New environment for pensions
Following the law on pension reform in 2003, the different regulations that we were all waiting for have finally been published. The result is a much clearer (and attractive) pension environment than before.
Companies can sponsor three tax-favoured retirement systems – traditional DC and DB plans, and the new locked-in savings account called PERCO. In addition, individuals can set up their own individual retirement accounts with their banks (PERP).
The clarification on the tax and social charge treatments of company sponsored plans will increase their use and will also result in more funded DB plans (there is no minimum funding requirements in France).
The interesting question at this point is to what extent the PERCO will replace the more traditional DC plans?
Figure 1 shows the net cost to the employer and the net value to the employee (as % of gross payment) of the employer contribution to the three company sponsored plans, taking into account social charges and income/corporate tax payable. As a reference, we also show direct cash payments (ie salary).
As can be seen on the chart, the PERCO is a clear winner from a pure tax effectiveness point of view.
In terms of design, the PERCO also accumulates advantages compared with its DC counterpart: it is a voluntary scheme and payments can be made as tax-free lump sums at retirement, instead of the usual conversion to life annuities in the case of DC plans.
This last feature is important in France: taking into account the relative importance of State and mandatory basic coverage payable as lifetime pensions, it is easy to understand the appetite of French employees for alternative modes of payments for their supplementary pension schemes.
PERCO’s voluntary nature makes it a vulnerable long-term savings vehicle for retirement if employees lack the necessary self-discipline.
It is also necessary to have a PEE in place (a five-year locked-in savings account) before offering a PERCO to employees. Finally, the PERCO must be offered to all employees, making it difficult to target a subgroup of employees.
In terms of numbers, the PERCO, so far, has been a success: there are already around 23,000 companies with a PERCO in place, covering close to 600,000 employees in total and assets of e330m (AFG numbers).
Notwithstanding all the current discussions about the PERCO, DB plans should not be forgotten. They are less popular as a retirement solution for employees as a whole, but they have become more attractive for executives because of their increased tax ceiling. They are also the only solution for mid-career recruits and for rewarding short periods of service (typically less than 10 years).
In addition, as we mentioned earlier, now that the tax rules have been clarified (with some important advantages for the DB plan), the last barrier to the implementation of a clear funding strategy has been removed.
We often forget a very important advantage of DB plans: the possibility to pool assets on behalf of employees of all ages, making it possible to conduct a much more dynamic and rewarding investment strategy, even for employees close to retirement.
Indeed, when employers transfer risks to employees by switching their retirement coverage from DB to DC plans, there is a very material, and often overlooked consequence: the fragmentation of the assets. Since employees have to deal with investment risks on their own, they will tend to adopt a more (and earlier) protective investment strategy for their accumulated capital, putting a strain on future investment returns. The result is a series of small ‘pockets’ of assets invested in low-return strategies.
The solution, of course, would be to create true pooled DC plans with all assets being merged into a large single fund, invested with a much longer and stable investment horizon on behalf of all employees.
So, how do we choose among all the possibilities in France?
Following the new pension reform, we now have the luxury, and difficulty, of choice. Should an employer offer a DB plan, a DC plan or the new PERCO plan? Or should it be a combination?
We saw earlier that the tax (financial) effectiveness of the PERCO plan was optimal. But it does not necessarily follow that it is the best choice for all companies independently of their HR strategies and the demographic characteristics of their staff.
To help companies take these implications into account, we borrow from the investment management world the concept of ‘efficient frontier’ with two axes:
q The financial effectiveness axis, which we have discussed earlier. It is expressed as the ratio of the net value received by the employees over the net cost for the employer. It measures the cost savings that companies can achieve by taking advantage of the different tax exemptions available; and
q The HR effectiveness axis, expressed as ‘HR points’, which measures the alignment of the different reward programmes with seven HR objectives: Recruiting, Training, Retaining, Motivating, Engaging, Moving in and Moving out. According to their strategies, the companies will apply different weightings to each of these HR objectives. Given each reward programme’s respective contribution to these objectives, the model will calculate a number of weighted ‘HR points’. The more points a possible mix of programmes gets, the better its HR alignment.
If we consider the total reward budget of a company as a portfolio that can be invested in different programmes (salary, bonuses, DC plans, DB plans, PERCO, etc), the efficient frontier will show, for a given level of financial effectiveness, the mix of programmes that will lead to the highest number of HR points, ie, the maximum alignment to the HR strategy (and vice versa).
It is then up to the management to decide which position it wishes to take on the efficient frontier. In other words, what trade-off it wishes to adopt between pure financial effectiveness and pure HR effectiveness.
Simon de Rochers is managing consultant at Watson Wyatt in Paris