Rachel Fixsen assesses Denmark's transition away from DC with guarantees to unit-linked schemes - a move accelerated by the EU's Solvency II regime
Across Europe, the EU's Solvency II regime is changing the future for financial institutions. In Denmark, the upcoming EC legislation is pushing the country's defined contribution (DC) pension schemes into a slow revolution.
The yield guarantees that past generations of scheme members were accustomed to have decreased - often down to nothing, and traditional with-profits plans are being swapped for unit-linked arrangements.
Denmark's pension system is affected more than many by Solvency II, because funds are incorporated as insurance companies. Under the new regulations, guaranteed pensions will draw high reserve requirements.
Some pension funds have been forced to lose their guarantees quickly. In August 2010, labour-market scheme Sampension notably abolished yield guarantees on its with-profit pensions and replaced them with ‘statements of intended pension payments'.
The DKK150bn (€20bn) scheme argued that because it was essentially a non-profit organisation, this intention to provide a certain level of pension made members no less likely to end up with reduced pensions if they had retained the guarantees.
The step attracted criticism, but was soon approved by Finanstilsynet, the financial regulator, although it did mention the shortcomings of Sampension's communication with members over the issue.
The regulator said the pension fund should have informed customers about the alternatives to scrapping the yield guarantee, as well as telling them that the statement of intent involved a chance of higher risk with the investment strategy.
Industriens Pension, the DKK90bn (€12bn) labour-market scheme for the industrial sector, made the change from with-profit, with-yield guarantee to a life-cycle unit-linked arrangement last December, and included all members at the same time.
It said it had no problem meeting the Solvency II requirement, and the move was mainly to make returns fair for all members.
Denmark's industrial sector has suffered heavy job losses in the past few years, which means - among other things - that workers are transferring to other funds. With the amount of reserves in the old system, members leaving would effectively have also left part of their savings behind, the scheme said.
Like many Danish pension funds, the pension fund for employees in financial businesses, Finanssektorens Pensionskasse (FSP), currently runs both traditional guaranteed with-profits products and unit-link pensions. Also in common with other funds, FSP is actively encouraging scheme members to move to the unit-link product.
"There are several reasons for this," explains managing director Steen Jørgensen, "but our main argument is that the introduction of a number of additional risk restrictions associated with traditional DC pension schemes means the investment horizon has to be very short.
"Because of this, the expected return is far below unit-linked products where funds still can be invested with a long-term horizon," he says.
Jørgensen says that examples are an important tool for effective communication with members about changes such as the switch to unit-linked. "Pension issues are rather complicated and members, in general, do not devote much time to their pension scheme," he says.
FSP says that feedback from its membership over the changes to products has ranged from the very positive to the extremely sceptical.
At some pension funds, the change has been a gradual one. PKA, the joint pensions company for five occupational schemes in the health sector, runs traditional with-profits pensions. While this type, theoretically, gives a minimum guaranteed yield, in practice the value of these promises has reduced to zero for new members.
An individual's level of guaranteed pension in the PKA scheme depends on the year of enrolment, as the guaranteed level for new members has been reduced over the past 15 years, and contributions increased.
Today, new members are enrolled with guaranteed pensions based on an interest rate of 0%, but older members may have pensions based on interest rates up to 4.25%, according to Peter Damgaard Jensen, CEO of PKA and chairman of Danish industry body, Forsikring og Pension.
Back in 2008, PKA offered members with high guarantees the option of changing their guarantees to those given to new members. In return, those members' pensions were to rise 10% immediately.
"PKA estimated that approximately 100,000 of the 250,000 members would benefit from this transition and set up a campaign to inform them about this option," Damgaard Jensen says. "Almost 75,000 accepted this and, as a result, the majority of PKA members now have their pension guarantees based on low interest rates. The strategy enabled PKA to reduce the guarantees it offers overall, but it has no plans to move away from with-profits plans altogether.
PensionDanmark manages around DKK110bn of pension assets for more than half a million members working in a range of industries.
