Nordic Region: A lone rider?
Is the closure of Swedish energy company Vattenfall’s pension foundation a one-off or the shape of things to come? Nina Röhrbein reports
In 2012, the Swedish energy company Vattenfall surprised the pensions world by dismantling the pension foundation it created in 1999 – which had assets of SEK7bn (€834m) – and returning the pension liabilities to its balance sheet because it deemed the investments by its pension foundations to be too risky.
Then, Eddie Dahlberg, managing director at Volvo Pensionsstiftelse, the SEK7.5bn pension foundation of truck manufacturer AB Volvo, alluded that closure could also be a possibility for his entity as increasing regulation, such as IORP II, could result in more restrictions on investments. This was also Vattenfall’s concern.
“One big issue is the resulting increase in bureaucracy surrounding our financial activities, particularly as we are a small organisation,” Dahlberg says. “Therefore, there is a limit on how much we can do or we would have to hire more people which would significantly increase our costs. The even bigger threat, however, is the restrictions on our business as a result of the new regulations. Under the regulations, our investment returns might be so low that it would be better to put the assets back into the company.”
But the closure of pension foundations does not seem to be catching on – at least for the time being.
A Swedish pension foundation – pensionsstiftelse – is a vehicle to finance the company’s pension promise. Thus the foundation has no liabilities and no members – those remain with the sponsoring employer. In order to keep the pledge viable a special law regulates the entities.
Swedish companies traditionally either finance their pension promises by purchasing insurance or keep them on their balance sheets via book reserves. Sometimes they use a pension foundation to fund the liabilities.
But although the employer carries the sole responsibility for paying pension liabilities retained on the balance sheet, companies are required to take credit insurance with PRI Pensionsgaranti (PRI) in the event they do not have sufficient assets to cover liabilities.
The credit insurance will cover the employees should the company go bankrupt, as was the case with Saab Automobile.
“The option – insurance or book reserves with or without foundation – a company prefers and chooses is often driven by cost and cash flow, and on how much demographic and financial risk it is willing to take,” says Albert Bergendal, Nordic international consulting leader at Towers Watson in Stockholm. “Insurance is normally associated with low risk, while a pure book reserve without a pension foundation is seen as riskier than one with a foundation because the capital is in one stock, namely the company itself, implying a higher financial risk. Vattenfall has achieved a return on equity of more than 10% in most years since 2003, however.
“With a pension foundation, however, the company can diversify some risks and meet fluctuations in interest rates,” Bergendal continues. “The reason companies move from one form of financing to another can also depend on factors such as current market conditions regarding discount rates and a change in the attention a company pays to financial figures. Another reason might be to prepare for a potential sale of the company or whether the company believes Swedish pension foundations will be affected by IORP II, which may lead to restrictions on the investment return and increase bureaucracy.”
Pension foundations essentially reimburse the company for the pension payments, but ultimately it is still the company that is responsible for the pension payments – in other words the liabilities remain on the balance sheet and companies will continue to have large exposures to interest rate movements, inflation movements and increased life expectancy.
But to date, the most popular solution remains the pension foundation, particularly for large companies.
“Many foundations were set up 10-15 years ago around the introduction of IAS19,” says Colin Haines, principal consultant in Aon Hewitt’s Nordic retirement practice. “Companies realised that they could get a better expected return on their assets in a foundation than from using insurance options. Many set up foundations because it meant they could reduce the net pension liability and overall net debt shown on the company balance sheet.
However companies have now begun to ask themselves whether this is the most effective financing vehicle for them and whether the returns they receive are worth the risks they run. Some are asking whether they would be better off with a pension foundation that, in current conditions, is expected to generate a relatively low level of return or transferring the money back to the business in the hope of achieving a higher return on their assets. It all depends on how they want to use their capital.”
Anna Gustring Boman, manager for tax services at PwC in Sweden, adds: “We have noticed a trend among companies to review the current financial situations of their occupational defined benefit pension plans and the risks related to those. This is clearly a result of the volatile financial markets, low discount rates and poor returns on investments, as well as the revised accounting standard IAS19.”
