Risk sharing on agenda
Pension fund deficits and international accounting pressures are encouraging employers in some European countries to move from defined benefit (DB) pension plans to defined contribution (DC). The effect is to shift the financial risk of the pension from the employer to the individual employee.
So can pensions be designed to share both investment risk and the risk of company failures more fairly between employers and employees, and between different generations?
We wanted your views on these and other options. As ever, we found that views varied according to the risk-sharing characteristics of pensions schemes in different countries. There are also different perceptions of corporate risk. For example, the manager of a Belgian pension fund points out that continental Europe does not necessarily share the UK’s concern that defined benefit-type corporate pension schemes may not be able to fulfil their pension promise.
“In my view public opinion on corporate pension plans is not a lack of confidence or even mistrust. On the contrary people see corporate pension funds as an extra security in case of a crisis in the first pillar state retirement system, which is perceived as quite likely to happen,” he says.
“This might be different in the US and the UK, but I believe continental Europe hasn’t seen a lot of big financial scandals, bankruptcies which have affected employees pension rights or savings – or at least these consequence have not been particularly highlighted in the popular press.”
Yet there is some consensus about general trends. A clear majority of the pension fund managers and administrators who responded to our survey agree that, in occupational pensions, a reduction in collective risk-sharing and an increase in individual risk are inevitable.
In some countries, however, whether the risk is borne individually or collectively will depend on the nature of the benefit. The manager of a Spanish pension fund, for instance, points out that “for the moment the risk is supported by the employees, but collectively with respect to disability and survivors’ pensions.”
The remedy is to spread the risk more equably. A smaller majority, four out of seven respondents agree that financial risk in occupational pension plans should be shared equally between the sponsoring company and the pension plan members.
“Perhaps more equally rather than equally,” one UK pension fund manager suggests. “A more balanced approach could be good for both parties,” the manager of a Swedish pension fund agrees. “Only if the ‘going concern’ risk is shared equally as well,” cautions the manager of a Swiss fund.
A majority also agree that sponsoring companies that move to defined contribution (DC) pension plans are placing too much financial risk on their employees. One manager of the pension scheme of the French operations of a multinational observes, “At the moment there is no real obligation for the company to select a ‘good’ set of funds.”
Yet the risk of DC schemes is simply investment risk. One UK pensions fund manager points out “at least the risk in a DC scheme is transparent risk. In DB schemes there is the hidden risk of an employer becoming insolvent and an individual’s entitlement being eroded partially or completely.”
Indeed, proponents of DC pensions and individual savings have argued that they are the best market solution to risk sharing. This claim gains scant support from our respondents. One pension fund manager perhaps speaks for many when he says that “DC pensions put too much of the risk on the member. All the employer has to do is meet the contribution.”
Defined benefit (DB) pension plans confer their own risks. It could be argued, for instance, that DB plans transfer unrestricted risk to younger generations. Only one three of our respondents support this proposition.
A Spanish pension fund manager comments: “I agree that they pass on some risk but they also pass on scale economies, momentum and buffer funds.” And for a Swedish pension fund manager “the funding level is important”.
Perhaps only a pay-as-you-go (PAYG) pension system can provide true inter-generational risk sharing.? This suggestion gets short shrift, with four in five respondents agreeing. “PAYG is the younger generations taking the risk of the older ones,” says one manager.
The real risk lies in the plan design, the manager of a UK pension fund suggests: “Potentially perhaps the biggest risk is that the benefit is not actually defined until retirement.”
Demographic changes or merely disenchantment with pensions are likely to mean fewer young people are willing or able to underwrite the pensions of older generations. A large majority of those who responded to our survey agreed with our suggestion that the support base of younger generations in DB pensions systems is limited and is likely to diminish further in the future.
What, then, is to be done? Compulsory membership of an occupational pension scheme is one way to ensure some level of inter-generational support. A substantial majority agree.
One pension fund manager adds “automatic take-up is also a good solution, with an option to opt out”.
Yet some have doubts about whether this would have the desired effect. “Membership should be mandatory but I’m not sure that it would necessarily promote inter-generational risk sharing,” says the manager of a French pension plan. And the manager of a Swedish pension fund says that tying young people to pension schemes misses the point. “We in the pension market talk as though a pension was the only way to support yourself as a rentier. A pension is only about money, and you can live just as easily off the sale of a house or some other asset that is protected against tax.”
One way of sharing the risk of company failures is through multi-employer pension schemes, already a familiar feature of continental pension systems. A large majority of respondents - four out of five - agree that this is the way forward, although as much for cost reduction as risk reduction.
A Danish pension fund manager says: “It is best for all employers.” However, one UK pension fund manager disagrees strongly, suggesting that such schemes result in good companies propping up the schemes of bad companies. “There is a serious problem of risk-sharing between employers – the ‘free rider’ problem.”
There is also near unanimous support for the suggestion that hybrid pension plans could lead to a more balanced sharing of risk between sponsor and employee than pure DB or DC plans.
Finally, Bernard Dumas, a
professor at INSEAD, and Andrew Smithers chairman of UK asset management consultancy Smithers & Co have proposed sharing risk by creating a market in pension rights. Part ownership of a pool of similar risks would have the same value as the original right but the effect of pooling would be a marked increase in welfare. The risks of a scheme defaulting would not change but the impact of default would be spread.
A slight majority of respondents would support such a proposal. However, the large number of ‘don’t know’ responses reflects the fact that this idea has yet to be widely disseminated.
Only one in four think that a market for trading pensions rights would restore people’s confidence in company-sponsored pension plans. One manager of a Swedish pension fund comments: “That might help, but there is a cost.”
Perhaps it is not possible to eliminate the risks of a pension, nor should governments or regulators try to do so. One UK pension manager probably speaks for many when she says that so long as people are free to choose their pension, they must accept some risk
“While supplementary pension provision is not compulsory, then employers should be free to provide pensions in whatever way they see fit, be it defined benefit or defined contribution. What is more important is that employees understand the nature of risk of each type of plan in terms of investment, longevity, adequate contribution levels, employer insolvency, etc.
“In a global business environment, companies must compete on costs and cannot afford to write the virtually ‘blank cheques’ associated with DB provision without transferring some costs and risks.
“The alternative is to pay everyone cash and let them get on with it. Companies will get increasingly fed up with added governance, costs and aggravation for what is essentially a voluntary benefit, at least in the UK.”
The risk of pensions, in this case, is that companies will no longer want to provide them.