All its pensions now run on a unit-link basis, but this was not always the case. Up to 2009, half of members' savings - the part used for life-long, or annuity, pensions - were in a traditional pension savings product. The account dividend or yield was set every year by the board.
In 2009, that part of members' savings - along with part of the company's reserves - were transferred to a unit-linked life-cycle product, with the risk level of investments adjusted according to a member's age.
"This transition has been received very well among members," says CEO Torben Möger Pedersen. "They have been very pleased with the return on their investments and the added transparency of their savings and return on investment."
The other half of members' savings that is used for a ratepension - a pension in instalments which typically lasts 10 years - have been handled as a unit-linked product since its introduction in 2000.
Unit-link pensions are unequivocally the way forward for Danish pensions, according to Möger Pedersen. "Especially within sectors and job categories where wage-earners very often change jobs and in many instances change pension fund as well," he says.
"For those wage-earners, the unit-linked life-cycle products gives them an easily trackable link between their actual savings, the return that is earned on the assets associated investments and the return on investment that is added to their savings account.
"The product is very transparent and, combined with a reduction of investment-risk as wage-earners approach retirement, it also provides a very high degree of safety and security for the future income of pensioners," Möger Pedersen says.
Far from complaining about the upcoming Solvency II regulation and the upheaval it may be causing, the PensionDanmark CEO finds it "very fair" that it will result in larger solvency requirements for traditional pension products with nominal guarantees.
In the end, he says, the Danish krone interest rate swap market is too small for large pension funds to hedge their interest guarantees in DKK-denominated structures.
"The recent developments in the swap market where interest rate swaps in Danish kroner now trade at a lower interest rate than the euro-denominated swaps serves as a very clear reminder of the problems for pension funds in having guarantees that they are not able to precisely hedge in the financial markets," he points out.
Damgaard Jensen believes that Danish pension funds are acting very responsibly in relation to the current financial challenges.
"Pension funds may have to act in different ways to the same challenge due to scheme and demographic structures. But, in general, Danish pension funds have been very prudent and taken action in due time.
"In Denmark, we have had asset-liability matching demands for a long time, and we have got used to tough solvency requirements ever since the Danish FSA introduced the traffic-light system," he said.
Whether more of the country's DC schemes will eventually become unit-linked plans is not clear. Some have pledged not to withdraw guarantees already given, while few give a significant level of guarantee on their with-profits pension for new or recent entrants. Even here, members have been encouraged to switch to unit-linked accounts.
Lærernes Pension the teachers' pension fund, has told members it has no plans to move to unit-linked, but the guarantees on its with-profit schemes have gradually diminished. Plans set up in the few years after 1993 and 1997 have guarantees of up to 2.5% and 1.8%, respectively. But those starting after 2008 have no guaranteed minimum yield. In 2009, members were given the option of switching their older guaranteed savings into the potentially higher-yielding, but unguaranteed, 2008 plan.
It is hard to find anyone around the pensions industry who believes the changes now taking place are not necessary.
One pensions academic points out that there have been many winners among scheme members. "If you are someone near retirement with 4.5% pension guarantees, then it is good for you," she says.
And those without guarantees could find themselves in a better situation too, because under the older system under Solvency II, pension companies would have been forced to give very low returns for many years as they built up sufficient reserves, she says.
Certainly, members of Industriens Pension, for example, have benefited from a one-off return of around 20% because of the change.
Even the Danish Consumer Council recognises that many pension funds need to shed the guarantees and move to a less reserve-hungry investment method.
But Morten Bruun Pedersen, senior economic adviser, consumer interests group, says that from a consumer welfare point of view, it is difficult to say generally whether the moves to unit-link from guaranteed schemes are positive or negative.
"It depends on future economic development. For individual consumers, it is a trade-off between security and the possibility of a high, but more uncertain returns," he says.
Bruun Pedersen says there has long been very significant pressure on consumers from some companies to get consumers to switch, and this has not always been objective enough.
"In some cases, companies' information was very one-sided as to highlight the benefits of changing to unit-linked products," he says.
The pension providers ought to give members more objective information where the pros and cons of both systems are reported.