Frances Kehoe evaluates Ireland's minimum funding standard and the introduction of sovereign annuities
Over the last 18 months, many trustees have made use of extensions to the deadlines for submitting funding proposals. The extensions were granted while the regulator reviewed the funding standard, in particular in anticipation of sovereign annuities being made available and updating legislation with the proposed changes.
The funding standard, as it currently stands was introduced 20 years ago to set out the minimum assets that a defined benefit scheme must hold and what steps must be taken if the assets of the scheme fall below this minimum. It is a wind-up standard. Under the original 1990 Act, a scheme not holding sufficient assets must plan to build up the scheme's funding to the required level within a period of three years.
Existing funding standard
Based on the provisions of the Pensions Act the following liabilities must be valued:
• Expenses of winding up;
• Benefits in respect of additional voluntary contributions (AVCs);
• Benefits in course of payment and immediate benefits (excluding post retirement pension increases) to those who could opt to retire immediately without company consent;
• Benefits payable (excluding post retirement pension increases) in respect of service after 1 January 1991, including revaluation* of preserved benefits and benefits payable in respect of service prior to 1 January 1991 (but excluding revaluation* of pre 1991 benefits);
• Post retirement pension increases
• Revaluation* of benefits in respect of service prior to 1 January 1991.
The market value of the assets, at valuation date, are used to determine the funding position.
Proposed new funding standard
In November 2011, Joan Burton, the minister for social protection announced that the government would introduce legislation in 2012 to amend the funding standard, with the changes to come into effect in three years' time. The existing standard, adjusted to allow for sovereign annuities in a manner yet to be announced, will apply for the next three years after the last filing date (yet to be announced, but expected to be spread over the year starting in July 2012).
The new funding standard will be strengthened by requiring an additional risk reserve to be held, to better equip schemes for future volatility. Although no detail of the calculation of this reserve has been given, the minister has indicated that it would add on average 10% to the existing reserves. The Pensions Board has indicated that the reserve should be sufficient to enable the scheme to withstand a 15% fall in equities and 0.5% decrease in interest rate. The impact of such a requirement on each scheme would depend on its membership profile and asset mix: the minister pointed out that a lower risk reserve would apply when a scheme reduced its weighting in equities.
We have calculated the impact of such a risk reserve requirement on three notional schemes which were exactly 100% funded on the funding standard basis, had such a requirement been introduced as at 1 November 2011, as set out in the table.
In addition, the pensioner priority is to change with the introduction of a threshold on wind up, with amounts in excess of the threshold having lower priority, thereby increasing the amounts available for active and deferred members where a scheme winds-up in deficit. The proposed change in the priority order is welcomed and should provide a more equitable outcome to all pension scheme members. The current proposal - although this is subject to "detailed drafting considerations" - is as follows:
• The threshold will be the lower of 75% of the pension and €30,000 per annum;
• Pensions (excluding future guaranteed increases) up to this level will have priority on wind-up as at present;
• The remaining assets would be applied for active and deferred members "to the same limits";
• Any residual assets would be applied to top up the pensions to 100%, before any further assets are available for active and deferred members.
Change in revaluation requirements
There will be a legislative change to limit the requirement for revaluation of deferred pensions to the level of increase of salaries of active members of the scheme. This change will address the unfair situation where former employees must be granted increases to their deferred pensions while current employees may get no increases in their accrued benefits because of a pay freeze
Pensions Board power to wind up
The Pensions Board will be given power to wind up schemes in circumstances where employers and trustees are not in a position to agree on a solution to keep the scheme going, and where the position would otherwise deteriorate.
There will be a period of transition before the new funding standard is fully operational.
It is understood that a scheme which satisfies the existing funding standard will not be required to establish an additional risk reserve until the new standard comes into effect - possibly out to mid 2016.
For a scheme currently in a funding proposal, the "on track" checks may be carried out with reference to the current standard, provided the scheme remains on-track. However, where a funding proposal is being prepared following the reintroduction of the deadlines by the Pensions Board, this must be designed to enable the scheme to meet the new standard at the end date of the proposal if the funding proposal period is longer than three years. The maximum period for a funding proposal will be 11 years.
The concept of a sovereign annuity has been under discussion for over a year. A sovereign annuity is an annuity contract issued by insurance companies where the annual income payment is linked directly to payments under bonds issued by Ireland or any other EU member state (known as reference bonds). The income payments made would be adjusted in the event of "non performance" of the sovereign bond(s) to which the annuity was referenced.
The Pensions Act was amended in December 2011 to enable trustees to meet their obligations to pensioners by securing their benefits with a sovereign annuity. Such annuity policies will be certified by the Pensions Board, although the Board has no role in assessing the credit risk in the underlying bonds.
There is no detail on how the funding standard will be adjusted in cases where sovereign annuities, or sovereign bonds, are held as assets. If the scheme holds sovereign bonds it is expected that pensioner liabilities can be discounted at the yield on such bonds to the value of the bonds held but only up to their duration. In addition, trustees will have to state, and disclose to pensioners, that it is their intention to buy sovereign annuities in the event of windup.
It is expected that sovereign annuities will be market ready and available in the first quarter of 2012.
*Pensions Act revaluation involves increasing the benefit in the period before a member's normal retirement age in line with the lower in each year of price inflation or 4%.
Frances Kehoe is senior actuary at Aon Hewitt in Dublin