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Pensions promises - made to be broken?

Faced with demographic and accounting pressures, many European companies that sponsor defined benefit (DB) pension plans are seeking to change the terms of this promise by moving the pension fund risk they bear from themselves to their employees.
The simplest way for them to do this is to close the DB scheme to new members and replace it with a defined contribution (DC) scheme, where the investment risk is borne entirely by the individual pension fund member.
However, there are other options, such as risk-sharing DB plans, where pension fund members agree to bear a share of the longevity risk, by paying higher contribution rates if mortality assumptions change.
Opponents of such risk-devolving or risk-sharing measures say that employers are reneging on the pension promise they made to their employees when they joined the pension scheme.
Supporters say that they are a fair and equitable solution to the problems facing company pension plans, and that, in a changing world, it must be possible to change a pensions promise.
So who is right? The response from the pension fund managers, administrators and trustees suggests that it is time for a little
realism. Pension promises were good for the times they were made, but the times have changed. No employer can afford to write an open cheque for his employees with a non-negotiable pensions promise.
The principle of the pensions promise is a good one, people feel. A majority, five out of six respondents, agree that if a pensions promise is made it must be kept. There are some qualifications. A Dutch pension fund manager says this should apply to “older employees at least”, while the manager of a Swiss pension fund says the promise should be kept “for past service”.
For some managers, there is no simple answer. A UK respondent observes: “The easy answer is yes, but that fails to recognise reality, and the fact that in a DB world there are no certainties, with assets and liabilities bobbing up and down and with companies unable to stay in business for ever. Yet saying no suggests that reneging on obligations is acceptable, which cannot be the answer.”
In practice, the pensions promise does not take account of present day realities, some feel. The manager of a UK scheme points out that “when DB plans were set up, there were far fewer legal obligations, longevity and demographics were not an issue and we didn’t have a European funding directive to contend with.
“What employers are faced with now is quite different and employees need to understand that they have a responsibility as well as their employers.”
A Swedish pension fund manager says that people must face up to the unpalatable truth that “if there is no money there are no guarantees. Or to put it more bluntly, sometimes reality kicks in”. Others agree with the manager of a German pension fund “it must be possible to change, at least in the future”.
Taking a pension fund off the
balance sheet by switching from
a DB to DC scheme is one of
the ways that companies have sought to change their pensions promise. It has been argued that a company has a duty to its shareholders to remove pension fund risk from the balance sheets and that this takes precedence over the promise it makes to its pension fund members.
One in five of our respondents agrees with this line of argument. A UK pension fund manager suggests “a company can remove the risk only if it pays the price to fulfil its pension promises”.
Yet there is some sympathy for the predicament of companies. A Swedish pension fund manager points out, “while historic promises must in principle be met, sometimes changes in how a company makes money will have to influence the risks a company takes”.
Similarly, an overwhelming majority agrees that employees who were contractually required to join their occupational pension scheme, and have been made a specific pensions promise by the scheme, should be compensated if that promise is broken.
But again there are qualifications. A Dutch pension fund manager suggests that compensation should extend “at least to older employees”. A UK manager points out that there “it is a good principle, but there is often no mechanism to enforce it. Who pays the compensation if the company goes out of business?”

Most of our respondents agree that reneging on a pensions promise sends the wrong message to old and new employees, although a Swedish pension fund manager notes that “this is not always a negative message”.
Likewise most agree that companies that have DB schemes with large and growing deficits are right to close them to new members, although some say this should happen only “if the debt is getting out of hand”.
A UK pension fund manager wonders whether closing a DB scheme to new members is always the right course. “Have they considered sufficiently that if investment returns are robust and bond yields rise keeping DB schemes open could be more cost effective in the long run?”
There is strong agreement with the idea that employees should be expected to bear some of the risk of the company pension fund to which they belong. A UK pension fund manager says that “belonging to a company scheme should help protect individuals from the risks that an individual cannot protect himself against and a group can, but there is no reason why the risk should be all one way.”
Yet they should not be expected to bear a share of longevity and investment risk. “Unless individuals are prepared to die at pre-determined ages, no one can give any certainty on longevity. On the investment side, most individuals do not have access to the knowledge and advice to help them make sensible decisions on asset allocation, so this is better done by trustees with advice from professionals. After that it seems reasonable to share risk.”
There is also broad agreement that employees in DB schemes should be prepared to bear some of the responsibility for changes in mortality assumptions when a company calculates future liabilities, either by accruing benefits at a slower pace or by accepting increases in retirement age.
Opinion is divided about whether the risks of a company pension scheme should be shared equally between employee and employer. A Swiss pension fund manager says that employers should bear a minimum of 50% of the risk.
There is more agreement about sharing both the downside and the upside. A majority - three in four respondents - thinks that where there is equal risk sharing, employer and employee should share the upturns and downturns in the pension fund, both in terms of surpluses and deficits.
One way in which companies can share risk more equably is by insisting that directors join the same pension scheme as their employees. This requirement gets solid support from our respondents, with six out of seven in agreement.
Yet there are arguments both ways, as one pension fund manager points out. “If executives in the same scheme have the highest benefits they may get the lion’s share of assets if the business collapses, which will lead to a sense of real injustice among employees. But if you put them in a separate scheme their own self-interest may not work in favour of the rest of the employees. It is a real dilemma.”
Overall, the feeling is that a touch of realism is needed about what companies can be expected to deliver to their employees. A Swedish pension fund manager takes a pragmatic view of the pensions promise. “At the end of the day a pension promise should reflect how the company makes its money and how high the turnover of staff is. A DB scheme is not a good idea for a consultancy but it should not be a problem for a utility. For everything in between it is more a matter of choosing what you need to recruit the staff you need and keep shareholders happy.
“What is right tends to change from time to time but a DB promise can last for more than 80 years. You have to accept that and live with it.”
The lesson for companies therefore is: do not make promises you may not be able to keep.

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