Pensions: Change management
There is a range of rules applying to pension funds in different European countries. Many regulators have responded strongly to the problems caused to pension funds by the credit crunch. In continental Europe, pension funds are regarded as much closer to insurance companies than is the view in Ireland and the UK. The pension fund is seen as a much more independent entity and, as a result, most countries require that the minimum funding level includes an explicit margin of assets over accrued liabilities (making no allowance for future salary increases or indexation) to allow for future adverse experience. The recent legislation in the Netherlands, and in other countries such as Sweden, uses stochastic modelling to determine probabilities of full funding and determine a solvency margin to give a prescribed probability to be fully funded in the future.
Table 1 summarises the funding rules of five countries. The funding rules for Germany only apply to one form of pension provision (the ‘pensionskasse’), while much pension provision in Germany is essentially on an unfunded basis via the book-reserve system to which no funding rules really apply. The response of these countries’ supervisory bodies to the issues raised by the credit crunch vary. Belgium has taken no action — perhaps reflecting the fact that the minimum funding level is so much lower than the target funding level for most pension funds.
Germany has taken steps to modify some of its valuation regulations. One stress test that must be passed is a specified fall in the equity markets. Up until the change, the specified fall was a 35% drop in value. Given the current position, the stress test has been revised so that the funding margin only has to cope with a 16% fall. Another change made to cope with illiquid markets is that some commercial papers may now be valued on a discounted cash flow approach, rather than at market value.
In the Netherlands, the supervisor has extended the maximum period for reaching 105% solvency from three to five years. However, any pension funds adopting this relaxation will undertake annual checks to ensure that the recovery period remains on track and will take immediate appropriate steps if the position deteriorates further.
In Switzerland, the key control variable is the minimum interest rate because the pension funds are really defined contribution with an underlying guarantee of investment return. At the last review in 2008, the authorities reduced the minimum guaranteed rate of interest to 2% per year, which is lower in relation to prevailing interest rates than may normally have been expected. This means that pension funds have a lower funding target. It has been agreed that the minimum interest rate will be reviewed again in one year’s time, rather than in two years.
The position in Ireland is more interesting and there have been significant changes. A major reason for the response is that the average Irish pension fund holds a higher proportion of equities than pension funds elsewhere in the world and, therefore, the fall in equity markets has a proportionately greater impact on funding levels.
In December 2008, the Minister for Social and Family Affairs announced that the supervisor, the Pensions Board, would be allowed greater discretion in approving recovery plans. The Board published revised guidelines in February 2009. These clarify the areas in which relaxation has occurred:
>> A recovery plan can now extend for more than 10 years, provided there are appropriate circumstances.
>> Recovery plans can be reviewed part-way through and extended beyond the original term if the reason for the extension is due to poor investment performance.
>> The existence of a voluntary employer guarantee will be taken into account when approving recovery plans — presumably meaning that the employer guarantee will allow a longer recovery period.
Where an extended recovery period is allowed, the Pensions Board will want to see evidence of a prudent investment strategy which is appropriate for matching the liabilities of the pension scheme. The Irish Government has also recently announced the formation of a State Annuity Scheme which will fund the pensions of scheme members whose pension funds become insolvent due to the insolvency of the sponsoring employer. This will operate in a similar way to the Pension Protection Fund (PPF), accepting insolvent schemes’ assets and paying out members’ benefits on a reduced basis. However unlike the PPF, the assets will not be held in a separate fund but paid into the general government account.
Pensions will be paid on a pay-as-you-go basis. The Bill to enact this scheme is still going through Irish parliament and details are yet to be clarified. The Irish Government could also find itself under increasing pressure from unions and from the EU to introduce legislation to prevent employers abandoning their pension schemes, as SR Technics has done recently. Currently, there is no specific legislation to prevent this, so the SR Technics pension scheme is winding up and members’ benefits are being cut. The company has been told by the Irish Labour Court to make good the deficit and to ensure members get their full accrued benefits.
So far, the reaction of pensions regulators has been to increase supervision and the permitted recovery periods or to relax some aspects of the solvency tests (as in Germany). One question remains: can sponsoring employers and pension fund managers meet the increased levels of contributions required to bring the pension funds back to 100% even over the new, longer periods? The answer probably depends on the country considered, and the following factors are at play:
>> Is the regular funding target more than 100% of the assessed value of the liabilities as it is in the Netherlands? In this case, the current funding levels are probably closer to 100% than other countries and it will be easier to get back to that level quickly, and leave getting back to the regular funding target for later.
