Pensions the Hibernian way
The Irish pension system was very often thrown alongside the UK system for general discussion purposes and was considered as a mirror image of the UK system 10 years ago. How very wrong that image would be today.
Like the Irish economy, the Irish pensions system has had to evolve, adapt and react to a very rapidly changing economic environment. Consider some of the key features of the new Irish economy:
q Full employment;
q Surging property prices;
q High performing stock market;
q Enviable GNP per capita;
q Favourable balance of trade and payments.
This situation has lead to a very serious increase in living standards over a relatively short period of time. How therefore does all this affect pension requirement and provision for the population as a whole? Let’s consider two elements of the economic edifice, one financial and the other demographic. Let’s examine how (a) interest rates and (b) life expectancy are affected by the new economy and then how they in turn have impacted the pension system.
Ireland is part of the EU and as such is governed by euro interest rate levels. Our booming economy is locked into an interest rate structure dictated by less well performing economies such as France and Germany. This low interest rate environment has helped to fuel growth and generate high living standards for those in employment. The reverse side of this coin is a demanding one for those who are retired. Low interest rates means less income from investments and consequently the challenge facing both government and employers has emerged as follows:
q The need for high contributions to fund occupational pension schemes;
q The need for high real increases in state social welfare pensions in order to keep pace with the rising GNP.
Simply, when interest rates are low the cost of providing a pension rises correspondingly.
For decades Ireland has propped up the league table of mortality rates and life expectancy in Europe. Often quoted reasons such as poor diet, no exercise, excess alcohol consumption, lack of medical treatment and
so on. were put forward to explain the differential between Ireland and other countries. In turn this was reflected in the assumption
made by actuaries in relation to pension provision and annuity costs. However, you have to only think back to the Japanese model at the beginning of the last century to be aware of
how this can all change from one generation to the next.
At the beginning of the 20th century Japanese mortality rates were high and it was only with the advent of a more buoyant economy that we witnessed the turn-around that ensued. Is it possible that a similar phenomena will occur here in Ireland? Whether or not it does happen, we are no different to the rest of Europe in experiencing a prolonged trend to ever increasing life span. Similar to low interest rates, this means higher costs to be borne by both state and employers in meeting funding charges and pay-as-you-go pension costs respectively.
How has this impacted pension provision? Employers in particular have reacted in the swiftest way possible by taking steps to control costs. Many have closed their defined benefit pension schemes to new entrants and new employers have opted for defined contribution arrangements. These continuing but closed defined benefit schemes are causing major controversy due to increasing cost when expressed as a percentage of payroll due to:
q Natural ageing and decline of the payroll in respect of affected employees.
q Reluctant switching from equities to fixed interest bonds in order to close out volatilityand cost uncertainty.
In due course the shifting pattern will place more pressure on government to examine its role more closely. At present the basic state pension of circa e10,000 is the only income available from the state to a 65 year old retiring today. For 50% of the working population this is an issue as they have no supplementary occupational cover. For the remaining 50% the future seems reasonable if you are a member of a well provided defined benefit scheme. However, increasingly the position will deteriorate for an increasing number of existing employees. That is, of course, unless they choose to increase their personal pension provision and / or private savings. Given that much of personal wealth consist of the family home plus in some cases an overseas holiday home then the risk of a property crash combined with an impoverished generation of retirees becomes more apparent.
With the decline in interest rates and increasing life expectancy we have reached the inevitable point when the cost of purchasing an annuity from an insurance company has reached boiling point. For a married male at age 60 the cost of a last survivor annuity of e10,000 annually is now circa e400,000. Welcome to Ireland the land of centurnians. Perversely this rising annuity cost has had the effect of causing more pension schemes to be registered as ‘insolvent’ under the statutory funding standard. Hence another reason for scheme closures and switching to defined contribution arrangements.
One very positive development emerged from the abyss of spiralling annuity costs in 2002/03 when the then Minister of Finance and now European Commissioner Charlie McCreevey liberalised the pension system for self-employed and owner directors. McCreevey declared that such persons could take 25% of their pension fund tax free and invest the balance in a personal fund known as an Approved Retirement Fund (ARF). The ARF is effectively a substitute for purchasing an annuity. The retiree can then decide how to invest, when to draw funds down, how much to draw down, etc. This wise and visionary move was extended to apply also in the case of an employee’s personal voluntary contributions. In all cases this is subject to the individual having a minimum level of e12,700 annual “guaranteed” income.
Following in the footsteps of Charlie McCreevey, our present Minister for Finance, Brain Cowan has innovated further. At the risk of being labelled a follower of UK practice, he has introduced a lifetime allowance of e5m. with a cap of e1.25m. on tax free lump sums. In addition all holders of ARF’s must pay annual income tax by reference to a minimum drawdown rate of 3% per annum.
Given the inevitable trap that the various stakeholders feel they are now in, some sense of ‘option’ needs to emerge in order to salvage what is good under defined benefit. Government could extend the ARF option to members of defined benefit schemes as they retire, subject to a new higher minimum “guaranteed” income requirement. This could go a long way towards removing the annuity trap that currently snares employers and employees alike. Nevertheless even in such circumstances there is no guarantee that the exodus from defined benefit would reverse itself as the current onerous accounting requirements under IAS19 will continue to prevail.
In the absence of some form of release of pressure, government will ultimately be forced into introducing a mandatory pension system. This will probably be at a relatively low level and would unfortunately form the benchmark for the standard of future pension provision by employers and employees.
Clearly one way or the other, the responsibility for saving to enjoy retirement will rest increasingly with the individual. Employees must understand that one consequence of their high salaries / living standard is the need to consistently forego part of their income in order to pay for their retirement years. The alternative is to have lots of children who you hope will look after you in later years, potentially a much more costly option I suspect!
Ireland is not alone in wrestling with the challenges that befall a successful economy in the context of its present and future retirees. We can learn from the examples of France, Germany, Switzerland and further afield Japan and China. We have been wise and have taken a precautionary step (again under the vision of Mr McCreevey) by establishing a National Pension Fund. Each year government invests 1% of GNP in order to accumulate a fund which will help to stabilise the cost of pensions to the Exchequer from 2025 awards as the population ageing begins to impact.
Beyond this initiative there is the potential for Ireland to become a major centre for the administration/investment/regulation of multinational pension funds and in particular for Pan European pension funds. As employers, governments and savings institutions strive for efficiencies they will find that Ireland offers an ideal location. The experience of practitioners, the structures to operate internationally and the attention to high levels of governance will ensure success and promote confidence. In a sense it is not too late for Europe to diffuse its ageing time bomb and Ireland can lead the way.
Gerry O’Carroll is actuary with Watson Wyatt and heads the Irish practice