the retirement benefit is a DC arrangement and death and disability coverage is carried over from the DB plan. In practice, most employers provide minimum death and disability benefits through a group insurance policy, says Hernandez Guillen.
“Most plans do provide for minimum death and disability benefits. However, in our experience, these minimum benefits are rarely financed through the EPP itself. Even if risk contributions are not a significant amount, most companies have decided not to integrate them into the EPP to allow individuals to increase their own saving opportunities,” she says.
Until now, there has been little opposition to the changeover from DB to DC from employees or unions, chiefly because the equity markets were buoyant and DC plans were perceived as a way of profiting from rising stock markets. There were also other advantages. DC plans provided immediate vesting, whereas DB plans either did not provide vesting rights at all or provided them after long service.
It is estimated that of the 1,532 company-sponsored pension plans in Spain, only 20 to 30 are now DB schemes. Christian Lux, senior consultant in the Madrid office of Watson Wyatt, says: “Everybody was very satisfied with DC plans – the employer because he got rid of his DB scheme and the employee and trade unions because they believed high returns would go on forever. Everybody believed they had a good deal.”
Three years of a bear market in equities has reversed this optimism. According to figures from Inverco, the association of institutions of collective investments and pension funds, returns in employer-sponsored plans were minus 0.78% over the three years to 31 December 2002 and minus 3.72% over one year. This has caused anxiety and resentment among employees who belong to DC plans, says Lux: “Now they feel what it means to transfer from a DB to a DC plan. Now they are asking questions about what has gone wrong and everybody is thinking about changing things.”
A move back to DB is unlikely. Although the law allows employers operating EPPs to opt for DB or DC schemes, DB plans are considered more complicated and burdensome for both employer and employees. For example, DB schemes are required to keep a 4% solvency margin in bad times as well as good. There is also a maximum level of employee contribution, so employers cannot improve the health of their pension funds by raising contributions.
The employer has another option – to set up a group insurance policy. There are several advantages to this. One is that the employer does not have to provide immediate vesting. However, this is not as tax-effective, since contributions to insurance contracts are not tax deductible, except where they are considered as taxable income for employees.
The fiscal advantages of an EPP are a considerable counterweight to the flexibility offered by group insurance policies. Within an EPP, employees can deduct contributions of up to E7,212 a year, with higher allowances for employees over 52. The E7,212 ceiling applies only to employees’ contributions, and excludes contributions made by the employer.
Currently, people seem prepared to let the dust of the externalisation legislation settle before deciding what to do next. However, there is little doubt in that, in the next year or two, there will be pressure from employees for some change to the current employer-sponsored DC plans.

Have your say

You must sign in to make a comment

IPE QUEST

Your first step in manager selection...

IPE Quest is a manager search facility that connects institutional investors and asset managers.

  • QN-2575

    Asset class: Core Real Estate Muli-Manager Separate Managed Account.
    Asset region: Global.
    Size: CHF 150m.
    Closing date: 2019-12-20.

  • QN-2576

    Asset class: Small Caps Equity.
    Asset region: US.
    Size: $>100m.
    Closing date: 2019-12-09.

  • QN-2578

    Asset class: Sovereign Local Currency Emerging Market Debt.
    Asset region: Local emerging markets.
    Size: EUR 950m.
    Closing date: 2019-12-19.

Begin Your Search Here
<