>> What is the quantum of the pension benefits in relation to the sponsoring employer’s employment costs? If the benefits only supplement a generous social security system, the plan benefits will be small in relation to the typical benefits provided by a UK or Irish pension scheme.
>> The impact future recoveries in the investment markets have on funding levels. For instance, a recovery in equity markets will greatly improve the funding position in Ireland, where pension funds continue to hold a large proportion of equities.
>> The level of future indexation that is guaranteed by the pension fund. In most countries the answer is none.
As a result of these issues, the cost of a good quality, defined benefit occupational pension plan in the UK may be three times that of an equivalent scheme in a country such as Belgium. Therefore, a 20% increase in pension costs will have much more significance for a UK company’s profits. The pension funds solvency regime seems to have worked well so far in the current financial crisis. Unless equity markets resume a severe downward trend, the prospect of a large number of pension fund insolvencies seems unlikely. Perhaps recognising the unusual conditions, pension regulators have acted to increase the flexibility of funding regimes, but not to a great extent. It is also notable that the relaxation is not really in the underlying funding target but mostly by way of an extension in the time period a pension fund has for making good any shortfalls.
Therefore the response of the UK pension regulator has been typical of the rest of Europe. It remains to be seen what impact the higher pension contributions that result from the interaction of the current financial crises with the various solvency regimes, despite the increases in recovery periods, will have on companies’ profitability, and their inclination to continue providing defined benefit pension plans.
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Belgium
Minimum funding target
Fair value of assets (FVA) must be greater than accrued liabilities plus solvency margin for disability and death-in- service benefits
Liability valued
Maximum of accrued benefit or vested right
Discount rate
6% per annum Mortality MR/FR standard tables
Frequency of valuation
Annual
Recovery period
As agreed with supervisor — up to 20 years for shortfalls caused by increase in min. funding as result of legislation
Funding practice
Prudent funding valuation based on market-related discount rates and future salary increases
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Ireland
Minimum funding target
FVA must be greater than liabilities on discontinuance basis. Pensions in payment: liability assessed using current annuity rates. Non-pensioners: actuarially guided transfer value (gilt-based approach)
Liability valued
Accrued pension on discontinuance
Discount rate
Set out in actuarial guidance notes — government bond/annuity-based
Mortality
Actuarial guidance
Frequency of valuation
Triennial
Recovery period
Min. 3 years — supervisor may approve up to 10 years, subject to 85% funding level reached in 3 years
Funding practice
Ongoing valuation allowing for salary growth and planned indexation
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Germany (Pensionskassen)
Minimum funding target
Book value of assets must be 104.5% of assessed value of liabilities.
Liability valued
Benefits are individual with-profit deferred annuities. Accrued amounts are valued
Discount rate
Guaranteed interest rate applying to contract — currently 2.25% (higher for longer-standing contracts)
Mortality
Standard tables
Frequency of valuation
Annual
Recovery period
Must always be fully funded, otherwise will be declared insolvent
Funding practice
Normally an asset surplus due to low guaranteed interest rates and cautious bonus allocation policies
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Netherlands
Minimum funding target
Fund should have sufficient solvency margin to meet liabilities with probability of 97.5%. Approved model used. In practice, typically, asset values must be 25- 30% higher than expected liability value
Liability valued
Accrued pension with no allowance for future indexation
Discount rate
Risk-free term-related discount rate prescribed by regulator
Mortality
Prescribed table
Frequency of valuation
Annual
Recovery period
Agreed with regulator up to 15 years. If solvency margin less than 5%, needs to be restored within 1 year, or 3 years conditionally
Funding practice
Pension funds allow for planned level of indexation and future salary growth
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Switzerland
Minimum funding target
Market value of existing assets plus future contributions at agreed levels should be sufficient to finance Technical Provisions incl. projected future additions plus asset fluctuation reserve
Liability valued
Typically DC with guaranteed rate of return on contributions, and stated annuity rate. Technical Provisions use projected guaranteed benefits
Discount rate
Determined by pension fund with actuarial advice
Mortality
Determined by pension fund with actuarial advice
Frequency of valuation
Triennial (annual for larger plans)
Recovery period
If funding ratio over 90%, no immediate action. If below 90%, recovery plan required. Must be less than 10 years, typically 5 to 7
Funding practice
As above
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Tim Sharples is a partner in Lane Clark & Peacock's international department and a member of the PPEC Developing Issues Group
Tim Sharples
