Collective defined contribution pension schemes have been in existence for years in a number of countries. As with all pension funds, risk sharing between generations, and also between scheme members, can be a vexed issue. One area where there has been considerable innovation on this question is pension funds for members of professions, such as doctors and architects. And three countries in particular – the Netherlands, Germany and Italy – have long-established schemes for professional groups.
There are around a dozen Dutch pension funds for professional groups. Membership is mandatory for all of them except the pension fund for freelancers, known in Dutch as ZZPs.
As second-pillar funds, they are generally career-average DB plans or DC schemes financed by premiums fixed for five years. Contributions are around 20% of salary.
The relatively high premiums support intergenerational solidarity and the premiums rise with age. Premiums for DC plans have also been raised in recent years because of legal changes making it easier to use 3% ladders; previously, 4% ladders were more common. For example, more of the premium from a 3% ladder can now be invested, compared with before the changes.
But because of the absence of a sponsor, there are no guarantees and at least one fund has reduced benefits because its deficit could not be covered by investment returns or increases in pension contributions.
Other solutions have been more innovative and at least one professional scheme has organised a one-off extra contribution from members. But other schemes have rejected this idea because of perceived risks.
Corine van Egmond, senior ALM consultant at Aon Hewitt Netherlands, says the feasibility of this strategy depends on the nature of the relationship between the professionals.
“If they are close to each other, they might be happy to make a payment,” she says. But if they are professionally competitive, it might not be possible.”
Another solution is to close an unrealistically generous scheme altogether. For example, SPT, the pension scheme for dentists, was closed to new entrants in 1997 and was exempted from mandatory participation in 2010.
Van Egmond says that in trying to promote intergenerational fairness, funds need to look at the different age cohorts in order to see what any changes to the current plan will cost them.
And she says it is also important to assess the risk appetite of participants so that this can be translated into investment policy.
Some Dutch professional funds do this via membership surveys, which include questions on financial knowledge, financial possibilities and attitude towards risk.
“In general, professional groups are well-educated and earn high salaries, so are likely to have a more offensive attitude towards risk,” van Egmond says. “In contrast, members of industry-wide schemes earn less, with more demands on their pockets, so are likely to have a more defensive risk appetite.”
Each risk profile has its drawbacks. In particular, for professional schemes, asset mixes that produce excess returns can allow for continuing indexation. But they also run the risk of losses, leading to benefit cuts.
Although professional pension funds lead the way in terms of risk-sharing, van Egmond says there are still things they can learn from the rest of the pensions community.
“Industry-wide funds need to comply with collective labour agreements, so both employers and unions have to discuss pension plan design,” she says. “However, with pension funds for professional groups, there is only one party involved – the professional group, represented by their association.”
Van Egmond says pensions are often not on the agenda for these associations, because their priorities are elsewhere – for example, with raising professional standards. “These pension schemes need more attention from their own professional bodies – members of that vocation are individuals who need retirement provision like anyone else,” she says.
In Germany, members of certain professions such as architects, chartered accountants and dentists are not subject to the pay-as-you-go national social security pension scheme – a situation dating back to the nineteenth century.
To secure first-pillar provision, each of these professions runs its own scheme (Versorgungswerk) which all members of the profession are required to join.
These schemes are regulated under German public law; the governance structure usually entails executive and supervisory bodies, plus general assemblies, each with specific rights and obligations. They are generally DC schemes.
The scheme benefits provided include retirement pensions, and pensions for disability, widow(er)s and orphans, as well as death benefits. These are guaranteed benefits tied to a certain discount rate. The value of these guaranteed benefits is derived from age-specific mortality tables.
At a glance
• Pension schemes for professional groups have no third-party sponsor to plug any deficit.
• Some of these schemes in countries such as the Netherlands, Germany and Italy are leading the way in terms of risk-sharing.
• Methods to improve intergenerational fairness can include reducing benefits, closing over-generous schemes or using open capitalisation to cover contributions.
• Some funds are looking to boost younger members’ representation and allocate to investments that support growth.
As with other countries, a feature of schemes for professional groups in Germany is that individual contribution levels may be less stable than those for corporate schemes, since income will vary year-on-year.
From a scheme point of view, contributions are covered either by straight capital reserves or by a system called open capitalisation.
This latter combines capital reserves with contributions from future members, in other words combining elements of capital funding and pay-as-you-go. In general, this means that one contribution payment provides the same level of benefits, no matter when the contribution is paid.
Versorgungswerke reserve the right to adjust tariffs and rates, such as their discount rate, and reserves for longevity.
As with any other DC scheme, ensuring fairness between generations where beneficiaries take investment risk is an important consideration.
Ralf Filipp, principal at Mercer’s retirement consulting business in Munich says the members of a Versorgungswerk represent a single community for purposes of mutuality and solidarity. “This can be seen from the fact that neither the health status nor the number of children are factored into the actual contributions,” he comments.
The investment policy for these professional schemes is different from that for other pension funds, according to Mercer’s annual German institutional asset allocation survey.
Carl-Heinrich Kehr, principal at Mercer’s investment consulting business, Frankfurt, says: “When comparing investment policy between Versorgungswerke and those corporate pension schemes which are not subject to insurance-like regulation, we can generally observe a lower allocation to equities, and a higher allocation to property. Most Versorgungswerke invest a significant proportion of assets in low-risk bonds on a hold-to-maturity basis.”
And he says German GAAP accounting regime plays an important role in investment policy: “One of the reasons a strategy of buy-and-hold of certain risk-free or low-risk assets is preferred is because these assets can be accounted for according to their nominal value, and any changes in market values do not affect their valuation on the balance sheet.” Meanwhile, according to Filipp, schemes for professional groups have a pithy message for other types of pension fund: “Waste not, want not”.
