Pressure to scale up to hold down costs
Gail Moss looks at how multinational companies are grappling with pension scheme underfunding in the face of rising longevity pension scheme underfunding in the face of rising longevity
As longevity increases and pension fund liabilities grow, underfunding continues to be widespread. So many multinational companies are recognising the advantages in placing their pension schemes throughout different countries under the control of the corporate centre, where the chief financial officer and the risk officer can keep closer tabs on them.
The concept of the multinational pension scheme does, however, raise issues that companies need to consider carefully in order to develop a successful model.
In-house or outsourced?
One of the basic decisions is whether to outsource all or part of the pension administration and investment functions, or to run them in-house. As with any other outsourcing decision, the main criterion is size.
"As a rule of thumb, it would be worthwhile to consider in-house technical administration if the sponsoring company has a 1,000-plus workforce," says Peter Zanella, director, retirement solutions, Towers Watson in Switzerland. "Investments, however, are normally outsourced to external asset managers, unless their funds exceed €1bn, in which case part or all of the assets are often managed in-house."
Another important factor is the quality of personnel available. Some smaller pension funds employ special staff covering financial corporate services, who are highly effective in managing their own assets. Technical administration, however, is usually outsourced because smaller companies tend not to have adequate staff.
But many other companies which could theoretically use an in-house solution, deliberately choose an external provider.
"Usually this is because of governance, and also to avoid being involved in non-core business," says Zanella.
"Even so, increasing regulation both in the EU and in some individual countries will strengthen the arguments for outsourcing, leading to lower thresholds. This is particularly true since the provision of technical administration services is becoming highly competitive."
In Switzerland, the pressure for more transparency, and hence cost reduction for asset managers, has also been fuelled by the low performance realisable in the past couple of years, continues Zanella.
But a government study on costs in the second pillar has just been published, indicating that the undisclosed investment costs are about three to four times higher than those formally reported.
"We expect there to be some political sympathy with this study, and consequently more pressure to reduce costs, particularly for asset managers and certain types of alternative investments like hedge funds and private equity," Zanella adds. "We believe this will lead to more demand for services to monitor all providers in the marketplace, especially on cost-efficiency."
The decision to outsource is also dependent on how centralised the scheme is: if the company is too decentralised, outsourcing is more difficult, says Stephan Wildner, head of general consulting at Towers Watson Germany.
Pension benefits do have a role for companies finding it hard to recruit the right skills, a growing concern in Germany at present, thanks to the current set of positive circumstances.
"Companies can use pension benefits as one way to ease the labour shortage," says Jasper. "But they need to have cost transparency in order to work out how much the company will have to pay for these benefits. Companies also use benchmarking for the admin process, and outsourcing is always part of such benchmarking, so companies are considering it."
DC pooling platforms have grown in popularity over the past few years.
One reason is that they allow small and medium-sized schemes access to specialist funds or asset classes - such as currency or property funds - which might otherwise be impossible for them to invest in. This is important, as many multinational companies have large pension schemes in one or two countries, with much smaller schemes elsewhere.
There are also cost advantages to pooling, says Andy Cheseldine, principal, Lane Clark & Peacock."Pension funds investing small amounts often pay substantial charges, even if they can get access to funds," he says. "But pooled platforms consolidate smaller amounts into much bigger investments, so they pay lower percentage fees."
All this is true of both DB and DC schemes. But it is particularly true of DC schemes, since they are more likely than DB schemes to be recently established, with much lower cash inflows.
Furthermore, transaction costs can be reduced substantially. Each time a pension scheme client changes investments, instead of buying and selling funds, asset platforms can simply switch the ownership of funds between clients. This means they only need to sell or buy whatever is left, once these internal transactions are netted off.
Administration costs can also be reduced, where members of the same trust-based DC scheme are moved wholesale from one fund to another on the same platform.
"Switching members from one fund to another means maintaining records of the two different unit prices," says Cheseldine. "Fund administrators can charge, say, £20,000 to £30,000 plus an annual fee for doing this. Using a platform means that funds can be white-labelled and maintained at the same price, which reduces costs for switches between them."
The use of a platform also reduces market-related risk, he says.
"Some of these investment funds may not be very liquid, so for individual investors they may take a week to sell, another fund may take a week to buy, and in the meantime the market may have moved in the wrong direction," says Cheseldine. "But if sales and purchases are taking place between members of the same platform, ownership can be transferred very quickly."
However, pooling platforms aren't always a win-win situation. Platform providers may well charge an extra layer of fees, and pension schemes have to calculate whether the bulk purchasing power and transactional simplicity makes these fees worth paying.
