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Pensions in trouble globally
The present global financial crisis has seen assets in private pension plans – which have become an important component of diversified retirement systems in member countries of the Organisation for Economic Co-ordination and Development (OECD) – fall by nearly 23%, or around US$5.4 trillion, between the end of 2007 and December 2008. They have likely fallen further since then, according to an OECD report on reform- and exit strategies for government interventions.
Where these assets fund defined benefit plans, in which benefits are linked to individual wages or annuities, this decline adversely affects the adequacy of plans’ funding. This puts financial pressure on the sponsors of the plan. In some cases, where the sponsor of the plan faces retrenchment or bankruptcy, it can impinge on the plans’ solvency, states the report as it highlights major long-term concerns for pension funds due to the present crisis.Where older workers or retirees have defined contribution plans, in which pensions depend on asset values in individual accounts, this decline may imply important losses in permanent income. Younger workers with defined contribution plans may suffer less damage. They have many years to wait for recovery.
Confidence in plans that leave people so exposed to market developments is likely to be hurt. Public pension benefits, usually taxpayer funded on a pay-as-you-go basis, are not directly affected in the sense that political commitments to them remain generally intact. However, the fiscal challenges that these commitments pose as populations age, will be made more daunting as unemployment increases and public indebtedness and future debt servicing costs rise as a consequence of the crisis.
Furthermore, to the extent that private pensions are impaired, public pensions must bear more weight in diversified retirement systems. This may affect the political context in which the fiscal challenges are addressed. It is notable, the report states in this regard, that in countries where substantial reliance is placed on private pension arrangements, public pensions replace relatively low shares of pre-retirement incomes. The core of any long-term strategy to assure retirement incomes in ageing populations will be more saving, at both public and private levels. But other measures may be required, particularly given the damage to pension funds caused by the current turmoil. The OECD Insurance and Private Pension Committee has issued guidance on priorities going forward:
• Avoid funding crisis management initiatives through Public Pension Reserve Funds. Where such funds are not ring-fenced with governance structures independent of the government, there may be a temptation to fund crisis measures from these pools to inject capital into banks and to support fiscal spending programmes. This would exacerbate pressure on future funding of liabilities and undermine confidence in pension arrangements. Such policies may reinforce the incentive to save privately, with little net benefits for crisis management.
• Strengthen confidence in private pension systems. Concern about market risk may lead to retreat from private systems and arrangements, and to pressure to compensate by making public pensions more generous. The best approach over the longer term is to rely on a diversified system, with both public and private sources of income and a mix of pay-as-you-go and asset-backed funding. Governments should articulate the case for avoiding panic and taking a long-term view.
• Any forbearance over funding should be temporary. Losses on investments in pension plans may force many companies to increase their contributions. Since contribution levels are often already high following the losses of 2000-02, this will add to the stress many companies are facing as the economic situation deteriorates. Some countries (e.g. Canada, Ireland and the Netherlands) have already provided relief by allowing various means of deferring the return to adequate funding levels. It is important that any such forbearance be temporary, as otherwise the security of pension benefits will be impaired. Since confidence in private pension schemes is likely to be influenced by their funding levels, this forbearance should be withdrawn as rapidly as is feasible.
• Reconsider statutory performance requirements. In some countries (e.g. Belgium and Switzerland), pension funds must guarantee minimum returns. In the current environment, such requirements could encourage imprudent portfolio management designed to achieve unrealistic goals. Countries should make these requirements more flexible during difficult market conditions or, even better, replace them with market-based benchmarks.
• Strengthen pension fund governance. Reform has been warranted since before the current crisis, but is all the more important now given the funding and confidence issues that pension arrangements are likely to face. More effective monitoring of investment risks, performance and balance sheets are required. Pension boards should have greater expertise and knowledge of financial management issues and they should include more independent experts.
• Consolidate small pension funds. Small pension funds often have weak governance arrangements, and they are expensive to manage and supervise. In some cases, consolidation would help to achieve a more efficient balance between scale and governance.
• Reconsider regulations that aggravate the economic cycle. In some countries (Denmark, Sweden, Finland, Netherlands), regulations designed to protect participants of designed benefit plans can force asset sales on falling markets, locking in losses and driving prices down further. Mark-to-market accounting and the practice of linking minimum funding levels to investment risk may have reinforced this effect. Corrective measures such as increasing contributions and lowering benefits, while necessary to restore funding levels, also have negative macro-economic implications. As with capital adequacy requirements for banks, ways should be sought to introduce funding regulations that are more counter-cyclical in their impact.
• Promote hybrid pension arrangements to reduce risk. Wider funding gaps and higher contribution requirements are likely to reinforce the existing trend to closure of defined benefit plans. Insolvency guarantee funds will also be active in taking over pension funds sponsored by bankrupt companies. The extent to which regulation reinforces these trends should be reviewed, and ways to promote hybrid arrangements that retain a component of defined benefit features should be sought in order to better spread risk. For example: indexation features where solvency positions permit; altering target returns for defined contribution schemes to the lifetime of individuals rather than current year returns, etc.
• Reform mandatory and default arrangements in defined contribution systems. Defined contribution plans should be designed to integrate accumulation and retirement stages in a coherent way. Often, default arrangements for asset allocation or requirements to convert accumulated capital into an annuity are built-in. As regards allocation default options, which generally involve reduced exposure to equities as a person approaches retirement, their design should take account of the extent of choice in the payout stage, the generosity of the public pension system and the level of contributions. As regards conversion, a key issue is how to minimise the timing risk of the purchase of an annuity. Making the conversion mandatory may make sense where public pensions are low. But forced conversion is inconsistent with principles of free choice and can impose a heavy penalty in poor market conditions such as are now prevailing. Greater flexibility in the timing of the annuity purchase is necessary.
• Strengthen financial education programmes for pensions. The rapid growth of defined contribution plans in many countries means that individuals face more of the risk in, and assume more of the responsibility for, assuring their own long-term financial well-being. They are likely to make better decisions, and contribute to better overall functioning of financial markets, if they are well educated and informed about issues relating to management of personal finances.
