Portability: benefit or burden?
In October 2005 the European Commission published a draft directive on the portability of occupational pension rights in the EU. (Like all other directives, the requirements would be considered minimum standards; member states could maintain or create more favourable conditions for employees.)
The Commission has always promoted the freedom of movement of goods, services, capital and people, and is always on the lookout for obstacles to any of these. The review process for the directive is expected to last one year, and the proposed deadline for implementation by the member states is July 2008.
The Commission estimates that approximately 9% of employees in the EU 25 change employers every year and an estimated 33% of employees in the EU 15 change jobs within five years.
Do occupational pensions restrict the freedom of movement of people within the EU? The answer in many countries must be yes, or at least must have been yes, judging by legislation enacted to protect ‘early leavers’ from losing some or all of their pension benefits. Losses arise for two main reasons:
q Waiting periods and vesting: People with short periods of service may either not have joined the scheme at all, or lose their rights completely. In extreme cases such as most French final salary plans, there is no vesting at all, and employees who leave service before retirement lose all their rights. Many other EU countries have imposed maximum vesting periods, but employees who leave a job after a shorter period than the minimum are still at risk of losing their rights;
q Revaluation: In defined benefit (salary-related) schemes, the amount of retirement pension accrued for a particular period of service depends on what the employee does between that period of service and retirement date. Employees who leave service with vested rights may have their rights frozen (as in Germany) or linked to inflation (as in the UK, with a cap), both of which would probably be less than the rate at which their own salary would have been expected to increase if they had stayed in the job.
In addition, employees are often unable to transfer their accrued rights from one plan to another; for example from a previous employer to a current employer, or perhaps to a non-employment-related pension plan in the form of a pension policy with an insurance company.
The directive seeks to enhance employees’ rights under two main headings:
q Protection against loss (covering waiting periods, vesting, and revaluation);
q Transferability of rights earned in previous employers’ schemes.
But is that what really matters, and will the directive make a real difference?
Firstly, it is important to stress that transferability of rights from one scheme to another, or indeed from one country to another, is perhaps desirable (it can be used to manage risk to an extent, and allows the employee to receive pension from fewer sources), but is certainly not necessary to ensure freedom of movement. A transfer value is “the present value of the benefits given up”, that is, the present value of the vested deferred rights, and if those rights are worth less than the benefit the employee had earned immediately before leaving service, transferring those rights to another scheme will not change that.
This point has been made forcefully on many occasions by the French complementary schemes ARRCO and AGIRC, which are not funded in advance (they are national social security-type pay-as-you-go schemes), and which have in the past been threatened with occupational pensions legislation, before it was confirmed that they should be considered as social security schemes and be regulated as such. They quite reasonably point out that they are no barrier to mobility, as benefits once earned are not affected by what the employee subsequently does (with the possible exception of retirement age if his career is partly in a country with no totalisation agreement with France), and are payable from ARRCO and AGIRC from retirement age wherever he happens to be at the time.
Secondly, why should this be an EU issue and not a national issue? The number of people changing jobs across borders in the EU is tiny compared to the number of people in the EU who change jobs within the same country. An employee in Germany who leaves service after four years (the maximum vesting period is five years, and few companies offer vested benefits before this) will lose his accrued pension rights, irrespective of whether he takes up another job in Germany or elsewhere in the EU (or the world).
But the most important issue at stake is that being an area of social and labour law, the directive will require unanimous approval from all member states before being enacted. Pension provision is a politically sensitive area: the trade unions pay close attention and are not afraid to strike on the subject (witness recent events in Belgium and France), and governments are painfully aware of the significant macroeconomic cost of providing pension benefits. We can therefore expect to see some serious compromises, the most important of which will probably be the definition of what schemes are covered.
The draft directive quite reasonably excludes all social security schemes and others covered by EU Regulation 1408/71 (the EU-wide totalisation agreement that ensures employees do not lose social security pension rights if they move around the EU to work). However, it then goes on to offer member states the option to exclude unfunded pension schemes in
their own countries, when they transpose the directive into national law.
