Hybrids offer extra dimension
Slumping investment returns in the major stock markets, an increase in longevity and the introduction of new accounting standards, among other factors, have left many pension funds in deficit. Conversely, the downturn in the global economy has forced organisations to be more cost-aware. As a result, many companies are currently reviewing their occupational pension provision.
In the UK, as the National Association of Pension Funds reports, 46 defined benefit (DB) schemes were closed to new members and 13 switched to defined contribution (DC) schemes in 2001 alone. Prominent examples include Selfridges, J Sainsbury, Marks & Spencer, BT and Ernst & Young.
The movement away from pure DB schemes is not exclusive to the UK. Evidence from Germany and Switzerland indicates a similar trend. However, German and Swiss employers seem to prefer hybrid pension schemes instead of pure DC schemes.
Hybrid schemes can offer employers a mechanism to retain some of the investment risk without incurring the extensive fund management, compliance and administration costs of pure DB schemes. There are several varieties of hybrid pension schemes – each offering a different combination of DB and DC elements. The two most prevalent types are cash balance and floor offset schemes.
Cash balance schemes differ from pure DB schemes in that every member has an individual account, similar to a DC scheme. Contributions are expressed as a percentage of salary and allocated to the member’s account. The member’s account is credited with interest at a predetermined guaranteed rate rather than actual earnings, effectively making it an ‘indexed career average scheme’. At retirement, the account balance is paid to the beneficiary as a lump sum. An example scheme design would be a contribution rate of 6% of pensionable salary for the first nine years of service and 8% thereafter with the employer guaranteeing a 7% annual interest credit on the account balance. Cash balance schemes can effectively combine the paternalistic benefit philosophy of DB schemes with the protection against sponsor’s bankruptcy risk of DC schemes, making them suitable for companies of all sizes. For employees with high salary growth, however, cash balance schemes produce a lower replacement ratio (defined as pension benefit relative to final salary) than for employees with average salary growth.
A floor offset scheme, or floor scheme, is effectively a DB and a DC scheme run alongside each other. Based on the specific features, it can be designed either to provide a:
o relatively low DB that will likely be offset by the DC scheme; or
o relatively generous DB that will only be offset by the DC to plan, if high investment returns are being achieved.
In any event, at retirement, the member receives either the DB pension, when the assets of the DC scheme did not yield high enough investment returns to offset the DB guarantee, or the accumulated assets of the DC scheme. Thus, a floor offset scheme can provide members with the best features of DB and DC schemes. For employers, though, the cost of providing benefits under a floor scheme with generous DB can be potentially be expensive, since they retain most of the investment risk.
One issue that does need to be considered with floor offset schemes which guarantee significant levels of DBs is the separation of investment risk and return. The employer assumes investment risk and is, therefore, required at least some control over asset allocation. If members were allowed to control asset allocation, they might be inclined to invest in high risk asset classes knowing that they could benefit from high investment returns while passing the associated risks onto the employer. For employers, this feature could prove expensive since there is no potential to benefit from favourable returns, only investment risk that may need to be insured.
Both types of hybrid pension schemes have been imported from the US and are not equally available throughout Europe. According to the British government actuary’s department, there are 3,580 hybrid pension schemes with 290,000 members. The vast majority, though, are small schemes – 3,100 schemes have 11 members or less and an additional 400 have between 12 and 99 members. Just five hybrid schemes have more than 10,000 members. Hybrid schemes represent 2.4% of all UK pension schemes and 4.8% of all members of occupational pension schemes belong to a hybrid scheme (all figures are from 1995 and the latest available).
In Switzerland, as reported by IPE (March 2002, p46-47), cash balance plans are quite common. There are, however, some distinct differences to British cash balance schemes as described above. Firstly, the Swiss second pillar is mandatory and not voluntary. Secondly, the Swiss cash balance plans provide a minimum return of 4% whereas the British counterparts provide a specific return figure. Thirdly, the minimum return of investment is guaranteed by the plan and not the sponsoring company.
In Germany, the recent pensions act (Altersvermögensgesetz) has introduced pension funds (Pensionsfonds) as a fifth occupational pensions vehicle. In contrast to Anglo-Saxon pension funds, German pension funds are insurance carriers and, therefore, subject to German insurance supervision. Furthermore, their asset allocation is subject to a guaranteed return of contribution, as imposed by the recent pensions act. As a result, at normal retirement age members are guaranteed at least the nominal amount that they and their employer paid into the fund. Because of this feature, one could argue that a German pension fund is effectively a cash balance scheme with a minimum return guarantee of 0% (ie, no negative return is allowed).
However, German pension funds are different from British and Swiss cash balance schemes. Unlike British cash balance schemes, the fund and not the sponsoring company guarantees the return. Contrary to Swiss cash balance plans, the investment guarantee is provided to each individual and not on a collective (ie, plan) basis.
The latter aspect influences the asset allocation of German pension funds, expecting to reduce investment returns by up to 150 basis points. In conjunction with the premium to compulsory mutual insurance system (Pensions-Sicherungs-Verein), German pension funds appear to be less competitive than their Anglo-Saxon counterparts.
An attractive alternative to German pension funds are pension investment funds (Altersvorsorge-Sondervermögen). Pension investment funds are open-end investment vehicles especially designed to provide a retirement lump sum. They are organised outside of the extensive German occupational pension legislation, which makes them especially appealing for employers. Even though pension investment funds are subject to quantitative portfolio restrictions (maximum 75% equities and property investment), their asset allocation is roughly equivalent to Anglo-Saxon pension funds.
Although no pension investment fund has actually received tax-approved status under the pensions act, they are almost certain to obtain certification. Unlike German pension funds, though, a modified return of contribution guarantee applies whereby a reserve will have to be put aside only if the actual fund value plus discounted future contributions fall below the return of contribution limit at normal retirement date. As the German Mutual Fund Association reports, such a scenario is ‘highly unlikely’, so that pension investment funds present an efficient retirement vehicle. According to the German newspaper Handelsblatt, Daimler Chrysler is the first company to deploy pension investment funds to supplement its occupational pension schemes.
These examples demonstrate that hybrid pensions offer employers a mechanism for providing DB elements to their workforce in a more cost-effective way. Even though different schemes are available in different jurisdictions, by choosing the appropriate solution in any one jurisdiction, hybrid pension schemes may be a valuable alternative to both, DB and DC schemes and, thus, add an additional dimension to the existing range of pension options.
Karl Wirth is a compensation and benefit consultant with HCM International in London