Guarantees - whose business?
IPE asked three pension funds in three countries – in Denmark, Belgium and Germany – the same question: ‘Should pension funds offer a minimum guarantee?’ Here are their answers:
Hervé Noël, director of the pension funds of Suez-Tractebel in Belgium which has AUM of e1.33bn
“We have had a legal obligation since 2004 to give a guarantee of 3.25% where pension fund contributions come solely from the employer and 3.75% on employee contributions. While some pension funds in Belgium take employee contributions it is most usual to do as we do and pay them to an insurance company.
“I think it’s normal that a member gets some kind of guarantee, and certainly as one moves from a DB context I don’t think it’s fair to push people towards a DC jungle and say ‘there’s the money, make the best of it’. The problem is the level of the guarantee. I find that 3.25% is quite high because it is the long-term rate that we have today. We could have been inflation-adjusted, for example, which would have ensured the purchasing power of the contributions. And while the minister of pensions is right in stating that our long-term returns are 7-8%, that includes the returns of the 1980s and 1990s which saw a resurgence of confidence in the stockmarket and declining interest rates, things we can no longer anticipate. So today’s long-term risk-free returns would be something like the 3.25% or 3.5%, and if one took risk one could hope for 5% but probably not more.
“However, since a pension fund does not have to show the 3.25% every year, it’s a medium- to long-term commitment. When an employee is going to leave the company, we calculate the contributions capitalised at 3.25%, and that amount is the minimum that has to be paid out.
“It is also worth mentioning that the guarantee is not given by the pension fund itself but by the employer, so if the pension fund underperforms the company will have to make up the difference. As this only applies to contributions since 2004 and the pension funds returned 9% on average last year we don’t yet have experience in applying the guarantee. However, according to the IFRS the sponsor has to calculate a potential liability since DC with a guarantee is treated like DB.
“But whereas an employer in a DB scheme has the good and the bad side of the risk, as if the pension fund’s performance is better than assumed the contributions can be reduced, in a DC with a guarantee there’s just the downside risk because if the performance is fine the employee gets all the gain.
“And that leads to a slightly more conservative investment policy. Our reaction is to accept some risk on the asset side, so that the companies could in theory have to make top-up payments because the 3.25% return was not achieved on average during the career of a member, but there is also a risk associated with being too conservative. We could invest in long bonds, but then we run the risk that the member would conclude that his contributions have been or are being managed poorly and that his pension is not acceptable because of his employer’s excessive risk aversion.”
Peter Melchior, executive director of Danish industry-wide fund PKA, which as AUM of DKR100bn (e13bn)
“Yes, I think so, because when you give a guarantee you are under certain investment rules, the regulator says you are not allowed to make any really crazy investments. And this is a protection for the members. But of course the guarantee should be at a reasonable level.
“Most of the current guarantees were last set in 1982, with the whole industry giving a minimum guarantee on a basis of a 4.25% interest rate after tax, and that means we have to earn at least a 5% return. And I remember when we made the tables many people in the industry suggested that as interest rates were close to 20% we should set the guarantee at 7%, 8% or 9%. But others urged caution and time has shown that they were very wise.
“We had some subsequent problems when the government levied yield taxation and although we should have reduced the guarantee at that point we didn’t, because even after tax interest rates were high.
“However, in 1995 we reduced it to 2.75% then in 2001 to 1.75% for new business and on the additional amount when our existing members increased their premium contributions. However, the old guarantees are in fact a locomotive for high returns because, as we have to give our old customers 4.25%, it means everyone’s getting it.
“But over the past few years the debate on guarantees has focused on the problem they pose for the government as they prevent the government from making taxation changes because it is aware that to do so could push company pension funds into bankruptcy.
“So the government wants us to lower the level of the guarantees and has indicated that we should be able to cope with so-called Japanese-level interest rates, at very close to zero.
“And many pension funds – including PKA – will respond positively to this within the next few years, although they will do it in different ways – some will simply skip the guarantees while others will skip them until a member reaches retirement age at which point they will give a guarantee based on the current interest rate, and some pension funds and insurance companies offer their members inducements to surrender the guarantees.
“We don’t do this because we think that there could be a problem around whether people understand the implications of giving up a guarantee, meaning that we could have a potential advisory problem and at some point face a legal challenge on whether we had advised people the right way. And the members of our pension funds are health sector employees, people with no or very little financial training, and it would be a very difficult decision for them to make.
“Another problem is that we have guaranteed the level of a pension to a certain mortality level so a substantial fall in the mortality rates could be even more expensive than if interest rates fall. The mortality rate of Danish women, and 85% of our members are women, is higher than that of our neighbours. Consequently, when we calculate that in 10 or 20 years people will be living longer we have a problem. A couple of years ago it was calculated that if Danes lived like the Swedes the VAT rate would have to rise to more than 40% from 25% just to fund the first pillar pension.
“The guarantees have some, but not much, impact on our investment strategy. Our allocation for equities is around 30% – it varies a little because we have eight pension funds – and that is rather high in Denmark. But if we did not have the guarantee we would have something like 35%, and should one day interest rates fall a further 100 bps we could not afford to have as many equities as we want.”
Hans Willi Siegberg is a member of the executive board of DEVK Pensionsfonds-AG which includes the pension funds of the German railway system. It has AUM of e25m
“It is part of the German mentality to avoid risks that are too high, and that applies especially to retirement provision. So we have a long tradition of DB schemes. But the strong trend to DC schemes of recent years has led to the inclusion of an implicit guaranteed benefit plan, for example, by a formula which computes the expected guaranteed pension from the premiums.
“The new German pension law, the Altersvermögensgesetz, which came into effect in 2002 created Pensionsfonds and requires that on a member’s retirement they give a minimum guarantee of at least the sum of the contributions that is used to pay a life-long pension. You can interpret this as a guaranteed rate of return of 0%.
“Pensionsfonds are separate companies and do not appear on the sponsor’s balance sheet. They are funded by contributions from both employers and employees, funding by employers still being rare.
“DEVK Pensionsfonds offers an extended guarantee, including survivor and in invalidity pensions to the total of contributions. I think that it is only fair that employees get back the money they have paid in.
“And the level of guarantee is not so high. So it does not impose restrictions in terms of asset allocation and so allows us to pursue better performance. It is a good compromise between performance risks and a guarantee.
“To finance our guarantee, premiums are divided into two parts, one being invested in AAA-rated zero coupon bonds with a duration that ends at the member’s retirement date while the other part is put in investment funds.
“On the member’s retirement the zero-bonds ends and the premium is disposable, and a small part of the allotment to investment funds is used to provide the minimal risk premium needed to finance our guarantee in cases of death and invalidity.
“In this way we have developed a natural and individual life cycle model for our asset allocation. For young employees we invest in a high portion of equities and a small portion of zero coupon bonds and for older employees it’s vice-versa.”