Remember that ‘unfunded’ simply means that no funds are set aside in advance, and cash is only paid by the employer when the benefit falls due. The most common example of this is the direct pension promises made by many German employers, and backed by balance sheet provisions or ‘book reserves’, but unfunded top-up schemes in the UK, France and elsewhere are the same. (National pay-as-you-go schemes such as ARRCO and AGIRC are different in that a cash payment is made by the employer as soon as the rights are earned. But such schemes are generally covered by 1408/71 and automatically excluded from the draft directive anyway.) And it would seem sensible to allow unfunded schemes to be excluded from the ‘transferability’ part of the directive, as raising the capital required to pay a transfer value (being the discounted present value of benefits to be paid in the future) could pose serious and unpredictable cash flow problems, and transferability is after all more a matter of convenience than of protection against significant loss.
But there is no logical reason for excluding unfunded occupational pension schemes from the ‘protection against loss’ part of the directive. From the employee’s perspective, it does not matter whether or not a pension promise is funded, unfunded, insured, pay-as-you-go; the actual benefit remains the same. (Security of financing and the risk of non-payment are not the subject of this article nor of the draft directive.) Why should an early leaver’s benefit be protected if it happens to be from a funded pension plan, but not from an unfunded one?
Therefore, this option to exclude must be a political ‘fudge’, designed to avoid the opposition of Germany, for whose employers shortening the vesting period from five to two years and introducing mandatory revaluation during the period between leaving service and reaching retirement age would represent a significant additional cost. (Curiously, the original argument put forward against the previous shortening of the vesting period from 10 years to five was firstly that as relatively few employees changed jobs after less than 10 years it would not have much of an effect on benefits, and secondly, that shortening the vesting period would be too expensive; you do not have to be an actuary to see that these two arguments are completely contradictory.)
If we exclude the Germans, what practical effect will this directive have on European employees? The directive will have virtually no effect on defined contribution arrangements, where vesting is often immediate, and rights are revalued in line with credited investment returns whether the employee leaves or stays. Further, many countries with significant defined benefit occupational pension provision have already addressed these issues; the UK, Ireland, Netherlands, Belgium (for example) all impose requirements on vesting and revaluation that would largely satisfy the requirements of the directive.
Some practical effects might include:
q The minimum age, not exceeding 21, at which employees would acquire supplementary pension rights would have the greatest impact in Belgium and Germany. In those and many other countries, employers would be obliged to admit their employees in their early to mid-20s to their pension scheme. Limiting the waiting period (before a new employee of any age may join a scheme) to one year would have an effect in Luxembourg where this is often up to 10 years, or Spain where it is up to two years, but rarely anywhere else;
q Employees would be subject to a maximum vesting period of two years. There is some diversity among the member states with regard to the legal requirements for vesting. In practice, benefits generally vest after five years in Denmark, Germany, Luxembourg, and Austria (in certain instances);
q Employers would be required to revalue deferred vested pension rights—the acquired rights left in the supplementary plan of the former employer—so that the real value of the benefit does not fall as a result of inflation. In order to reduce employers’ administrative costs, member states would be allowed to establish a threshold by which deferred vested rights would not be preserved in the original plan but transferred to another plan or paid as a lump sum. Currently, most member states do not have legal provisions for the treatment of deferred vested rights, although for example in the UK and Ireland some or all vested rights in defined benefit plans must be increased annually by the inflation rate subject to an annual ceiling;
q Employees would be entitled on request to certain details in writing regarding acquisition, revaluation and transfer of pension rights.
So we can see that in exchange for relatively little overall practical effect across the EU, many small changes will need to be made to pension arrangements in order to make them comply.
Further, many smaller schemes which might be aimed at senior executives and intended to provide only a part of their benefit will be disproportionately affected, and in some cases (such as French top-hat schemes) the tax-efficiency of the plan could be jeopardised.
We can expect considerable discussion, amendment, and concessions if the directive is to be passed at all. The author’s view is that without requiring unfunded schemes to be included, the ` will have little practical benefit while imposing an administrative burden on many smaller schemes. Perhaps a long transition period, in the tradition of many EU directives, for unfunded schemes would be preferable instead? Watch this space!
Tim Reay is an international pensions consultant with Hewitt Associates