"Going through a platform may not make sense if, for example, you're investing in index trackers," says Cheseldine.
Meanwhile, there are also external factors that can affect the usefulness of pooling platforms. For example, the legal framework in Switzerland does not favour pooling investments. So pension funds normally achieve economies of scale by linking into multi-employer funds (BVG-Sammelstiftung), which have been gaining in momentum.
"But we do often see pooling arrangements at multinational firms for covering risk benefits in the case of disability and death," says Zanella. "However, there are also legal issues here. Employees of a subsidiary in one country may end up subsidising employees in another country. From a strict legal standpoint, this uneven distribution does not comply with Swiss law."
The rise of DC platforms
The benefits outlined above have contributed to the growing popularity of DC pooling platforms throughout Europe.
"In the UK, this has partly been driven by trustees and their advisers wanting to choose between best of breed managers," says Cheseldine. "We see this happening across the world as well, and we think it will be the norm in all DC schemes as these schemes develop."
Strictly speaking, pure DC plans do not exist in many countries, including Switzerland, because of the legal requirement to guarantee a minimum termination benefit where an employee leaves the company (although this guarantee is to be abolished as soon as possible).
"In many cases, the subsidiaries of multinationals are pushing for such plans, and the big globally operating Swiss companies also envisage such schemes," says Zanella. "Novartis has recently introduced such a plan for salaries higher than CHF150,000 (€123,585) per year, and we expect that in the next five years, at least half the Swiss market index companies will do the same."
Communication of pension risk
It is not only pension scheme members who need to be educated about pension risk.
As funding problems across Europe have increased, multinational companies have reacted to the need to understand pension risks better.
In Germany, for instance, companies have started to implement governance structures to keep directors and key stakeholders informed about funding developments.
"The aim is to create transparency in internal communications and make all departments, including the finance and HR departments, involved and aware of what is going on," says Wildner. "Typically, German companies install a pensions committee, bringing together different departments involved with pensions, such as HR and finance. These discuss pension topics on a regular basis."
He adds: "These committees can alternatively be used as the boards of financing vehicles, or run side by side with pensions committees. But all companies have a strong reporting line for pension assets as well as liabilities, and also funding developments, receiving explanations for changes in funding levels. Reporting is no longer just once a year, but quarterly and sometimes even monthly."
But pension schemes still have to overcome the inability of many members to save adequately for their retirement. Even worse, there are those members who have become overly risk-averse because of the economic crisis.
"In the Netherlands, we didn't talk about risk or explain its benefits, so members only see the downside of risk," says Bram van Els, founder of PR and communications consultancy Backscratch. "But they should be told from the start that pension funds need to take a certain amount of risk to achieve an affordable, good outcome. No risk means no returns."
The ideal means of communication is one-to-one conversations with members, says van Els.
But given the practical difficulties with this, an alternative is meetings such those organised recently by the Dutch healthcare profession pension funds, covering two million members. Presentations by senior executives were held in local theatres, followed by an hour of questions and answers with members.
Around 500 people could be seated in each theatre, with a further 1,000 watching a live internet stream. Questions were invited from the audience, including internet viewers who asked questions via Twitter; these were then relayed to the executives on stage.
"It was very successful - people left the theatre thinking differently from when they arrived," says van Els. "They then spread information by talking about it to their colleagues."
Other useful means of communication include scheme websites with online tools.
Backscratch, in co-operation with the Dutch Pension Fund Federation and Ortec Finance, has developed an interactive package allowing users to act as the director of their own pension fund, altering their contribution rate, retirement age and level of risk, and choosing their asset allocation to show the effect on their real-time pension outcome.
"Our experience has shown that 60 or 70% of users choose to put their money in the bank," says van Els.
"So information tools like this have to be very explicit about the need for risk, as part of a wider aim to manage expectations, because the chances are that the return will be lower than members expect."
Nevertheless, says van Els, the truth is that a pension deal - from joining through retiring to death - can last as long as 70 years, and there is no such thing as a fixed deal for that length of time.
"We have to be fair with our members and say we don't know exactly what they'll get when they retire," he says. "But we can tell them it will definitely be more than they'd get from the banks and insurance company products."
Recent research from Ortec Finance has shown that a 1% lower return per year results in a 30% lower return overall for the average pension plan.
"The biggest industry-wide schemes charge around 0.5% a year in investments costs to members, but buying a scheme on an individual basis from commercial providers can more than triple that cost," says van Els. "In that situation, costs can be higher than the investment risks. So if you tell members about risk, you should also tell them about costs."