OPINION:DEFINED BENEFIT pension schemes in deficit need solutions, but all they have been provided with by government are impossible choices. In 2008, as pension fund values were being decimated by the financial crisis that shook the very foundations of the world's capital markets, the government here recognised that most "defined benefit" pension schemes were in trouble. (Defined benefit – DB – pension schemes promise a set level of pension in retirement, independent of fund investment performance).
Temporary relief was provided by deferring the deadlines for trustees and employers to submit recovery plans by up to six months. Subsequently deferred several more times, they are only now being reimposed.
Deferrals gave employers and trustees some breathing space to consider options. At the same time, they gave the government the opportunity to review the whole regulatory system for defined benefit schemes.
Another relieving measure the government introduced was an amendment to section 50 of the Pensions Act in 2009, allowing pension schemes in distress to reduce the benefits of members where no other option is feasible.
What has happened since? In most cases deficits have not really reduced – it’s estimated that 80 per cent of schemes are still technically insolvent.
The problem is only partly on the assets side. Asset values have generally recovered from the low point reached in March 2009. The bigger problem is now on the liabilities side. The culprit is annuity rates, which have fallen to very low levels in the past three years, and in so doing have driven up the cost to pension schemes of buying out pensions.
Why does the cost of buying out pensions matter when most schemes pay pensions from the fund when employees retire?
The reason is that all funded DB schemes are obliged to meet a statutory minimum funding standard, tested annually. The test notionally assumes that the scheme winds up and buys out annuities for pensioners. With the growing maturity of Irish pension schemes, it’s not uncommon for 50 per cent or more of a scheme’s liabilities to be for pensioners rather than the company’s current employees. So annuity costs really matter.
It now costs about €210,000 to secure an annual pension of €10,000 for a man aged 65. The same pension cost just €140,000 10 years ago. Annuity costs have accelerated in the past three years in particular – by about 40 per cent – as a consequence of the euro zone crisis. Bonds issued by “safe-haven” countries such as Germany and, to a lesser extent, France, have become very expensive.
The biggest single problem for Irish pension schemes now is that the minimum funding standard requires them to have enough assets to buy annuities at a very high cost, even though they don’t do so in practice.
The current Government raised the bar further last month by requiring DB schemes to hold an extra risk reserve as a cushion against potential adverse events. For most schemes, this will add 10 to 15 per cent to liabilities.
For many trustees, the rest of 2012 will be spent trying to agree recovery plans. There are just two ways of doing this: making the fund larger through employer or employee contributions, or by cutting benefits.
A small minority of trustees will, enviably, have an employer who can pay enough into the fund to eliminate the deficit. Most trustees, though, will have to consider tougher solutions likely to involve employees and employers taking a lot of pain through higher contributions and lower benefits. We expect at least one in 10 DB pension schemes will be unable to continue and will wind up.
Faced with these difficulties, the Government’s response has been frustratingly narrow. The only concession has been to allow trustees the option of buying “sovereign annuities” for their pensioners instead of conventional annuities, or at least assuming that they would buy such annuities in the event of a wind-up for the purposes of the minimum funding standard test.
A sovereign annuity differs from a conventional annuity in that there is a default risk for the annuitant. If, for example, the insurance company issuing the annuity holds Irish bonds and the Irish Government defaults or restructures its debt, the annuity payments being made by the insurance company can be reduced, or, in extremis, wiped out.
Sovereign annuities have a role to play, but they are unlikely to be fit for widespread use. They are complex, transfer significant risk to pensioners and, unless a competitive market develops in the insurance industry, they may be relatively expensive.
If sovereign annuities are not considered suitable by trustees, pension schemes will have to meet a funding standard that is largely dictated, in effect, by German bond yields.
Mercer’s view is that the minimum funding standard must be amended to break the link to annuity rates and so to German bond yields. Otherwise, many Irish pension schemes that could have survived will be forced to wind up.
Is there an alternative? Our proposal is that the funding standard should only require annuity benchmarking for a low level of pension, say the first €6,000 per year. When added to the State pension of €12,000 a year, this would give a reasonable base level of guaranteed income in retirement.
For any scheme member entitled to a higher pension, the balance could be converted into a lump sum on the basis of a fair actuarial value rather than the cost of an annuity. In a real wind-up, this lump sum could be invested in an approved retirement fund from which income could be drawn down as needed by the pensioner.
We believe this approach would result in a fairer distribution of schemes’ resources in the event of winding up. Mercer and others put forward this solution several years ago, but the regulatory authorities have baulked, instead opting only for sovereign annuities.
Over the coming months, as trustees grapple with their funding problems, many will feel the Government has unfairly passed the buck by failing to legislate effectively and leaving them with impossible choices.
Challenging times call for imaginative measures. The world has changed radically since the current legislative framework was established. This system won’t work out for anyone – Government, employers, trustees and, most of all, pension scheme members.
Michael Walsh is leader of Mercer’s Irish retirement, risk and finance business