ANALYSING THE CHANGES IN PENSION FUNDING AND OPTIONS FOR INVESTING

Category: Accounting

Since the collapse of Lehman brothers in September 2008, many pension funds have moved from being in surplus to being in deficit. This dramatic movement in pension funds means that companies have had to make tough decisions with regards to employee pensions.

Companies recognise that pensions remain an essential employee benefit, and a valuable source of competitive differentiation. A generous, well-run pension scheme can serve as a powerful recruitment and retention tool at a time when loyalty is in scarce supply. While companies are keen to minimise their defined benefit liabilities, they still feel an obligation to at least offer a basic level of retirement provision and guidance. With an increasing number of companies changing the model of their pension provision, and with the impact of the financial crisis still weighing heavily on scheme funding and risk, what decisions are companies taking with regards to pension schemes? (The Economist: 2010)

This chapter outlines the issues regarding defined benefit funding and the investment strategies of pension funds.

Defined Benefit Funding

Together with the retreat of defined benefit plans as discussed in Chapter 3 problems also arise with regards to these schemes in terms of funding these plans. The problems currently being encountered are now in the public domain. These are largely caused by the sharp decline in asset values over the last 2 years and a continuing rise in the cost of pension provision.

In Ireland, it is estimated that 90 per cent of defined benefit schemes would not currently meet the funding standard - i.e. they would not be able to pay the retirement benefits relating to past employment on wind-up. Furthermore, a significant number would not have sufficient assets to secure the pensioner liabilities in a wind-up situation. In this scenario, those members of the scheme who have not yet retired would not receive any benefits. The current economic environment has greatly increased the likelihood of schemes winding up and not being able to pay full benefits. (IAPF, 2008:1)

According to a Mercer's Defined Benefit survey carried out in 2009, 30 per cent of defined benefit schemes had a funding proposal in place before 2008. However, all these schemes now require revised funding proposals because the current proposal is off track.

Around 20 per cent of schemes are aiming to meet the funding standard within three years. Although over 40 per cent of all schemes are planning to apply for a funding proposal period of ten or more years. Mercer expect that this year (2010) will be a significant milestone for Irish defined benefit schemes, as employers and trustees reach conclusions as to how to address the current scheme deficits.

When equities fall in value it causes huge problems for trustees and sponsoring employers. In order to rectify the problem a number of solutions could be considered such as the employer funding the pension deficit, cutting the scheme benefits or reducing the investment risk. According to the Mercer survey (2009) some form of change is being considered for nearly half of all defined benefit pension schemes as a result of defined benefit deficits. The options that are being considered by employers in the survey are to wind up the current scheme or change to a defined contribution scheme, to provide no future DB benefits, to reduce benefits, to reduce accrued benefits or to increase employee contributions.

Investment Strategy of Defined Benefit Schemes in Ireland

Another method in trying to solve deficit problems would be to reduce investment risk by changing the fund's investment strategy. A survey conducted by Mercer (2008) indicated that 33 per cent of defined benefit schemes have changed their investment strategy over the past two years and that many have increased the amount of bonds they hold. This trend of increasing the amount of bonds held has been caused by stakeholders aiming to limit volatility in the contribution rate and the solvency level in future years. These companies and trustees are willing to forgo the possibility of extra returns in return for reduced risk.

There has also been evidence of increased use of indexed funds, which are designed to match stock market movements rather than to out perform them. The survey reveals that 54 per cent of schemes have a bond strategy that is broadly in line with the average managed fund while 34 per cent of schemes have a bond strategy higher than the average managed fund (the average manager bond weighting at 31 December 2007 was 14 per cent of portfolios).

A Pension Investment Survey carried out by the IAPF in 2009 revealed that 64.3 per cent of assets being managed on behalf of defined benefit schemes accounted to equities. Almost a quarter of the schemes assets were allocated to bonds, while property made up 3.8 per cent and cash 4.2 per cent on average. With regards to how schemes are managed the survey states that 54.3 per cent were actively managed and the remaining 45.7 per cent were passively managed.

Investment Strategy of Defined Contribution Schemes in Ireland

Investment losses have impacted on the behaviour of defined contribution schemes. A survey carried out by PwC (2009) found that 30 per cent of employees are seeking to reduce their exposure to equities. At present in Ireland, most defined benefit schemes operate on the basis of a 'best efforts' approach which means that investment choices are provided which typically offer the highest expected rate of returns in the longer term. However, there is a practical difficulty to this approach as many contributors to these schemes do not have enough financial knowledge or understanding of investment market movements and are finding their high level of investment loss to be unacceptable. As a result of this many are opting out or choosing to reduce their exposure to risky assets or by reducing their contributions. For members that are not confident enough to make investment choices for themselves a default fund option is available. The default strategy is likely to be actively invested, passively invested or by way of life-styling. When members begin to understand how the characteristic of each asset class differs they can move away from the default mix set by trustees. An appropriately designed default strategy will encourage members to take responsibility for their retirement and possibly deviate from the default. Many employees at present are looking to reduce their exposure to equity markets but by doing so they will not enjoy any investment recovery which may come. This lack of confidence by employees in the equity markets must be considered as part of the scheme design.

The chart below outlines whether members of defined contribution schemes intend on reviewing their default fund. The majority of respondents seem satisfied with their fund strategy.

With regards to what assets defined contribution schemes invest in an IAPF (2009) survey reports that equities accounted for 58.7 per cent of the assets being managed on behalf of defined contribution schemes. Another 22.5 per cent of assets were allocated to bonds, property made up 4.9 per cent and cash accounted for 12.5 per cent of the value of defined contribution assets. A major difference in how funds are managed is highlighted in this survey as 72.1 per cent of assets under management on behalf of defined contribution schemes are actively managed as opposed to 54.3 per cent of assets under defined benefit schemes.

The asset classification structure of defined contribution investments may change in the future members are likely to move away from equity exposure. The chart below outlines what defined contribution members are considering if they switch investment strategy.

Summary

This chapter has outlined the problems encountered with defined benefit funding and issues with pension scheme investment strategies. Many companies that are offering defined benefit schemes are now realising that the risks that these schemes are posing to their company are unacceptable. Companies are now starting to take action to address these problems. However, the challenge for employers is how to solve the problems effectively. It will be necessary for employers and employees to understand the price they are willing to pay to reduce or eliminate pension risk.