There are around 20 pension funds in Italy specifically for professionals (casse di previdenza), the largest being ENPAM, the scheme for medical doctors and dentists, with €14bn of assets.
All are mandatory first-pillar schemes except ENASARCO, the fund for sales agents, which covers the second pillar.
But unlike company pension funds, which are mainly run on a DC basis, most casse di previdenza are DB schemes using either a salary or contributions method.
The schemes were originally set up on a public basis, but have been privately run since a change in the law in 1995. However, if the supervisory authorities discover a deficit, or if the funds fail a stress test over a 50-year time horizon, they will require the fund to raise contributions and retirement age. They can also ask a fund to modify its life expectancy coefficient, which is used in applying the contribution method.
As with similar schemes for professionals in other countries, the absence of a sponsor is a drawback in achieving full funding.
Furthermore, the government plans to increase capital gains tax for these first pillar funds to 26% from 20%, a level first introduced as a temporary measure.
Second-pillar funds pay only 11%, although this has also been raised by 0.5% as a temporary levy for 2014. It is not known if these rates of tax will be continued next year.
On the other hand, the government has allowed pension funds for professional groups to cut benefits for pensions that have already vested.
“Most casse di previdenza changed their benefit calculations after this reform, and in some cases it has also affected vested benefits,” says Claudio Pinna, head of consulting at Aon Hewitt in Rome. “It is one of the most effective ways to guarantee fairness between generations. Many of the funds have also increased contributions.”
Francesco Verbaro, professor at the Italian School for Public Administration, says that these funds can and should take a holistic approach towards improving intergenerational solidarity.
“Professional pension funds have more investment freedom than company schemes and can reduce risks by their strategic and tactical asset allocations,” he says. “Another measure is to allow younger scheme members to have a weighty vote on governance bodies and the board of trustees.”
He adds: “Furthermore, the attention to long-term financing is pushing pension bodies to finance productive activities that support growth by reducing costs, diversifying means of production and creating jobs in a smart, sustainable and inclusive way. They can also take longer-term aspects such as environmental, social and governance issues into account in their investment strategies.”
Verbaro says another big issue is the governance of pension funds – above all the trade-off between skill requirements and representation on committees. Italian institutions are working to raise the skill requirements for committee membership, providing training both initially on appointment and on an ongoing basis.
The Italian Association of Liberal Profession Pension Funds (ADEPP) has set up a working group to draft a conflict of interest code and guidelines to identify and manage conflicts of interest.
It is also promoting new measures to help the professions face the challenges of a changing economy, working with national and European governments to enable longer working lives for members, and support adequate earning capacity.
Dutch medical specialists: protecting solidarity without a sponsor
Stichting Pensioenfonds Medisch Specialisten (SPMS) is a mandatory defined benefit pension (DB) scheme for medical specialists who are either self-employed, or employed by a colleague. As with other similar schemes, it provides second-pillar benefits to its 15,000 members.
The yearly accrual secures a fixed DB pension right of almost €1,000, although this can be reduced if the member’s turnover is below a certain threshold.
The benefit increases over time by 3% per annum, with possible profit sharing.
The scheme’s historical average replacement income is around 40%, so most members also have to arrange additional sources of retirement income, for which SPMS offers financial planning services.
The DB pension and indexation is guaranteed by the scheme itself. As the scheme’s members are also its economic owners, a high funding ratio will give potential for profit-sharing and SPMS will increase the accrued pension.
The downside is that SPMS will have to reduce the promised benefits if the scheme is seriously underfunded. The funding level is currently 120%, taking indexation into account.
Jeroen Steenvoorden, director at SPMS, says the premium has increased markedly over the past seven years because of longer life expectancy and the obligation to incorporate an investment buffer into the premium calculation. So maintaining a stable premium in the current low-interest-rate environment will be a challenge.
Like all professional group schemes, SPMS has no sponsor to make payments if it runs into deficit. Steenvoorden says asking members for an additional capital contribution would be unrealistic, as it would immediately reduce the support for a mandatory scheme. The same would probably be true if benefits were reduced.
The scheme will only stay mandatory if 60% or more of participants are in favour. Support is currently 80%.
The scheme’s main priority is to (re)build relatively high financial buffers. It is also conservative by pre-financing indexation through premiums and by using relatively conservative actuarial and financial assumptions. SPMS also operates a relatively high interest rate hedge.
On the other hand, it does take (relatively) controlled investment risk, with a reasonable expectation of increasing pension accrual.
Around 60% of its €7.8bn-worth portfolio is invested in stocks, hedge funds and real estate.
Steenvoorden says the issue of fairness must be approached holistically. “One of many tools in the fairness toolbox is investment risk,” he says. “The main way to control this is by buffer management. Buffers should not be too big or too small. Furthermore, if there is room for additional indexation or profit sharing, all members need to benefit from it.”
Steenvoorden believes SPMS differs from other Dutch pension funds, in that it deliberately takes investment risk in an attempt to boost its benefit levels. So although SPMS has reduced investment risk over time, other Dutch schemes have reduced theirs more heavily.
However, SPMS takes less interest rate risk than the average Dutch pension fund. “We think interest rate risk has not been rewarded over at least the past decade,” says Steenvoorden, who adds that the focus has also shifted over time from investment return to a balance sheet approach that takes into account the funding level.
He says the lessons for other pension funds are: to have a clear strategy, and adapt to a changing environment, keeping in mind the fund’s roots.
“You also need a conservative financial framework, with enough buffers, to survive in the long term,” he adds. “Also try to avoid over-promising and under-delivering.”
Last but not least, he advises: “Look on your members as clients, even if it is a mandatory scheme.”