Sections

Squeezing the life out of DB pensions

Related images

  • Squeezing the life out of DB pensions

Are tightening pension funding regulations throttling Europe's defined benefit (DB) pension plans? Is a threat to extend Solvency II to pension funds the final nail in their coffin? IPE readers give their verdict.

The primary aim of pension funding regulation in Europe is to promote a high level of benefit security. In particular, the intention is to protect members of DB plans from the risk that their sponsors will default.

Yet there is growing evidence that tighter funding regulations are having the unintended effect of persuading sponsors to close their DB plans to new members and move to defined contribution (DC) arrangements.

A recent policy report from the OECD suggests that "while the regulatory tightening may be  justified in the interest of benefit security it may contribute to the abandonment of DB provision, even in hybrid forms, leading to what are ultimately highly uncertain pure DC pensions."

The report suggests that funding regulation may have become over-protective. 

"Regulations should have as their main aim the provision of high levels of benefit security at an acceptable cost to members, sponsoring employers and other stakeholders. Hence, to the extent that regulations drive plan sponsors away from traditional DB and even hybrid DB  plans and towards pure DC plans, the soundness of theses regulations may be put into question.

"Regulations which are intended to protect beneficiaries may have had the unintended consequence  of raising the level of DB provision beyond the level at which they have a value to sponsors."

Future funding regulation poses a bigger threat. According to research by Allianz Global Investors, any move to extend Solvency II to cover pension funds will have the biggest impact on traditional DB schemes.

Allianz GI estimates that a DB scheme that is 100% funded under the accounting rule IAS 19 would be only 64% funded under the new regime. It warns that Solvency II could prove "the final nail in the coffin" of DB pension plans.

The Allianz GI report suggests that DB schemes require a different approach from that applied to insurance companies: "Without major amendments, the current Solvency II rules as drafted for insurance companies, if applied to pension funds, could force sponsors to reconsider their commitment to DB schemes," the report warns.

So what can be done? One solution is better sharing of risk between the plan sponsor and plan member - for example moving from unconditional indexation to conditional indexation or from final salary to cash balance plans. Another solution is to share the risks and rewards more fairly - specifically, by allowing sponsors of DB plans access to any surplus.

We wanted your views - and they make sombre reading. Most of the pension fund managers and administrators who responded to our survey (87%) agree that pension funding regulations in Europe have had the unintended consequence of raising the costs of DB provision. Some even doubt whether it has been unintended.

Most  (73%) think that funding regulations that force sponsors to move way from DB schemes are unsatisfactory and should be amended, although one notes gloomily that "the damage is already done and DB plans are destined for death by a thousand cuts".

Four out of five respondents (80%) agree that the two main reasons for the demise of DB plans in Europe are stricter funding regulation and market value accounting standards. "Over the years legislation has forced higher benefit levels than was originally costed  or  intended," one pension fund manager observes.

Some suggest other culprits, including "the change in fashion among actuaries", "employers that are only motivated by short-term financial measures", and  "the increasing cost and improving mortality".

Some feel accounting standards are not to blame: "Accounting requirements show more clearly - within the limits of the accounting standards - a truer cost of pension provision." Others feel governments are to blame: "Governments have adversely changed the benefits provided and increased costs at no cost to them."

Two thirds (67%) agree that any tightening of the solvency rules will have a negative impact on a DB scheme sponsor's costs and risks, while a smaller majority (60%)  agree that the possible extension of Solvency II to include occupational pension funds is currently the biggest risk facing DB pension funds in the European Union.

The Allianz GI report suggests that one effective measure to counter the impact of Solvency II is a risk-sharing agreement between the sponsor and members.

A small majority (60%)  of managers agree that the survival of DB plans will depend on a fairer sharing of risk between plan sponsors and  plan members

Yet some of those who responded to our survey feel that this is missing the point.

The manager of one of the UK's largest pension funds points out that "traditional DB plans did share risk because there was no guarantee that the benefits would be delivered - for example, in the event of failure of the sponsoring company. 

"It is the building in of guarantees, the removal of risk sharing, that is killing off DB schemes," he suggests.

Allowing employers access to any surplus in the pension fund is seen as one way of sharing the risks - and rewards - of pension fund investment. Most of the pension fund managers in our survey  think that sponsors of DB plans should be able to recover any surplus accumulated in these plans. "It would be great, but not an absolute prerequisite," the manager of a Swiss pension fund observes. "Contribution holidays and de-risking are other possibilities that can often be sufficient."

Some suggest that the employer is entitled to the surplus "only after all benefits have been secured".  Some feel that access to the surplus should be allowed "provided it is not done so as to leave the fund members with a potential double whammy of money being taken out because the sponsor is struggling, then the fund being left short".

Others feel that some of the surplus should be withheld: "At least some of the surplus should be seen as a safety net to give protection against other risk factors such as increased longevity and lower investment returns," one pension fund manager noted.

When is a surplus a surplus,  another asks. "The main problem is in defining what would represent a surplus in such ongoing conditions, as it currently fluctuates wildly due to the ‘mark to market' basis insisted upon by accounting bodies.

"For this purpose I suggest an averaged basis with a lower limit for safety would be more appropriate."

Most (80%) agree that some reduction in member benefits - for example, a move from unconditional indexation to conditional indexation - will be necessary if DB schemes are to survive.

There is similar support for hybrid DB/DC arrangements such as cash balance or conditional indexation. Most see these as a viable solution to the increasing cost of traditional DB arrangements, although some wonder why costs are increasing.

Yet this kind of tinkering  will do little to ensure the survival of a mature scheme, one manager warns. "None of these helps the employer where the scheme is already closed or virtually so, with a ‘fat tail' of pensioners and deferreds, where the liability will not go away and cannot be reduced without drastic legislation - unthinkable in our country."

So is the traditional DB pension plan inevitably doomed? Most (76%) believe it is. One UK pension fund manager  paints a depressing picture: "How many new DB plans have been started in the UK since the pension regulator was set up? Probably zero. How many DB plans have been closed or curtailed? Probably most of those in the private sector."

Some feel that DB will survive only as a retirement plan for the wealthy: "We will return to the days when such arrangements were for the privileged few."

Hardly an outcome the policymakers and legislators intended.

Have your say

You must sign in to make a comment

IPE QUEST

Your first step in manager selection...

IPE Quest is a manager search facility that connects institutional investors and asset managers.

  • IN-2454

    Closing date: 2018-08-01.

Begin Your Search Here