Onerous demands of DB funding
Defined benefit (DB) pension schemes established in Ireland are subject to the funding standard set out in the Pensions Act 1990 as amended. The trustees of such schemes are required to obtain actuarial certification that the scheme meets the funding standard on an annual basis, and if this is not the case, a funding proposal must be agreed between the trustees and the employer with the advice of the actuary, and submitted to the Pensions Board, the Irish pensions regulator. The Pensions Act provides that the funding proposal must be designed to enable the scheme to satisfy the standard in three years after the effective date of the certificate which gave rise to the proposal.
In the early years of its existence, the funding standard caused no difficulty for scheme trustees and sponsors, primarily because of favourable economic conditions, and also because there was a 10-year period before benefits for active employees earned before 1991 had to be covered. The end of this phasing in period coincided with the downturn in equity markets and the fall in bond yields which drive the liability calculations. Furthermore, amendments to the vesting and preservation provisions in the Pensions Act introduced in 2002 increased scheme liabilities. This amending legislation also introduced the requirement for a statement in the trustees’ annual report to members as to whether, in the opinion of the actuary, the scheme satisfied the funding standard at year end. This test had previously only been carried out every three years.
The funding standard liabilities for current pensioners are assessed by reference to the cost of purchasing these pensions on the annuity market, and for active and deferred members, the actuarial value of the accrued leaving service benefits is calculated on the same basis as used to calculate transfer values for members leaving service. This reflects what would happen in practice if the scheme were wound up on the date of the certificate, with the available assets being used first to secure pensions in payment, and the balance being applied as transfer values for active and deferred members, with any excess over the statutory liabilities being distributed in accordance with the scheme rules. The scheme is considered to satisfy the funding standard if there are sufficient assets (disregarding self – investment in the employer’s business) to meet the expenses of winding up, plus these statutory liabilities.
For mature schemes with a significant liability for pensions in payment, the funding standard has become very onerous as market annuity costs are at an all time high, reflecting both the low level of bond yields, and the allowance being made for recent and future mortality improvements. This is particularly the case where scheme rules guarantee pension increases at rates linked to Irish inflation, as there is not a deep or liquid market in government bonds linked to Irish inflation which insurers could invest in to back the annuity contracts.
For many schemes which were quite well funded at actuarial valuations in 1999 or 2000, the next actuarial valuation in 2002 or 2003 disclosed a shortfall relative to the funding standard, for the reasons outlined above. In some cases, this was exacerbated by the fact that the employer, and in some cases the employees, had been enjoying contribution reductions or suspensions as a consequence of the surpluses disclosed previously. These employers were now facing enormous increases in their pension costs to enable the scheme to satisfy the funding standard within 3.5 years, as required by legislation at the time. The government responded to these concerns by introducing discretionary powers for the Pensions Board to permit extended funding periods for schemes, where the reason for the failure to meet the standard was the performance of investment markets. This flexibility was used to derive a 10-year proposal in many schemes, which the Pensions Board indicated would normally be the maximum period permitted. However, this was not sufficient to enable the employer to agree the proposal in some cases, where the funding level was particularly low, or where a significant number of retirements were expected in the medium term. In such cases, the options available are one or more of
q Apply to the Pensions Board for a funding period longer than 10 years (which is only granted in undefined “exceptional circumstances”;
q Require member contributions to be increased to meet part of the additional cost;
q Reduce benefits for future service, thus containing costs going forward (this would include closing the scheme to new entrants if this had not already been done), or, as an extreme response, terminate the scheme.
It should be noted that there is nothing in Irish pensions legislation which requires an employer to make good a deficit in a scheme which is wound up with insufficient assets to provide the statutory benefits as outlined above. This is the case even if the employer is ongoing and able to fund the scheme, although clearly it would be difficult in practice for an employer to terminate a scheme in a manner which would take away accrued rights for existing employees.
Statistics provided by the pensions board show that approximately half of the funding certificates submitted to them since 2003 satisfied the standard, and half of those which did not submitted a funding proposal designed to enable the scheme to meet the standard within 3.5 years. Most of the remainder requested extended funding periods and only a handful of these requests were refused.
These statistics may paint an overly optimistic picture as for some schemes the position is still unresolved. In some cases there is an impasse in that the employer is paying a contribution rate which may be considered sufficient to fund the scheme in the long term, but this doesn’t satisfy the funding proposal requirements over a 10-year period, and hence a funding proposal cannot be agreed. The Pensions Board have power under the Pensions Act to cut benefits where a funding proposal cannot be agreed but understandably are reluctant to take this step.
The minister ordered a review of the funding standard which was undertaken by the pensions board in 2004, and their report considered a number of alternative standards, but concluded that the existing standard, with some amendment to the calculation of transfer values, be retained. On foot of the board’s recommendations, changes were introduced in 2005 which required that early retirement be subject to trustee consent where the scheme did not meet the funding standard, and which widened the grounds on which extended funding periods could be granted to include unexpected liability increases due to inflation or wage agreements. The board also considered other issues:
q Moving from a discontinuance standard to an ongoing one for some schemes;
q Changing the order of priority on wind-up;
q Introducing a “debt on the employer” provision and a State protection fund, as in the UK;
q Establishing a ‘state annuity fund’ which could offer annuities on wind up at a cheaper rate than a commercial insurer, making the funding standard less onerous for mature schemes.
None of these issues was addressed in the legislative changes introduced in 2005, and the changes which were made have had a relatively small impact on schemes.
Philip Shier is an actuary with Hewitt Associates in Dublin