What happens when the money runs out?
This month’s Off the Record looks at the ticklish issue of solvency insurance for company pension plans in Europe – how to protect members of corporate pension plans when companies go bust.
A number of European countries already operate solvency insurance schemes for corporate pensions. In Germany, and now in Luxembourg, the Pensions-Sicherungs-Verein (PSVaG) is responsible for insolvency insurance for corporate retirement benefit schemes. In Sweden, the FPG, a mutual insurance company, will redeem pension commitments and buy pension insurance.
Now the UK is proposing to introduce its own insolvency insurer, the Pensions Protection Fund (PPF). The UK government is asking employers to pay some £350m (E512m) year to get the scheme off the ground. However, the proposal has drawn protests from employers’ organisations. They argue that such a fund would force well-funded pension schemes to subsidise weaker schemes, and strong companies to provide a safety net for weaker competitors.
Employers also complain that they are being forced to carry all the risks themselves and say that the government should take its share by acting as a guarantor.
The UK government has refused. It says that if it guarantees private sector obligations, it will under-write the risk of ‘moral hazard’ – the risk that companies covered by insolvency insurance will behave recklessly.
Is it right to do so? We wanted your views on these and related topics. The response was surprisingly varied, particularly on the issue of who should pay and how they should pay.
An overwhelming majority of the pension fund managers and administrators who responded to our survey (91%) agree that there should there be a some form of protection for members of company pensions schemes when companies become insolvent or go bankrupt.
The manager of a French pension fund suggests that an insolvency insurance scheme protection should be limited to cases of fraud, as currently happens in Australia and the UK .
Similarly, a clear majority (70%) say that European governments have a responsibility to provide members of company pension schemes with a safety net.
Who would pay for such a safety net is another matter. Employers, as the sponsors of corporate pension plans, are the obvious candidates.
The idea that both employer and employee should share the cost of insolvency insurance wins support from our survey. Almost two in three of our respondents (62%) say both employer and employees should bear the costs. Opinion is evenly divided (50%) on whether the taxpayer should pay. There is less support for putting the onus entirely on the employer (25%) and even less (12%) for making employees alone pay for their pensions protection.
However, the manager of a Belgian fund points out that, one way or another, the employer will end up paying most. “The main cost will fall on the employer’s heads anyhow, either through tax or by insurance,” he says. “Most European legislation already foresee this with regard to pension scheme underfunding. Macro-economically, employers will pay most of this.”
One of the arguments against putting all the cost on to an employer is that it may encourage them to close their defined benefit pension plans. This view is shared by our respondents. A majority (57%) agree that thought the costs of a levy on employers might encourage them to close their plans. However, there is considerable scepticism. A Belgian pension fund manager observes wryly: “It’s the classic response to threaten to close a scheme. However, history shows that this rarely happens in Europe.”
Many of the employers’ objections stem from the fact that governments refuse to bear the costs of the insurance schemes they introduce. In the UK the government has flatly refused to underwrite the cost of the new PPF, citing the experience of the US, where the Pensions Benefit Guarantee Corporation (PGBC) has a deficit of $8.8bn. This has marginal support from our respondents. A slight majority (52%) say that it is not the business of governments to guarantee insolvency insurance schemes.
Who should manage an insolvency insurance scheme – a government agency, an independent agency or the insurance industry itself? Different countries take different approaches.
Our respondents tend to favour a hands-off approach. The largest single percentage (48%) would choose a non-governmental independent agency set up specially for the purpose. A smaller proportion (26%) would favour a government agency. One pension fund manager points out that “it’s the job of government, anyway, and it keeps administrative costs low”.
A similar percentage (26%) prefer a consortium of insurers. However, some respondents feel that insolvency protection should be left to market forces, and say that it should be handled by “competing insurance companies – ie no monopoly”.
Should there be any limits to the amount of compensation paid out? A salary cap on high earners’ benefits to be covered by compensation is supposed to be a disincentive to directors letting a company go into insolvency. In Germany, the PSBVaG scheme excludes the pensions slice above E82,000 a year. In the US the PBCC excludes the pension slice above $40,000 a year.
Exclusions also reduce the number of people eligible for compensation. In Germany, insurance does not cover pensions for people with less than 10 years service.
A substantial majority (83%) agree there should be a cap on compensation. However, this agreement comes with a number of provisos, such as “Only if there is a government guarantee” or “Only if the pension promise is unreasonable”.
Another matter of contention is how the levy on employers or employees calculated – by the size of the pension scheme or by the size of the liabilities or a by combination of both? In the US, the PBCG uses a combination of both, with a flat rate premium of $19 a year for each person covered, plus an additional variable rate of $9 per $11,000 of unfunded vested benefits.
Sweden’s FPG charges a uniform 0.2% of liabilities. Germany’s PSVaG imposes a levy on companies proportionate to their pension liabilities, averaging 0.15%. Contributions are calculated to reflect past claims levels and have see-sawed from 0.69% in 1982 – the year that AEG became insolvent – to 0.03% in 1990.
Two out of three (65%) of our respondents say that the amount of the levy should be proportionate to the size of the liabilities. Only a fraction (9%) suggest that it should be decided solely by the size of the scheme in terms of membership, although a one in three (35%) think that a combination of liabilities and scheme size is the fairest basis for a levy.
The UK’s new PPF will contain a flat rate element and a risk-based element depending on the degree of underfunding in the scheme. This means that schemes that are most underfunded will have to pay more, ensuring that well funded schemes do not take on the entire risk of schemes that are less well funded.
The aim here is to avoid ‘moral hazard’ – the idea that financial guarantees promotes reckless behaviour in the market. But does a pensions protection fund really encourage companies to operate their pension funds irresponsibly – for example, by investing unwisely in risky asset classes?. Most of our managers think not. Only a minority (30%) agree with the proposition that solvency insurance would lead to moral hazard. There is a feeling that companies have too much to lose. As one manager comments “After all, they pay into it as well”.
But do they? Labour unions blame the present crisis on employers who took pension holidays and did not pay in when times were good.
Employers argue that their contributions must meet the balance of the cost, and they must pay more if investment returns are poor. However, a small majority of our respondents (57%) say employers should be prohibited by law from taking pensions holidays.
Whether this would encourage employers to close their defined benefit pension plans is a question we didn’t ask…