Swedish companies want to manage their pension risk more effectively because they are affected by falling interest rates, volatile investment returns, and new longevity assumptions, which in 2011 increased liabilities by around 7% overnight. These have led to lower funding levels.
“The prospect of further longevity assumptions cannot be ruled out, and I predict that this could lead to further liability increases of 5-10% in the next few years,” says Haines. “Companies want to ensure they have a satisfactory financial solution to address these risks.”
Back to the future
According to Bergendal, it has hitherto been the common understanding that it is not possible to move pension liabilities from a pension foundation back to a book reserve. “The Vattenfall case changed this,” he says.
It is possible some companies will decide that transferring the pension liabilities back to their balance sheets will result in better returns than investing in financial markets in the pension fund. And maintaining a pension fund with the same investment return target may require higher risk.
Gustring Boman says a pension fund might be the better option. “Discontinuing the pension fund by, for example, keeping an unfunded pension plan on the balance sheet, is associated with the risk relating to falling interest rates, longevity and other factors, and will be associated with an increased cost for taking out credit insurance with PRI.”
In 2009, a court ruling also clarified that Swedish law prohibits employers from always being able to up a pension foundation to a 125% funding ration with tax-exempt capital. It also stated that it is not always possible to cover a deficit arising from negative returns with tax-exempt capital.
But Bergendal has not heard any strong objections. “After the financial crisis, pension foundations went through some tough times and, even though not required by law, many received top-ups from their sponsors of which a majority have had good investment returns since,” says Bergendal. “So with hindsight, it was not a bad action to take.”
Under current legislation Swedish pensions do not need to be fully funded, although sometimes PRI Pensionsgaranti might require it. This means many companies with separate pension foundations are in deficit, whether due to negative investment returns or increased liabilities on the back of new accruals.
“The fact that companies are required to take out credit insurance is also driving behaviour, as many companies can access credit insurance arrangements quite cheaply,” says Haines. “PRI has kept rates unchanged since 2003, and the basic insurance premium is only 0.3% of liabilities. This means strong companies pay exactly the same rate as weak companies. However, weak companies may need to pledge additional security to be able to receive credit insurance – if they cannot do this they are then forced to insure their pension liabilities with an insurance company, which will be more costly.”
The insurance option
Over the last six years, fewer pension foundations have been set up than before.
“The financial instability throughout Europe seems to have thrown a spanner in the works of setting up foundations, despite interest by companies,” says Bergendal. “Instead, several companies have settled their pension liabilities directly with insurer Alecta, which 10 years ago – with the exception of SAS and IBM, which bought insurance – was uncommon among larger companies. One of the main drivers behind this is companies reporting according to international financial reporting standards (IFRS), amid falling discount rates and increasing liabilities, while several of them do not make use of the IAS19 corridor. There has been a short-term positive financial impact by settling your pension liabilities with Alecta because the settlement premium for many companies has been less than what they have put on their balance sheet under IFRS.”
For all but a few former senior employees, the pensions of the Swedish Match company, for example, are now funded and managed by outside insurance companies.
“If you transfer the pension liabilities to an insurer then the risk is transferred completely off the balance sheet, meaning a third-party insurer takes responsibility for interest rates, longevity and life expectancy,” says Haines. “Companies need to consider whether the additional premium they need to pay to an insurer to take over the risks is worth it.”
But Bergendal says the trend towards insurance solutions will ease off after Alecta recently made significant increases to its premiums for settling pension liabilities.
“In addition, under IFRS many Swedish companies are now setting their discount rates using mortgage-backed, not government, bonds and as those are significantly higher, it allows them to have lower liabilities on the IFRS balance sheet,” he says.
PRI Pensionsgaranti is the monopoly provider of credit insurance in Sweden. It also administrates book reserve ITP liabilities and ensures that pensions are paid out.
“PRI is probably best suited to provide the credit insurance because the firm works closely with Alecta,” says Bergendal. “Although in today’s climate it is unusual to have a monopoly provider, most Swedish subsidiaries and Nordic multinationals seem to be happy with PRI.”
Haines adds: “There is not much pressure from the market for more credit insurance providers, although we could see a more sophisticated approach to the way credit risk is modelled in the future.”