From the desk of Amin Rajan, CEO, CREATE-Research
The financial meltdown sparked by Covid-19 is yet another nail in the coffin of the final-year salary scheme, where employers bear all retirement risks.
Yields have plunged to record levels and will be kept there for a long time to enable governments to fund their ballooning deficits. Schemes that are unhedged will be the hardest hit. To make matters worse, the asset side of the balance sheet has also seen plummeting values.
The sad truth is that even before the crisis, defined benefit plans worldwide struggled to build up healthy finances even against a background of the longest running bull market in history. Only around 40% of schemes went into this crisis with a funding level above their statutory level.
Last year, for example, six multi-employer pension plans in the US were terminated and sought assistance from the Pension Benefit Guarantee Corporation, the federal backstop for plans that can no longer provide the promised benefits. The main culprits were either zero-bound rates that inflated liabilities or inadequate contributions or both.
The harsh truth is that the DB pension promise was easy to make but hard to keep. It faces death by a thousand cuts. It's time to rewrite it. That is easier said than done, since the promise is hardwired into members' job contracts. Unless laws are changed, all that scheme sponsors can do is to chip away at the benefits piecemeal.
Across Europe, some schemes have changed the benefit structure: retirement age has been raised, payouts cut and the indexation of benefits made discretionary. Some have sought extra cash injections: both employers and employees have been enjoined to raise their regular contributions, with employers also providing hefty one-off top-ups periodically. Some have restructured the plans: existing members' future benefit accruals have been frozen and new members have been advised to join defined contribution (DC) plans where they bear all the investment risks. Those scheme members approaching retirement have been offered an attractive lump sum in lieu of an annuity, thereby offloading mortality risk, interest rate risk and inflation risk onto them.
As a default option, it is not at all clear why DC plans would succeed while DB plans have struggled, despite their access to the best advice and higher annual contributions. DC plans are neither a comfort blanket nor the only source of certainty.
There has also been a lot of talk about making DB plans less onerous for their sponsors by, for example, linking retirement age to life expectancy and replacing final salary by career average salary in calculating the entitlements. Politicians have shied away from the necessary legislative action for fear of alienating voters. It is unlikely that they will be able to long grass the problem when the full damage from the current crisis becomes clear.
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From the desk of Amin Rajan, CEO, CREATE-Research
The financial meltdown sparked by Covid-19 is yet another nail in the coffin of the final-year salary scheme, where employers bear all retirement risks.
Yields have plunged to record levels and will be kept there for a long time to enable governments to fund their ballooning deficits. Schemes that are unhedged will be the hardest hit. To make matters worse, the asset side of the balance sheet has also seen plummeting values.
The sad truth is that even before the crisis, defined benefit plans worldwide struggled to build up healthy finances even against a background of the longest running bull market in history. Only around 40% of schemes went into this crisis with a funding level above their statutory level.
Last year, for example, six multi-employer pension plans in the US were terminated and sought assistance from the Pension Benefit Guarantee Corporation, the federal backstop for plans that can no longer provide the promised benefits. The main culprits were either zero-bound rates that inflated liabilities or inadequate contributions or both.
The harsh truth is that the DB pension promise was easy to make but hard to keep. It faces death by a thousand cuts. It's time to rewrite it. That is easier said than done, since the promise is hardwired into members' job contracts. Unless laws are changed, all that scheme sponsors can do is to chip away at the benefits piecemeal.
Across Europe, some schemes have changed the benefit structure: retirement age has been raised, payouts cut and the indexation of benefits made discretionary. Some have sought extra cash injections: both employers and employees have been enjoined to raise their regular contributions, with employers also providing hefty one-off top-ups periodically. Some have restructured the plans: existing members' future benefit accruals have been frozen and new members have been advised to join defined contribution (DC) plans where they bear all the investment risks. Those scheme members approaching retirement have been offered an attractive lump sum in lieu of an annuity, thereby offloading mortality risk, interest rate risk and inflation risk onto them.
As a default option, it is not at all clear why DC plans would succeed while DB plans have struggled, despite their access to the best advice and higher annual contributions. DC plans are neither a comfort blanket nor the only source of certainty.
There has also been a lot of talk about making DB plans less onerous for their sponsors by, for example, linking retirement age to life expectancy and replacing final salary by career average salary in calculating the entitlements. Politicians have shied away from the necessary legislative action for fear of alienating voters. It is unlikely that they will be able to long grass the problem when the full damage from the current crisis becomes clear.
